For India, 2021 could be well called the Year of the Unicorns. 15 Indian startups reached the coveted unicorn status in the first half of the year with 9 more joining this club in the latter half. The year saw some record-breaking funding where startups raised $25.7 billion across 774 deals!
The startup boom has almost mainstreamed entrepreneurship in the wake of this funding bonanza. While the conversations revolving around the startup ecosystem veers towards innovative ideas and solving pressing problems, it also becomes clear that those who win the talent wars will be reaping the sweet rewards. Because without talent, there is no innovation.
The value of great ESOP strategies is paramount here. However, there are quite a few questions that emerge when you start developing one. Here are a few crucial questions for startup founders to answer when they plan to implement ESOPs as a part of their value proposition for their employees.
Why should I look at ESOPs?
While it can be tempting to look at ESOPs because a lot of other companies are doing it, peer pressure is never the right reason to take something on.
To answer “why ESOPs?”, founders have to understand the value that an ESOP plan brings to the table.
ESOPs help in displaying commitment towards employees and help them feel invested in the organization’s growth. Important drivers for the ESOP decision are the willingness to dilute shareholding to help employees build wealth, the readiness to sustain the plan over the long run, and the possibility of providing liquidity for the shares.
That apart, it is also important to assess if the employees see the same value in becoming shareholders as the other shareholders. Clear communication thus also becomes an essential component of an ESOP strategy.
For an ESOP strategy to be successful, it has to be implemented professionally, be objective and not subjective, and also completely transparent. The inability to do so can make ESOPs a disadvantage, rather than an advantage.
When should I implement the ESOP strategy? What time is the right time?
The beauty of ESOPs lies in their versatility. They can be implemented by growth or steady stage startups and also by established companies who want to demonstrate greater commitment towards employees.
The most ideal time to roll out an ESOP strategy is prior to some major capital raising events such as placement of Equity with a PE/ VC or strategic investor or before an IPO. Essentially, it has to happen before a market-driven price discovery takes place.
ESOPs can also be implemented when there is some visibility of providing liquidity to employees. The stage the startup is in influences the equity plan. In phase-I which is the initial establishment phase, the plan should be about creating value in the long run. As organizations become more established the equity plan has to function as a mechanism for retention and hence can be utilized more specifically, for example, to hire more specialized skills.
ESOPs can also be employed to reward stellar performance, driving fairness and generating wealth for all. So, while anytime is a good time to look at ESOPs, the earlier you start, the better it is.
What does it take to roll out an ESOP plan?
You cannot make impactful ESOP plans by copying and pasting someone else’s strategy. But when rolling out ESOP plans founders can wonder if they have to dilute their ownership for giving ESOPs. To answer this, founders/Promoters have to ask themselves questions such as how much dilution can they take on, and whom all should the ESOP plans cover.
It is important to evaluate the options at hand that can provide liquidity to the options.
Founders can avoid the dilution aspect by structuring their ESOP plans more adroitly and leveraging options such as cash-settled stock options plans or secondary shares acquired from the secondary market or existing non-promoter shareholders.
Why do I need to make my ESOP plan flexible?
ESOP plans are an ongoing journey and to be successful, the ESOP strategies need to be agile and flexible and capably accommodate the needs of an organization as it grows. If we were to call ESOP a building block of organization success, it is important to remember to create a strategy like a Lego block and not a Rubik’s cube. While both are blocks, a block made out of Lego can be altered in its size and structure while that is not the case in the latter cube.
Thus, founders have to be ready to calibrate ESOP strategies as the organization reaches the growth stage. It is also essential to ensure that the ESOP program remains consistent and the same during the foundation, validation, and growth phase of the startup and keep evaluating how to make the plan better.
How should I allocate ESOPs?
ESOPs act like a lifeline for a startup. As such, it is essential to identify when and how much equity you’re willing to give out. Give away too much equity too soon and you’ll find yourself replenishing the dilution pool often or turning away investors at later stages. Give away too little, and you might not be able to use ESOPs to attract those people who could move the needle for you.
ESOP allocation thus must be done carefully and should ensure that you are utilizing this tool to drive employee loyalty and support.
What kind of backend work goes into the making of a successful ESOP plan?
ESOP plans must be designed keeping the business, industry, and revenue in mind. Startups will have to additionally look into areas such as creating the right vesting schedules and designing and implementing processes that ensure that unvested portions of stock options of employees leaving the company are returned. In fact, as per Indian laws, the unvested stock options generally return in case of resignation.
Making the right technology investments to ensure proper plan administration and connecting all data points related to Planning, Execution, Taxation, and Compliance are important consideration points.
Managing tax calculations and reporting, options valuation, and related disclosures in financial statements (as required under IGAAP, IND AS, IFRS, US GAAP) effortlessly and accurately is also an important area to look into and an essential capability to discuss.
Who is the right person to design ESOP strategies?
Traditionally, startups have gravitated towards tax and accounting personnel to design their ESOP strategies. So, while tax and accounting expertise is essential, it is even more important to look at ESOP professionals who have the knowledge of all the functions like HR, legal, regulatory, finance and corporate (shareholders/investors) and the ESOP implications on them. Even the more significant of all these attributes is the experience/ seasoning of the ESOP professional over a long period.
Along with this, the value of a single-window service and a comprehensive technology platform to handle all aspects related to ESOP design, documentation, roll out, administration and compliance.
As the talent landscape becomes intensely competitive, startups have to ensure that they can attract and retain talents while navigating this through tight budgets. Startups have to make sure that the limited funds they have are allocated and used judiciously. Providing high salaries can sometimes be a challenge. ESOPs then emerge as a powerful tool to attract and retain employees and ensure that they remain invested in the start-up’s growth story. Trust us, we have seen ESOPs at work in hundreds of startups over so many years!