ESOPs – a powerful tool and valuable currency for startups

Employee Stock Options (ESOPs) is a powerful tool available to startups to attract as well as retain talent. However, often I have seen it being undervalued or under-utilised by startups.

ESOPs are shares that are given to employees so that they can enjoy significant monetary benefits if the startup is successful. Since the monetary value of selling equity of a successful startup can be several times higher than the salary, ESOPs alter the risk-reward equation and makes it attractive for potential employees to consider joining a startups, which otherwise at just salary levels may not be such a lucrative option.

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ESOPs are especially useful when startups or early-growth stage companies have to hire senior talent with experience, and they don’t have monies to pay full market salaries.

In fact, investors too encourage founders to carve out an ESOPs pool – often between 5 – 20% of the equity depending on how well balanced the existing founding team is. If the team has gaps that need to be filled in, it is important to carve out a higher percentage of equity, as that will allow you to hire the right resources to complete the team.

As an entrepreneur, it is important for you to communicate the ‘value’ that your enterprise is likely to create and thus explain to potential employees the potential value of the stock they are getting under the ESOP. If the company is successful, the stock can provide a significant upside to employees.

Not just in hiring, but ESOPs can also be a very useful retention tool. That is because a well-structured ESOPs plan ensures that the equity is vested over a period of time (i.e. it is given to the individual in instalments spread over a period of time), and if the startup is successful, the individual is incentivized to stay on even if there is a matching salary offer from another company.

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How much equity should I ask for, from an early stage startup, in lieu of a normal salary?

While there are several approaches available, and a lot will depend on the stage of the startup, status of funding, criticality of your role, etc.

Typically, if your role is critical to the success of the startup, the founders will be willing to give a higher equity in lieu of normal salary. However, if you bring generic skill sets to the team (e.g. social media marketing, sales, coding, etc.) then the percentage of equity will be, understandably lower.

A good way to think about this is to multiply the difference between ‘normal salary’ and what is actually paid by a number that you and the founders feel is right to justify the ‘risk’ associated with the engagement.

E.g. (and these numbers are just for illustration) if your ‘normal’ salary should be $ 10,000 pm, and suppose the startup was giving you $2000, and that this lower salary was to continue for a period of 18 months, then the total salary that you would not get would be $8000 pm X 18 months i.e $144,000. Now, assume that the founders and you agree that you should be compensated in equity worth 3x of the amount that you are foregoing, in which case, you would need to be given $450,000 in equity.

Now comes the tricky part… i.e. of estimating how much equity would be worth $ 450,000 when it is given to you. Here’s where the math changes into art/perceptions/negotiations. Assume that the founders feel that the startup will be valued at $ 45 million, then they would give you 1% equity, whereas if you feel that they would be valued at $4.5 million, you would want 10% equity. Here is where you and the founders would need to agree on the vision, aspiration, potential, etc.

Of course, this conversation will happen only if you are critical to the team… else, you will be given equity in line with the ESOPs policy of the startup.

What happens to the shareholding of a founding team member in case he decides to quit the company?

Ideally, the founder’s shares should vest over a 3-4 year period. This is not just in the interest of the investors, but also protects the entrepreneurs in case one of them decides to leave.

In simple terms, if there is a 3-year vesting period, then every month the promoters get 1/36 part of their equity.

For example, if there are 4-founders, and one of them who has 18% equity decides to leave the startup after 15 months because the venture faces significant challenges, then in a 3-year vesting period clause, the leaving founder will get to keep only 7.5% of his 18% equity, with the rest of the equity now available for the company and the board to offer to another person who may be brought in as a co-founder or at a management level to fill in the gap left by the leaving founder.

In case the equity that has not vested to the leaving promoter is not given to a new person, then in the case of an event like a M&A that equity is distributed to all the remaining shareholders, including the promoters in the proportion of their holding in the company.