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Last Updated : Nov 27, 2017 05:05 PM IST | Source: Moneycontrol.com

ESOPs & sweat equity: A start-up's payout perspective

ESOP is provided with an aim of empowering employees to partner with the financial outcomes of the firm.


Gaurav Barick

Startup companies, in their infant stages, face uncertainty given the macro cum micro operating environment, availability of continuous stream of funds, ability to make a mark with technological innovations and retain manpower. Employee retention and sustaining their motivation levels has been one of the key concerns for the empoyers of startup firms.

In this regard they always come up with one or the other new innovative and attractive compensation packages structured to target highly skilled niche workforce. Employee stock options (ESOP) and sweat equity are considered to be one of the favourite methods of attracting and motivating talent given the companies are illiquid to pay high salaries and need to utilize the freshly infused funds for growing their business.

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ESOP is provided with an aim of empowering employees to partner with the financial outcomes of the firm. Sweat equity, on the other hand, refers to the intangible benefits accrued through non-financial means in the form of employee know-how and niche skills. In certain cases, employers also consider awarding phantom stock options wherein the employees are not exercised to have a direct share of the actual stocks but instead provisioned with synthetic stocks that directly correlate to the financial outcome and well being of the startup firm.

However, employees in the last 2-3 years are inclined towards being compensated in the form of cash incentives and bonuses. In this context, it becomes interesting to find varied thought processes while deciding the benefits both from the employer's and employee's perspective.

Valuation, Success and liquidity are major factors

Arriving at the right reward mechanism in case of a startup firm is a confluence of firm’s valuation, success of the business idea in its sphere of influence and liquidity. Stock options permit employees to gain ownership in the company’s business as well as make the employees responsible for their actions for the rise and fall of its financial condition.

Founders and institutional investors consider stock options or sweat equities as dilution of their shareholding pattern. The first 1-3 years of their existence becomes crucial with infusion of funds at regular intervals forming the key. Hence, planning upfront by understanding the future dilution and allocation of shares (pre and post valuation) forms paramount.

Besides linking the stock option with a crucial funding event or reaching a key milestone in terms of revenue is important. Employers devise this mechanism by offering to employees or directors at a discount rate instead of cash based on their work, value additions provided and intellectual strides made.

The actual allocation amount is wide open to negotiation and will depend upon how passionate the executive sweat equity provider is about owning a piece of a promising enterprise, how critical the executives skill is to advancing the firm’s goals, and the level of trust that builds between the founder and the executive.

In a couple of cases, the employees have a chance of striking gold considering the case of successful startup firms like MakeMyTrip, Facebook or Paytm that started on such a humble note to begin with.

However, in most cases employees perceive such stock options, which are lacking in terms of liquidity. In certain cases the exercise price happens to be on the higher side compared to its face value when vesting the option of converting the stocks into equity.

At times even the stocks face the risk of becoming worthless given the inability of the company to grow anymore. A couple of well-funded start-ups such as AskMe, Zoomo & FranklyMe have failed. Hence, from an employee's point of view, understating the business of the company is very important.

Apart from that it is to be noted that at the time of allotment, the option is taxed in the hands of the employee (the difference between fair market value & exercise price). But, here again, the same question comes that most of the start-ups are unlisted and valuing the unlisted start-ups is always challenging task.

(In most of the cases, it generally happens that the fair market value is determined by the valuer at a very higher price by keeping the future fund raising in mind, but after a few years the start-ups collapse). Hence, as per law, the fair has to be determined by Category I merchant banker registered with the Securities and Exchange Board of India.

Placing a value on a startup venture is much more difficult, subjective and speculative. There are several methods used by financial analysts to estimate the enterprise value: earnings multiples of comparable companies, discounted cash flow (“DCF”), public market value, etc.

These methods are certainly appropriate for mature companies or publicly-traded firms; but are much more challenging to apply to early-stage startups that have not yet generating consistent revenues, much less reliable earnings.

The first actual market valuation benchmark set for a startup company occurs upon receipt of outside equity funding. After determining the value of the firm, the next step is to set the employee contribution towards the company. Here, the best method for determination employee contribution is applying the standard hourly rate. Here again the standard hourly rate can be used in determining the valuation using market the hourly rate or by using foregone wages.

Professional service providers typically have standard hourly rates applicable to the type of project work needed by a startup company. One can also assume that a general market value exists for the time contributed by a co-founder or key manager in the form of the full time salary that could have been earned under a traditional employment arrangement. The most important part of the ESOP and sweat equity from the employee's point of view is uncertainty surrounding the future financial success of a start-up firm, a risk premium is often applied when valuing a provider’s work.

It is not unusual for a provider to negotiate a doubling of standard rates in calculating the value of their contribution that is not compensated in cash.

 Conclusion

Stock option plan/ sweat equity are good plans through corporate rewards stock options to the employees, subject to good execution. In India, from a legal point of view, ESOP valuation is considered for accounting and taxation purposes. Corporates book compensation expense for issuing ESOPs over vesting period based on merchant banker valuation and at the time of exercise, valuations required for calculation of perquisite tax payable by employees.

(Gaurav Barick, is an Investment Banker & Venture Capitalist and is Mentor with Finshore Management Service Limited, a SEBI Registered Merchant Banker. He is reachable at gauravbarick@gmail.com).

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First Published on Nov 27, 2017 05:04 pm

tags #Startup

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