Article: ESOP liquidity: When actions speak louder than words


ESOP liquidity: When actions speak louder than words

A well-organised, generously structured ESOP liquidity programme can facilitate wealth creation opportunities for employees, and in doing so secure their engagement and loyalty to the organisation.
ESOP liquidity: When actions speak louder than words

One of the most-well recorded conflicts in antiquity is Caesar's civil war, fought between Julius Caesar and Gnaeus Pompei between 49 BCE to 45 BCE. When the war began, it was difficult to say who was the better general between the two. While Caesar, in his military career had brought to heel Britain, France and parts of Germany; Pompei, over the same period had humbled the military might of Persia and kings of Turkey. Even in terms of military strength and the number of veteran generals, the two rivals were almost evenly matched. But, as the war culminated in the climactic Battle of Pharsalus, in 48 BCE, it was Caesar who prevailed. It is interesting to ask why? And what all of this has to do with the topic of ESOP liquidity!

You see, at a key point in the battle, when the fight was well balanced between Pompei’s cavalry and Caesar’s footmen, something fundamentally changed. Pompei’s horsemen, facing the heat, decided to turn away from the battle, feeling that they were risking too much for a victory wherein they had little at stake. Caesar’s veterans, who had been rewarded well, with lands and bonuses after each of his victories, decided to stay put. The individual merit of two legends of world history was not a deciding factor in this battle. It was their willingness to share the fruits of their success with their teams. 

This lesson from the Roman civil war becomes pertinent in India’s current start-up zeitgeist, as start-up founders loom large as Roman titans, each with their own cult and mythical founding story, even as the battle for talent reaches uncomfortable levels of heat.  

While having a conversation with an early stage founder, I came across an interesting insight. As a non-tech founder raising seed capital for a start-up in the consumer tech space, potential VCs in the company had indicated that availability of capital would be highly conditional on his ability to get soft commitments from senior engineering and product talent to join him. The only option for him was to set aside a significant chunk of equity in the company aside for Employee Stock Option Plans (ESOPs). His story is not unique. A report by Captable in Q3 2021 showed that salaries for all categories of start-up talent went up by 1.5 -2x in the period between Q1 2020-Q3 2021. For early stage companies, or even late stage firms looking to pivot and expand, hiring mid-career talent within a budget of USD 100K per annum per head has become tough, to say the least. 

The demand for higher compensation, if you consider that India has the third largest number of unicorns and one of the most valuable companies in EdTech, FinTech and SaaS spaces, isn’t unfair if you benchmark the talent to its global peers. The upshot is, for start-ups where there is a yawning gap between the on-paper valuations and actual cash in the bank, increasing your burn rate to hire talent, especially when the future availability of funding is likely to remain tight, doesn’t look like a wise proposition. 

ESOPs are precisely meant to solve such problems - by giving senior and critical talent a sense of ownership and a seat at the table when the company is small, by encouraging them to stick with the firm and delineating a clear path to wealth building. However, this is not how they are perceived at present. 

In a widely read article from 2020, Ritesh Banglani of Stellaris Venture Partners lamented the hidden clauses and complexities that discourage genuine talent from joining start-ups. In that context, it would be useful to discuss some key obstructions here. 

  • If there is limited or no liquidity event during an employee’s tenure with a start-up, they are left with money on paper, and often at the end of the queue as a former employee, when the company does exercise its stock option plans. 

  • A really short window for exercising their ESOP plans, which forces employees to arrange for cash not only to exercise their options, but also to pay the capital gains tax that comes due on it. In any case, one ends up liquidating only a part of their ESOP pool or none at all if urgent cash is not available during the exercise period. 

  • The strike price at which the employees can purchase the options is either too high, or the price at which the company buys back their shares is at a steep discount to its last round, giving the employee little to no visibility on the pricing of their shares. 

  • Finally, even if the employees are able to find a secondary market buyer for their ESOPs, they are often hamstrung at the last step by hidden clawback clauses in their ESOP agreements, where the company could potentially demand that incentives be returned. 

In such circumstances, it is not surprising that talent, especially from established, corporate sectors  and publicly listed companies which has the experience in scaling businesses while being relatively mindful of expenses, remains on the fence about joining the start-up bandwagon. Ergo, ESOPs are still seen, outside of start-up hubs like Bengaluru and Gurgaon, as a distant windfall bonus, with only a modest probability of real wealth creation by many potential employees, than a sure-fire way of sharing wealth while building a company. 

That said, the past year 2021 saw a significant increase in well-organised, supportive start-up buyback programmes run by late stage start-ups in India. As per Entrackr, startups facilitated USD 440 million in ESOP buyback last year, an 8x increase over 2020.

We at Kristal.AI, also rolled out our first ESOP liquidity programme on blockchain. The key idea was to reward the employees who have been the main reason for the tremendous growth of the company in the last 5 years. We plan to conduct this exercise on an annual basis to help employees reap benefits of their hard work and commitment. Since providing a regular ESOP liquidity programme for the employees and raising secondary demand to facilitate the transaction can get complicated, we have designed a solution around ESOP liquidity to help private companies provide an easy and regular liquidity solution to their employees.

We believe that there are several motivating factors behind this phenomenal growth in ESOP buyback programs, some of which are structural in nature. 

  • First, the surge in ESOP buybacks is a reaffirmation of the faith that employees of some of these start-ups have placed in their employer during the COVID period. As much of our daily life went online, the demand for edtech, fintech, ecommerce and gaming related offerings surged. However, given that actual cash flows lagged the demand, start-ups were not able to offer anything but extra ESOPs to their employees to incentivise during this period.

  • Secondly, start-up founders have also begun to bake-in funding for ESOP buyback in their negotiations with venture capitalists. The quid pro quo is that if the term sheet from the investor’s side becomes conditional on hiring top talent, then the VCs should also factor in some money that the firm will have to distribute to its existing and future employees as a part of ESOP buyback programmes. 

When it comes to ESOPs, start-up founders have much to ameliorate to make these options appear as a real path to wealth and a fair opportunity cost for leaving an established job. However, the rush for talent in India’s innovation ecosystem, the growing familiarity of employees, a shift of balance in their favour and institutionalisation of funding for ESOP buybacks in primary fundraises and secondary liquidity programmes should make ESOP plans appear more authentic and become a way for start-ups to burnish their reputation for transparency and inclusion. 

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Topics: ESOPs, #RedrawingEVP

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