Employee Stock Options Article in the ken
The ultimate truth of startup life when it concerns employee stock ownership plans (ESOPs) is that…they don’t matter much. IT services company Infosys and e-commerce giant Flipkart are regarded as “ESOP poster boys” in the industry. But no other company has come close to replacing them in the ESOP hall of fame.
Despite that, ESOPs have emerged as an unlikely tool of leverage among startups and unicorns after the onset of the Covid-19 pandemic. The likes of food delivery company Zomato, scooter rental startup Bounce, e-grocer Grofers, and budget hotel chain OYO are compensating their employees for pay cuts with ESOPs. They’re also being used as a tool to acqui-hire companies on the cheap, said at least two venture capitalists The Ken spoke to.
On average, India’s new economy companies have 5-10% of their equity locked in an ESOP pool. Now, that pool is, almost counterintuitively, set to grow. “[Established] companies are seeing their ESOP pool grow by 25%,” said Neeraj Aggarwal, co-founder of xto10x, a consulting firm that works with multiple startups.
As it is, the value of unexercised ESOPs, or paper money, is staggering. The top 30 unicorns in India record close to US$80 billion in valuation. Almost 10-15% of the valuation of these companies resides in ESOPs, estimates Hari TN, head of human resources at grocery delivery unicorn Bigbasket.
Employees, however, have not been able to realise these gains. ESOPs are the promised land of riches, but one that can be unlocked only when companies go public or get acquired.
The incentive tool that startups have relied on to get the smartest talent ranges from 50% of cash compensation in late-stage companies to 200% in early-stage companies. Still, ESOPs are losing their sheen.
“The whole equity game was at its peak when the understanding of equity was low,” said Anandorup Ghose, partner at consulting services firm Deloitte. “People understand the pitfalls of it better now. So equity as a real differentiator is going down.”
While the rekindled fire for ESOPs isn’t warming up employees, companies and investors see it differently. “Companies are cash-strapped and ESOPs are a non-cash expense,” said an investor who didn’t wish to be identified. “We are replacing the salary with a higher value of equity. If the valuation is currently lower, employees get more shares. So the upside is higher if tides turn. Then, it’s a win-win.”
That upside, though, is a big if. Few companies will cross the Covid chasm, let alone return to earlier valuations. To further accelerate ESOPs’ decline, companies are playing fast and loose with their policies in these pandemic times.
It’s a house of horrors, said Ritesh Banglani, partner at Stellaris Venture Partners. “In several companies, the board can decide whether or not the employee can exercise their vested options. These are options the employee has already earned. They reasonably expect to be able to exercise them freely, especially when they decide to leave the company.”
The wild, wild ESOP vest
In startup lore, there are two diametrically opposite ESOP stories.
In the case of ride-hailing company TaxiForSure*, everyone who had ESOPs, even month-old employees, were allowed to vest their shares and became millionaires when Ola Cabs acquired it in 2015, according to VCs The Ken spoke to.
Then, there is intercity bus aggregator redBus. When it was sold to travel aggregator Ibibo in 2013, only redBus’ three founders walked away with their millions. None of the other 22 employees who had ESOPs were allowed to vest their shares on an accelerated basis. This is usually the expectation when companies head for an IPO or acquisition. Though the clause for accelerated vesting existed in ESOP agreements, it was left to the company’s interpretation.
RedBus is hardly alone. What is happening now is equally egregious.
“I have seen founders unilaterally cancel an employee’s vested options,” said Stellaris’ Banglani, who is putting together a model ESOP policy for his portfolio companies to use. “That is no different from refusing to pay an employee’s promised salary after they have already put in the work.” Banglani did not disclose names but indicated that these include companies that have raised late-stage capital from top VCs.
Companies also have troublesome clauses mandating vested stocks to be exercised in as few as 30 days. For instance, Paytm* has an exercise period of just 30 days. (On an average, the exercise period spans about two years.) That means employees need to pay both the strike price and the tax to get their shares transferred to their Demat account as soon as they resign. After 30 days, their vested options would go back to the company.
“Because of this clause, I’ve had to exercise my shares, and I’m desperately looking for buyers,” said a former Paytm employee who quit in late 2019. “At least I have to recover the tax I paid on this. Paytm shares were being lapped up at Rs 18,000 (US$238) in 2019. Now, I’m not finding buyers even for Rs 8,000 (US$106).” This person paid a tax of Rs 2,600 (US$34.4) per share and wants to hold out till the price recovers.
Investors argue that a company needs the right to cancel vested options if an employee joins a competitor or leaves on a sour note. Their other fear is the prospect of former employees as shareholders who have a right to the company’s information and need to sign off on key documents. Such employees could hold the company hostage over matters that require shareholders’ approval.
The other tactic Banglani has noticed is that companies keep the exercise price very high. Not because they need the money as equity, but often as a way to discourage employees from exercising the options when they quit. If an employee earns Rs 20 lakh annually (US$26,460), she could end up paying as much as Rs 10 lakh (US$13,230) to buy company stock. Not many employees have that kind of cash lying around.
One of the reasons this happens is because founders may value personal loyalty more than an employee’s contribution, said Banglani. “As long as you work for me, you’ll get what is promised. If you leave, all bets are off.”
What companies are not gauging here is the long-term loss of reputation such policies lead to. “Such clauses should not exist in the first place,” added Banglani. “The founder and the board should have no discretion over an employee’s vested ESOP. When there is discretion, there is an incentive [to deny vested ESOPs].”
According to Banglani, there are three cardinal rules that can make ESOPs attractive for employees: a guaranteed exercise of vested options, reasonable exercise price, and no time limit for exercise. The employee should be free to exercise her stock any time until a liquidation event happens.
Flipkart, Bounce, and ad-tech firm InMobi are among the companies that give employees seven to 10 years to hold on to their vested options before they need to exercise it, said Sharat Khurana, chief executive of ZenEquity, a platform that helps companies manage their ESOP programme.
Companies like Bigbasket have a selective approach. If employees quit before four years, they’ll have to exercise the vested options within 90 days of resignation. If they leave after four years, they can hold onto the vested options (which would have vested in full by then) without exercising them till there is a liquidation event or the expiry date of the options (10 years from grant date)—whichever is earlier, said Bigbasket’s Hari.
Liquidation events, though, are far from frequent.
Listing for help
The only ray of hope for employees with exercised shares are companies like wealth management firms and investment banks that aggregate buyers and sellers for shares of unlisted companies.
In the first few months of 2020, queries from startup employees who want to sell their shares have increased over 25% compared to the whole of last year, said Abhishek Ginodia, investment advisor at Abhishek Securities, a popular wealth management firm that helps sell unlisted shares.
But because the unlisted market takes cues from the IPO market, investor interest in these shares has dried up, according to brokers The Ken spoke to. Investors can range from high-net-worth individuals to family offices, to Chinese or American mutual funds.
Even if the former employees find a buyer, they’ll still need the approval of the board, as companies have the first right of refusal. The platform usually helps in doing the paperwork for the approval. This is the step where most trades fail.
Companies like Ola and OYO have tight control over this kind of share sale, as they don’t want competitors or current investors to increase their shareholding. Companies are also wary of the price at which the former employees are willing to sell. “If the price at which the shares trade here are lesser, companies feel it dilutes their reputation,” said Ginodia. As a result, most trades fall by the wayside.
Startup fundraising platform LetsVenture launched a new business vertical, LetsVenture Plus, in May to address this problem. It aims to digitise data in private markets by providing a cap table and ESOP management software, along with a liquidity solution designed for ESOPs. Currently, about 20 startups in India, the US, and Singapore use the management software. The liquidity solution is in the pilot stage.
Something like this could be the relief startup employees need. So far, the only fallback for cashing out has been secondaries, as IPOs and exits via mergers and acquisitions are few and far between.
Secondary blues
Secondaries are celebrated events for employees in startups. Here, investors buy shares from founders, employees, or other angel investors, instead of buying it directly from the company.
In modern times, no Indian company has done this better than Flipkart. After its first secondary in 2013, it had one almost every other year, allowing current and former employees to cash out.
Even though there have been many unicorns after Flipkart, no other company could really follow up on its act of buybacks.
Companies are realising ESOPs mean nothing till they’ve had a secondary to talk about. Series C funded startups like payment gateway Razorpay have had two investor-led buybacks—in 2018 and 2019. And naturally, the scale is small. If Flipkart saw secondaries worth US$100 million, Razorpay’s is around US$2.5 million.
The reason for fewer secondaries, according to VCs, is because no company made it as big as Flipkart.
When investors come for a new round, companies want to use that money to grow the business. For companies to attract investors for secondaries, the stock needs to be much sought after. Companies can see secondary action only when investors are queuing up for stock and are ready to get it in any way possible.
“Flipkart was in a position to tell its investors that, if you want to put US$100 million, set aside another US$10 million for secondaries. Investors were happy to put in more money,” said a former Flipkart executive.
A secondary can happen only when there is more capital than what a company can utilise. This hasn’t happened in the last two years for startups. All of the late-stage companies in India, from Swiggy to Paytm, have been in very high burn mode. Also, the unicorns have more or less struggled to raise money.
As a result, expectations of buyback by startups are misplaced, feel investors. “Companies can buy back ESOPs only in two circumstances: either they are making large profits that they deploy for share buybacks, or there is more capital chasing the stock than the company can reasonably absorb,” said Banglani.
No one is profitable, and most late-stage companies are continually raising capital. In that scenario, it is both an unrealistic and unfair expectation that startups will buy back employee options, he added.
Moreover, investors won’t approve buybacks if they don’t get an exit. “We have been invested for over 8-10 years. So the order of exit is a fund, founder, angel, and only then employees,” said a VC.
Why even Flipkart’s ESOP hot streak eventually ran out of steam. After Walmart acquired over 80% of the company, former employees could not encash all their ESOPs. That leaves over US$200 million worth of unclaimed vested ESOPs in Flipkart. But no former employee has had the appetite to buy them because of tax and cash flow implications, said a source aware of the matter.
For all the millionaires that ESOPs created, there are more that got left behind. Companies will now have to try harder than before to make their ESOP pitches resonate.
*Paytm founder Vijay Shekhar Sharma and TaxiForSure co-founder Aprameya Radhakrishna are investors in The Ken
Despite that, ESOPs have emerged as an unlikely tool of leverage among startups and unicorns after the onset of the Covid-19 pandemic. The likes of food delivery company Zomato, scooter rental startup Bounce, e-grocer Grofers, and budget hotel chain OYO are compensating their employees for pay cuts with ESOPs. They’re also being used as a tool to acqui-hire companies on the cheap, said at least two venture capitalists The Ken spoke to.
On average, India’s new economy companies have 5-10% of their equity locked in an ESOP pool. Now, that pool is, almost counterintuitively, set to grow. “[Established] companies are seeing their ESOP pool grow by 25%,” said Neeraj Aggarwal, co-founder of xto10x, a consulting firm that works with multiple startups.
As it is, the value of unexercised ESOPs, or paper money, is staggering. The top 30 unicorns in India record close to US$80 billion in valuation. Almost 10-15% of the valuation of these companies resides in ESOPs, estimates Hari TN, head of human resources at grocery delivery unicorn Bigbasket.
Employees, however, have not been able to realise these gains. ESOPs are the promised land of riches, but one that can be unlocked only when companies go public or get acquired.
The incentive tool that startups have relied on to get the smartest talent ranges from 50% of cash compensation in late-stage companies to 200% in early-stage companies. Still, ESOPs are losing their sheen.
“The whole equity game was at its peak when the understanding of equity was low,” said Anandorup Ghose, partner at consulting services firm Deloitte. “People understand the pitfalls of it better now. So equity as a real differentiator is going down.”
While the rekindled fire for ESOPs isn’t warming up employees, companies and investors see it differently. “Companies are cash-strapped and ESOPs are a non-cash expense,” said an investor who didn’t wish to be identified. “We are replacing the salary with a higher value of equity. If the valuation is currently lower, employees get more shares. So the upside is higher if tides turn. Then, it’s a win-win.”
That upside, though, is a big if. Few companies will cross the Covid chasm, let alone return to earlier valuations. To further accelerate ESOPs’ decline, companies are playing fast and loose with their policies in these pandemic times.
It’s a house of horrors, said Ritesh Banglani, partner at Stellaris Venture Partners. “In several companies, the board can decide whether or not the employee can exercise their vested options. These are options the employee has already earned. They reasonably expect to be able to exercise them freely, especially when they decide to leave the company.”
The wild, wild ESOP vest
In startup lore, there are two diametrically opposite ESOP stories.
In the case of ride-hailing company TaxiForSure*, everyone who had ESOPs, even month-old employees, were allowed to vest their shares and became millionaires when Ola Cabs acquired it in 2015, according to VCs The Ken spoke to.
Then, there is intercity bus aggregator redBus. When it was sold to travel aggregator Ibibo in 2013, only redBus’ three founders walked away with their millions. None of the other 22 employees who had ESOPs were allowed to vest their shares on an accelerated basis. This is usually the expectation when companies head for an IPO or acquisition. Though the clause for accelerated vesting existed in ESOP agreements, it was left to the company’s interpretation.
RedBus is hardly alone. What is happening now is equally egregious.
“I have seen founders unilaterally cancel an employee’s vested options,” said Stellaris’ Banglani, who is putting together a model ESOP policy for his portfolio companies to use. “That is no different from refusing to pay an employee’s promised salary after they have already put in the work.” Banglani did not disclose names but indicated that these include companies that have raised late-stage capital from top VCs.
Companies also have troublesome clauses mandating vested stocks to be exercised in as few as 30 days. For instance, Paytm* has an exercise period of just 30 days. (On an average, the exercise period spans about two years.) That means employees need to pay both the strike price and the tax to get their shares transferred to their Demat account as soon as they resign. After 30 days, their vested options would go back to the company.
“Because of this clause, I’ve had to exercise my shares, and I’m desperately looking for buyers,” said a former Paytm employee who quit in late 2019. “At least I have to recover the tax I paid on this. Paytm shares were being lapped up at Rs 18,000 (US$238) in 2019. Now, I’m not finding buyers even for Rs 8,000 (US$106).” This person paid a tax of Rs 2,600 (US$34.4) per share and wants to hold out till the price recovers.
Investors argue that a company needs the right to cancel vested options if an employee joins a competitor or leaves on a sour note. Their other fear is the prospect of former employees as shareholders who have a right to the company’s information and need to sign off on key documents. Such employees could hold the company hostage over matters that require shareholders’ approval.
The other tactic Banglani has noticed is that companies keep the exercise price very high. Not because they need the money as equity, but often as a way to discourage employees from exercising the options when they quit. If an employee earns Rs 20 lakh annually (US$26,460), she could end up paying as much as Rs 10 lakh (US$13,230) to buy company stock. Not many employees have that kind of cash lying around.
One of the reasons this happens is because founders may value personal loyalty more than an employee’s contribution, said Banglani. “As long as you work for me, you’ll get what is promised. If you leave, all bets are off.”
What companies are not gauging here is the long-term loss of reputation such policies lead to. “Such clauses should not exist in the first place,” added Banglani. “The founder and the board should have no discretion over an employee’s vested ESOP. When there is discretion, there is an incentive [to deny vested ESOPs].”
According to Banglani, there are three cardinal rules that can make ESOPs attractive for employees: a guaranteed exercise of vested options, reasonable exercise price, and no time limit for exercise. The employee should be free to exercise her stock any time until a liquidation event happens.
Flipkart, Bounce, and ad-tech firm InMobi are among the companies that give employees seven to 10 years to hold on to their vested options before they need to exercise it, said Sharat Khurana, chief executive of ZenEquity, a platform that helps companies manage their ESOP programme.
Companies like Bigbasket have a selective approach. If employees quit before four years, they’ll have to exercise the vested options within 90 days of resignation. If they leave after four years, they can hold onto the vested options (which would have vested in full by then) without exercising them till there is a liquidation event or the expiry date of the options (10 years from grant date)—whichever is earlier, said Bigbasket’s Hari.
Liquidation events, though, are far from frequent.
Listing for help
The only ray of hope for employees with exercised shares are companies like wealth management firms and investment banks that aggregate buyers and sellers for shares of unlisted companies.
In the first few months of 2020, queries from startup employees who want to sell their shares have increased over 25% compared to the whole of last year, said Abhishek Ginodia, investment advisor at Abhishek Securities, a popular wealth management firm that helps sell unlisted shares.
But because the unlisted market takes cues from the IPO market, investor interest in these shares has dried up, according to brokers The Ken spoke to. Investors can range from high-net-worth individuals to family offices, to Chinese or American mutual funds.
Even if the former employees find a buyer, they’ll still need the approval of the board, as companies have the first right of refusal. The platform usually helps in doing the paperwork for the approval. This is the step where most trades fail.
Companies like Ola and OYO have tight control over this kind of share sale, as they don’t want competitors or current investors to increase their shareholding. Companies are also wary of the price at which the former employees are willing to sell. “If the price at which the shares trade here are lesser, companies feel it dilutes their reputation,” said Ginodia. As a result, most trades fall by the wayside.
Startup fundraising platform LetsVenture launched a new business vertical, LetsVenture Plus, in May to address this problem. It aims to digitise data in private markets by providing a cap table and ESOP management software, along with a liquidity solution designed for ESOPs. Currently, about 20 startups in India, the US, and Singapore use the management software. The liquidity solution is in the pilot stage.
Something like this could be the relief startup employees need. So far, the only fallback for cashing out has been secondaries, as IPOs and exits via mergers and acquisitions are few and far between.
Secondary blues
Secondaries are celebrated events for employees in startups. Here, investors buy shares from founders, employees, or other angel investors, instead of buying it directly from the company.
In modern times, no Indian company has done this better than Flipkart. After its first secondary in 2013, it had one almost every other year, allowing current and former employees to cash out.
Even though there have been many unicorns after Flipkart, no other company could really follow up on its act of buybacks.
Companies are realising ESOPs mean nothing till they’ve had a secondary to talk about. Series C funded startups like payment gateway Razorpay have had two investor-led buybacks—in 2018 and 2019. And naturally, the scale is small. If Flipkart saw secondaries worth US$100 million, Razorpay’s is around US$2.5 million.
The reason for fewer secondaries, according to VCs, is because no company made it as big as Flipkart.
When investors come for a new round, companies want to use that money to grow the business. For companies to attract investors for secondaries, the stock needs to be much sought after. Companies can see secondary action only when investors are queuing up for stock and are ready to get it in any way possible.
“Flipkart was in a position to tell its investors that, if you want to put US$100 million, set aside another US$10 million for secondaries. Investors were happy to put in more money,” said a former Flipkart executive.
A secondary can happen only when there is more capital than what a company can utilise. This hasn’t happened in the last two years for startups. All of the late-stage companies in India, from Swiggy to Paytm, have been in very high burn mode. Also, the unicorns have more or less struggled to raise money.
As a result, expectations of buyback by startups are misplaced, feel investors. “Companies can buy back ESOPs only in two circumstances: either they are making large profits that they deploy for share buybacks, or there is more capital chasing the stock than the company can reasonably absorb,” said Banglani.
No one is profitable, and most late-stage companies are continually raising capital. In that scenario, it is both an unrealistic and unfair expectation that startups will buy back employee options, he added.
Moreover, investors won’t approve buybacks if they don’t get an exit. “We have been invested for over 8-10 years. So the order of exit is a fund, founder, angel, and only then employees,” said a VC.
Why even Flipkart’s ESOP hot streak eventually ran out of steam. After Walmart acquired over 80% of the company, former employees could not encash all their ESOPs. That leaves over US$200 million worth of unclaimed vested ESOPs in Flipkart. But no former employee has had the appetite to buy them because of tax and cash flow implications, said a source aware of the matter.
For all the millionaires that ESOPs created, there are more that got left behind. Companies will now have to try harder than before to make their ESOP pitches resonate.
*Paytm founder Vijay Shekhar Sharma and TaxiForSure co-founder Aprameya Radhakrishna are investors in The Ken