The ESOP Complex – Part III

In the final part, the author dwells on how to engage with employees while allotting options and use ESOPs as an incentive to recruit and retain employees.

The ESOP Complex – Part III

Thursday September 17, 2020,

4 min Read

In Part I and II of this series, we covered questions around the right ESOP structure and a framework for granting options. In this part, we will cover a few additional topics like handling the ESOP conversations with employees.

How to handle ESOP conversations with employees?

Every founder evolves her own style. Here are a few pointers. Even with the earliest employees, avoid discussing options in terms of ownership percentages. Employees want to derive their power by knowing the percentage ownership they have.

It has two challenges: one, percentage ownership is a changing number; it will keep going down with every round of equity financing. You don’t want your key employees to worry about their dropping ownership. The second challenge for founders is you cannot possibly offer meaningful percentage points to more than very few employees.

My recommendation is that if you have a valuation benchmark, speak in terms of the value of the options. If you are offering an exercise price of par value, then you should make an argument that you are offering that much value of options at the time of exercise. Now, the employee has to put in four years and grow that value 5-10x for himself. For example, the most recent private financing price is Rs. 5000 per share.

You decide to offer 1,000 options to an employee, you should say to him that you are offering Rs. 50 lacs worth options for which the employee has to pay just Rs. 10,000 while exercising. Of course, the employee has to stay for four years and hopefully in that period the valuation will triple and the price per share will be Rs. 15,000. The value of his options will be Rs. 1.5 Cr.

Conversations should always be around values and not ownerships. Ownership is a zero sum game; the total shareholding has to add up to 100%. Value can grow 

Can ESOPs help me in recruiting talent at lower cash compensation?

The only kind of employees who will take a hit on cash compensation are executives whose basic financial needs are taken care of and are looking for different challenges and in the process, swing for the sides. But I do recommend keeping an eye for such people. They typically tend to be seasoned executives with an appetite for risk. In my limited data set, they have worked out extremely well for the companies and the individuals.

Can I use ESOPs as a way to retain employees?

ESOPs are a great retention tool once both the employee and the firm have realised that they are a good fit. Employee is settled and the firm knows the value the employee brings. A generous option allocation spread over four years is a great way to retain the employee.

If the company has a large exit, then options should result in a large economic outcome for the option holders.

When is a good time to undertake liquidity events for employees? How do you handle unvested options in case of an M&A?

I recommend that founders should strive for employee liquidity before their own liquidity (assuming there is liquidity available). If you are raising $50m or above, consider giving 2-4% liquidity to employees. The immediate thought that comes in is, would employees leave the firm if they get cash?

In a counter intuitive way, it enhances the retention of the employees -- both, for those who tasted equity value creation and for those who are yet to be allotted/vested options.

Handling unvested options at the time of an M&A is tricky. Any money that is available at the time of an exit needs to be split between the shareholders (investors and founders) and option holders.

Like the selective approach for allotting options, I recommend that founders should identify specific people who had a disproportionate impact on the business which is not reflected in the vested options and negotiate with the board/investors for accelerated vesting. The founders are not obligated to do this but they will sleep peacefully if they do so.

In summary:

  • Create a large option pool
  • Allocate options to people who make a difference to the firm -- equity is valuable, preserve it
  • Any time you can trade cash for equity, pay cash
  • Have an employee-friendly policy -- exercise price of par value, 4-year annual vesting schedule and let employees keep vested options beyond their employment period
  • Prioritise employee liquidity over founder liquidity during investor-driven secondary share sales
  • In case of a sale, fight for the employees who made an impact

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)