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The Role of ESOPs in a Startup

Updated: Apr 17

In a roller coaster ride of a start-up, employee retention through thick and thin is extremely critical — especially in today’s market where the focus is on growing fast.

As an entrepreneur or founding team, if you want to add key members, who could be part of the team for the long haul, you have to pay a competitive package to attract and retain them. In order to do so, you basically have two choices:

  1. Infuse fresh cash into your start-up from investors and in the process dilute your ownership in the company. Use that cash to pay salaries which should ideally include performance-linked bonuses.

  2. Issue ESOPs to your employees and thereby give them an incentive to work towards earning those shares (through vesting) and increasing the value of those shares, which in effect increases the value of your start-up.

So, instead of getting ₹X per share by selling shares in your start-up to an investor to pay employees, you can provide the same share capital of ₹X per share to your employees directly.

For companies/employers, few things to keep in mind as you decide on your first ESOP:

  1. If you give them an exercise price close to the ₹X per share, they will be paying for the shares when they exercise and only be earning the premium (the increase in value from today’s stock price to when they sell) that they create while employed with you. Giving ESOPs at face value (typically ₹10) implies that you are also giving them the value created by the team so far along with the above. Design the rest of your ESOP accordingly.

  2. ESOPs are meant to compensate for the reduced salary. They carry real value and it is important that your employee recognizes it and works towards creating that value. Make sure you spend the time to explain to them how it works.

  3. Set your vesting period, schedule, and performance parameters so that the employee earns his or her options relative to his or her contribution.

  4. Don’t get bent over the fact that you will have free riders on your cap table if your employee moves on. Remember that if you designed your ESOP well, by serving the ESOP vesting period they have earned it. So, if and when your employees decide to move on, wish them well on their next endeavor or better still do what InMobi does.

  5. If you want to keep your equity close to you, have the right to be first in line to buy back the employees’ vested ESOPs/shares (at the market price) if they decide to sell.

For Employees, few things to consider when having the conversation around salary package and ESOPs:

  1. Make sure you actually get the ESOPs. Your founders grant ESOPs with a signed ESOP grant letter stating the terms of the ESOP and make sure they or someone competent take the time to explain the agreement to you before signing on the dotted line.

  2. Make sure that you have a sufficiently long exercise period so there is an opportunity to exercise closer to a liquidity event, this is important especially if your exercise price is not a notional face value.

  3. Make sure that the options granted to you immediately vest in the case of a liquidity event or allow you similar rights as your founders — if your founders are looking for some liquidity it is OK for you to look for the same, at least partially.

I believe wealth created through equity earned by working in start-ups is one of the biggest sources of founder seed capital of serial entrepreneurs and angel investments. Would be great to have real numbers on this, anyone at @ianetwork, @NASSCOMStartUps? or the @KauffmanFDN in the US? Would be useful for nations and start-up eco-systems to develop a “Velocity of Entrepreneurial Risk Capital” — Money invested in the Bansals (@_sachinbansal and @rohitkbansal) by angels to the money invested by them as angels.

But, I digress — so, back on topic. To all the founders and start-up teams out there — get cracking on that most awesome solution to that big hairy problem and make sure you pick up your raffle ticket (ESOPs, in case you also lost track) before you get on the ride! Till next time…

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