Despite its appeal, many startup founders think that liquidity generation via ESOPs is highly complicated. These founders believe that ESOPs bring value, but only on paper.
ESOPs help drive employee engagement, improving the company’s performance over the years. Of course, ESOPs are liquid sources in the long run, but in early and growth-stage companies, the primary purpose of ESOPs is to retain and attract employees. But for doing that, the C-Suite needs to understand ESOPs as a whole and develop an ESOP strategy looking at the bigger picture. Founders should educate employees about the value that ESOPs bring to the table and ensure that the company’s ESOP policy and liquidation plans are transparent to everyone who has been granted ESOPs. This will push employees to run the extra mile.
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Customize grants based on the employee’s risk-taking appetite & use FMV as Strike Price
Similar-level employees who join the startup early should be granted more options than those who participate in the growth stage. This is because early-stage employees exemplify belief in the founder’s vision right from the start, and they should be appreciated and rewarded more at the time of an exit.
Consider an employee ‘A’ joins at an early stage, and the FMV of each share is INR 200 at this point. After vesting, if the FMV of each stock exceeds INR 200, ‘A’ will gain an upside. However, if another employee ‘B’ joins the startup two years after ‘A’ had joined, the strike price of ESOPs offered to ‘B’ should be at FMV. If the FMV is INR 300, ‘B’ should be granted ESOPs at a strike price of INR 300. This is because ‘A’ has taken a much greater risk than ‘B’ and should, therefore, be able to make more money out of equity shares. But, if the strike prices are equal for every employee, early-stage employees should be granted more options.
Also, founders must understand that employees who join at a lesser remuneration or take a pay cut while joining look forward to making up the money through ESOPs. These employees understand how long it may take for equity shares to liquidate, and nonetheless, are taking the risk. Therefore, they should be granted the privilege to make more money out of ESOPs.
Offer ESOPs face-to-face as a preamble (and not on e-mail)
ESOPs hold great value in a startup employee’s career. Because they are complex, founders or HRs should sit down with employees and offer ESOPs in a face-to-face discussion. The management should explain the ESOP scheme document & tax implications related to exercising and selling ESOPs. It should be evident in the employees’ minds that ESOPs are not just money on paper. Employees should be briefed about the business’s KPIs and the business’s roadmap 4-5 years down the line. They should also be presented with an approximation of the stock price when the vesting period ends and the estimated wealth they can create after liquidating the granted options. This process will educate employees about ESOPs and encapsulate them firmly with the organizational vision and roadmap.
Therefore, founders or senior management must answer all questions, deal with the skepticism, and communicate a value proposition to employees.
Make subtle adjustments to the size of the ESOP pool.
The ESOP pool size should be directly proportional to the people and management skills of the founder. Some founders build businesses from scratch with a 5% pool, and there are ones who allocate a 25% ESOP pool in the early stage itself. There is no particular benchmark based on which startups should build their ESOP pool. The allocation can be anything depending on the company’s market position, investment stage, and other factors.
However, it is advised that founders should not dilute the ESOP pool when the VC comes in with the investment. Doing this, they would dilute everything on their part and have a lesser stake than the VC. Instead, founders should wait for the next fundraise to dilute the ESOP pool and partner with the VC. Both VCs and founders should share the dilution of the ESOP pool.
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