The art of a good unicorn | The losing allure of ESOPs in a downturn
For startups, the employee stock ownership plan (ESOP) uses stock-based compensation to fill the void of sufficient pay. However, with the rupee at an all-time low and share prices plummeting, these golden handcuffs may be unshackling
What do you do when you have a really cool idea for a startup and have a strategy for success? Your incredible idea needs a really smart and talented labour pool to execute that idea. But, how do you get the crème de la crème to help you build that dream, when you know you can’t pay them the market rate? Forget getting the best of the best, how do you get top talent to be incentivised to stick around to construct something glorious when you can’t pay them what bigwigs and competitors are paying? Well, you go the ESOP way: The Employee Stock Ownership Plan.
Flipkart had one of the biggest ESOP buybacks worth $80.5 million. Other companies include Browserstack, Swiggy, upGrad, Zerodha, Razorpay, CoinSwitch, CRED and more. (Shutterstock)
India Inc has bred a robust startup ecosystem that has fuelled the country’s economic growth. With the limited resources of startups, there needed to be a smart hiring strategy for attracting talent. That strategy was giving prospective employees some skin in the game.
Substantial equity packages may be enticing in lieu of a tangible cash salary. You use stock-based compensation to fill the void of sufficient take-home pay. Stock options make job offers competitive, allowing early workers to participate in the future success of the venture. Fledgling businesses get stakeholders in the form of early employees, who are invested in its growth and whose productivity is boosted. Low-level workers could potentially become millionaires and get rewarded for their efforts by growing their ability to create wealth. It locks in a long-term retention strategy of determined workers. And employees, eager to get in on the ground floor of the next Meta or the next Reliance so that they can reap the financial windfalls later, embrace the idea.
So, when the startup has a liquidity event, be it an IPO, acquisition or merger, employees know exactly how the venture has grown and how much wealth they’re creating. There’s a collective sense of achievement that also improves the morale of employees who believe in the company, even more, breeding an entrepreneurial mindset.
And why not? After all, startups have been having a ball of a time with their unprecedented growth, especially after the Covid-19 pandemic. Join the club early and you get a nice chunk of change later on. The risk of joining a budding venture becomes kind of neutralised. The party was so exhilarating that Indian companies spent about ₹2,500 crores to ₹3,000 crore to buy back ESOPs during the pandemic.
Think about some notable ESOPs in Indian company culture in 2021. Flipkart had one of the biggest ESOP buybacks worth $80.5 million. Other companies include Browserstack, Swiggy, upGrad, Zerodha, Razorpay, CoinSwitch, CRED and more. There were even ESOP variants. Unacademy had TSOPs for its teachers. Urban Company launched PSOPs (P=partner) for its gig workforce. BharatPe launched the Merchant Shareholding Programme (MSP) for its merchant partners.
However, the “any-dream-will-do” phenomenon may be losing its sheen. These golden handcuffs may be getting unshackled. Share prices are plummeting, rendering employees to learn a harsh lesson about the real world: It’s just not that simple. The stock market can be just as punitive as it is rewarding. With the Indian stock market taking a beating, the pot of gold at the end of the rainbow may be becoming a distant dream.
Let's set the stage for what's happening. The rupee is at an all-time low at $1= ₹80. The Reserve Bank of India (RBI) may be forced to increase interest rates and the decline in currency may make inflation worse than before. That means VC funds would be drying up, the brunt of which would be on the Indian startups. All in all, that means doling out more equity during rounds, smaller valuations and the pressure to be even more profitable earlier than expected. That spells a chaotic job market with startups scrambling. The layoffs and resignations aren’t helping either. They’d have to leave for other companies or startups and start from scratch with a fresh salary and new equity. Even existing employees may end up ruminating: is there an upside left with the startup I'm working for?
Free money was flooding into private startups and feeling profligate, they seemed to be offering both stock and cash salaries. There may be hangover regret now and the possibility of down rounds in the future.
To be fair, can employers really help in the midst of the downturn? Share prices are declining, why would founders do anything to dilute stocks and irk investors? If they issue more options or change ESOPs, they’d also have to deal with wild fluctuations in the stock market. One possible way for them to go is issuing one-time cash bonuses; although it may cut into profits, it may seem like a way to help employees navigate during turbulent times. But then, what do you do about existing ESOPs?
Startups were driving at breakneck speed in 2020 and 2021, generating opportunities at an unprecedented pace. And while the idea of ESOPs might sound appealing, many challenges are embedded in the premise. Founders need to understand how they can structure effective ESOPs and dive deeper into figuring out the ESOP game. A report by Saison states that ESOP pools tend to be stagnant because there aren’t top-up and buyback programmes held, even if founders understand ESOP vesting schedules. Around 60% of the surveyed entrepreneurs said they didn't really get top-ups and about 50% remarked that they didn't understand buybacks. They may not even understand how to convert ESOPs into cash through buybacks. People also need to understand their audit and accounting ramifications; it’s not just free future money, the valuation of ESOP changes with the valuation of a venture.
So, it’s important for everyone to dig deep into the framework of ESOPs and what they entail. Founders need to balance rewarding employees for their contribution with choosing suitable vesting periods. With stakeholder capitalism in the spotlight, ESOP holders ought to be fairly compensated. There may also need to be robust education programmes for employees to figure out the fine print of ESOPs, so they know where they stand and how they can contribute to the startup’s success.
India has emerged as the business hub for startups, especially after the pandemic. Ventures need their employees. And employees need money at a time when there's inflation, a looming recession, a pandemic, geopolitical crises and more. The relationship between a startup and its employees now could determine whether each could make it or break it in the future. Here is a way to align the incentives of founders, employees, and investors in the long term. In a world rife with possibilities, your options are limited.
Shrija Agrawal is a business journalist who has covered startups and private capital markets before it was considered cool in India
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