Why should I consider ESOPs?

As a startup employee, do you constantly discuss ESOPs with your colleagues and still walk away with more questions than answers? Have you made urgent calls to your friends when offered equity during salary negotiations? Are you still confused about your overall compensation, the balance between cash and equity, and their significant tradeoffs?

If your answer to any of the above questions is YES, then we are here to help. Even as the global startup ecosystem continues to evolve, there is a lack of awareness about equity compensation– its risks and rewards.

We have repeatedly seen reports of a startup turning their employees into millionaires by offering a piece of the company’s equity in options in their early days. For instance, Swiggy, Razorpay, PineLabs, and Rebel Foods are among the significant Indian startups that opted for ESOP buybacks in 2022.

And it’s not just in India. Globally there has been massive wealth generation with liquidity events like IPO for startup employees. For instance, in the case of Facebook, the first 3,000 employees of Facebook made roughly $23 billion at the time the company went public thanks to a variety of equity compensation schemes. More recently, Airbnb announced a $2.5 billion buyback plan, and Snap announced a $500 million share repurchase plan.

However, it’s not a smooth ride to the top. And we are here to help employees understand equity compensation from scratch.

In this series, Employee Lens, we will explore various aspects of owning equity in a startup as an employee, and everything it entails, from taxes to vesting schedules to transfer and exercise rules in case of resignation & other termination scenarios, and more.

In the first part, we will understand why equity compensation in its most popular form, ESOPs, is something you can consider as part of your annual compensation package. So let's dive right in.

What is Equity Compensation?

Equity compensation is fundamentally a non-cash incentive offered to employees as ownership in the company. It is seen as a reward to employees for their long-term association with the company, thus, acting as a great talent acquisition and retention method.

This type of compensation is typically offered to key employees, executives, or directors of a company to align their interests with its shareholders. Usually, when an early-stage startup hires a key talent, for instance, the head of product or engineering, they offer equity in exchange for not matching the current market compensation of the role.

Working at a startup comes at the cost of long hours, lower pay and higher stress with high ownership. Thus, the company promises a reward in terms of equity compensation which is redeemed when and if it succeeds and offers liquidity to the employees.

However, this liquidity may come in various forms– it can come via IPO, acquisition, merger, company buyback, or secondary opportunities from incoming investors during a new round of funding. Since the above liquidity opportunities depend on various external factors and market conditions, it’s safe to say that equity-based compensation is not a guaranteed reward.

The most commonly adopted equity compensation plans are Restricted Stock Units (RSU), Stock Appreciation Rights (SAR), and Employee Stock Option Plans (ESOP).

What is an ESOP?

ESOPs are rights granted to the employees to purchase the company's equity shares at a predetermined discounted price on a predetermined future date. ESOPs are granted out of an ESOP Pool, which the company's board must approve.

Who gets an ESOP?

During the company's initial days, generally, before the first employees are hired, a number of shares are reserved for an employee option pool (or option pool). A typical size for the option pool in the total stock pool can go from 5%-10% in the early days to 20-25% later.

Once the options pool is established, the company grants options to employees as they join. As the company grows, it may selectively offer options during its bi-annual or annual performance appraisal processes. These options reward employees who have made significant contributions and are willing to go the extra mile for the company.

Do I directly get equity in the company?

As an employee, you are given the option to buy the shares of your company, referred to as ‘granted’ options. An option is a right, but not the obligation, to buy a promised number of company shares at a pre-determined price, usually lesser than the market value.

You become eligible to exercise 100% of your options and thereby own company stock over a period of time referred to as the ‘vesting period’. The number of years over which your options vest is decided by the company's founders and board members. The most common vesting period is four years and has a one-year ‘cliff’.

During the cliff period, no options get vested. Hence, it is also important to remember that if an employee leaves before the cliff period, they lose all the promised options.

After the cliff period ends, the options allocated during that cliff period become yours, and then the vesting schedule is followed as specified (usually monthly, quarterly, or biannually).

I have vested all my options. Now what?

Once your vesting period gets over, you end up owning all of the options, which are the right to buy company shares. This is the point when you get to own the actual shares of the company and land up on the company’s cap table as a direct stakeholder.

When you decide to buy the shares, that's called ‘exercising’ your options. The price per share you pay to exercise your options is the strike or exercise price, which is pre-decided and mentioned in your Grant Letter. You also incur income tax on the profits yielded along with the strike price.

When do I make the money?

Before delving into how and when of monetising your startup equity, it is important to remember that ESOPs are highly illiquid assets. This means that it is not in the control of an employee, ranging from exercising to vesting to liquidation.

On a broad level, publicly listed company employee can exercise their ESOPs by trading in the stock market if certain conditions are met. We will discuss this in detail in the upcoming blogs.

As a private company, an employee has to wait for the company to introduce a liquidity event - by going public, issuing an ESOP buyback program, or other scenarios that we will cover in the upcoming blogs.

Can ESOP help generate substantial wealth?

There is no one size fits all answer to this question. Owning a startup’s equity comes with its own rewards and risks.

You cannot predict your company's growth and valuation assigned during a liquidation event, nor can you be sure if you will profit from ESOPs. However, in most cases, liquidity events happen only when there’s an uptick in the company’s share price, thereby ensuring a decent profit percentage against the exercise price originally offered to the employees.

But there are enough examples in the startup ecosystem where ESOPs have helped create a fortune for thousands of employees.

One of the biggest paydays came in 2018 when Indian e-commerce company Flipkart was acquired by global retailer Walmart and allowed its employees $800 million worth of ESOP buyback. In 2021, $400 million worth of ESOPs were repurchased by Indian startups, as per a report by Nasscom and consultancy firm Zinnov.

According to the latest S&P Global Market Intelligence data, in 2022, public companies worldwide bought back $1.661 trillion of their own shares, up from 2020 when companies bought back $825 billion in stock.

Note: If somebody (including company executives) claims that they know how a company's stock will perform, take it with a pinch of salt and do your own homework.

Thanks for reading till the end; this is a great start to building your ESOP knowledge. In the next blog, we will break down the basics of ESOPs you should understand and consider when making them a part of your compensation package. Stay tuned!