ESOPs were once the rage in startups. Not anymore

By these accounts, ESOPs should dominate the conversation at a time when startups, like the larger economy, have taken a beating due to the coronavirus outbreak and the lockdown.

But in India ESOPs have confounded employees and are a cause of frustration for founders who have found only limited use for them.

“It has not helped with hiring at all. We offer ESOPs to senior management in addition to a market level salary because many people still don't see the value. If we don't offer, they don’t even ask,” said the founder of a leading consumer brand, requesting anonymity.

From a founder’s point of view, ESOPs are a key hiring tool to attract the best talent without having to pay fat salaries like a multinational firm. They are crucial in the early stages when a startup may not be well funded. 

For employees, these are meant to align incentives and work by giving them a stake in the company.

Employees are unconvinced because they haven’t seen enough people cashing out. 

Barring some acquisitions and secondary sales, it takes longer for investors to make returns from Indian startups than most other countries.

"ESOPs are valuable if there is a precedence, where people have made money. It all depends on the credibility of the organisation and how employee-friendly it has been in the short to the medium term," said a person requesting anonymity.

"The early-stage startup I worked with crashed just after a few years. After that, I joined a unicorn. However, I left the company before a decent chunk of my ESOPs could be vested.” 

Back to ESOPs?

As companies conserve cash to survive in an uncertain economic climate, ESOPs become all the more important as founders prefer giving out shares than money.

“Now companies have started making larger ESOP pools. They are thinking of it far earlier, at a pre-Series A level, which was unheard of earlier,” said Sanjay Khan Nagra, partner at law firm Khaitan and Co.

While ESOP pools have generally been 10 percent of a company’s shares, lawyers and founders are pushing it to 15-20 percent. 

But problems remain. ESOPs vest for about four years after which they become fully valid for redemption. But even then, founders hold lop-sided rights. Some may get rich but not everyone is lucky. 

Over the last two months, India’s startups--from billion-dollar companies to year-old firms, have laid off more than 10,000 people, according to a Moneycontrol analysis. All these employees saw their ESOPs terminated overnight, for no fault of theirs.

Most of these agreements explicitly say that the founder has the absolute right to decide the fate of ESOPs. If an employee leaves for any reason, voluntary or involuntary, the shares stand cancelled, a document seen by Moneycontrol says. 

“There is possibly an ethical issue with terminating ESOPs during layoffs but these calls get taken in the apparent greater good, which is the company’s survival,” said Nagra of Khaitan.

Lawyers also say if they draft 15 agreements for 15 companies, each will have 15 different specifications. There are no standard norms, unlike in the US or China. This creates a further potential for unfair treatment of employees.

Moreover, employees hold ordinary shares and not the preferential ones, which founders or investors have. The value of these can erode quickly.

"The price at which stock options can be exercised (the strike price) is very important. The strike price varies from situation to situation and could be as low as the face value of the shares," said Karan Kalra, founder of Bombay Law Chambers, an advisory firm.

“When stock options are given in lieu of salary, typically the strike price is the ‘then prevailing market value’ of the shares. However, these days when the situation is tough, we’re seeing stock options being granted at much lower prices as well.”

In the current environment where ESOPs are often a balm for salary cuts, a senior industry executive said that these were just “feel good” ESOPs.

“The real value will emerge only in the long term. Besides, ESOPs as a part of the salary is mostly a good deal only when it comes over and above your lifestyle cost else it is far riskier,” another lawyer added.

While ESOPs are a long-term tool and meant to make holders richer, the uncertainty prevailing in India diminishes their value.

Employees, too, tend to value cash over stocks during uncertain times. “People are not using ESOP options as much as one would expect. Shares are further diluted because of down rounds, so ESOPs become tougher,” said Nagra.

A down round is when a startup raises funds at a lower valuation, giving out more shares for the same or less amount of money.

Some employees may not want shares but many times, candidates are not even aware of such an option, indicating ESOPs have not gone mainstream yet.

“Most people joining have a very poor understanding of what valuation you are getting shares at, what could be the upside, so just education of this option is also badly needed,” said Chaitanya Ramalingegowda, co-founder of online mattress retailer Wakefit.

Startups were not pushing hard enough for ESOPs, he said. They were either busy struggling to find funds or if they were well capitalised, they were looking to buy back the next round but ESOPs were not a priority, Ramalingegowda said.

Employees and investors remain unsure of the potential of ESOPs, with many lawyers asking for staff to have more rights, to make the stock option more mainstream and a wealth creation tool.

In the last one month, Zomato, Oyo and Grofers are among the companies to have offered ESOPs to those who have been furloughed or have taken a salary cut. 

The budget hotel chain Oyo said all its employees would be shareholders in the company. It announced an $18-million pool for the furloughed employees and also dropped the one-year cliff on the vesting of stock options. The cliff meant that 25 percent of the shares would have been vested on completing a year after which they would vest every month. 

Zomato, on the other hand, said it would offer ESOPs double the worth of salary cuts to the employees.