An ESOP or Employee Stock Option is distributed to the company’s employees in the form of stock options. The structure of an ESOP plan can range from simple to complex and, while an opportunity to become owners of the company you work for is always an attractive proposition, it is important to understand how ESOPs actually work.
Let me take you through what is known as ESOP Life Cycle through the example of a person — let’s call him Raghav — and the company he works for — let’s name it Netceptor Technologies.
Raghav joined Netceptor in 2017 when it was an early stage startup, and his contribution has helped the company grow. In 2018, the Netceptor board decides to reward its staffers through a new scheme called ‘ESOP-01-2018’.
On the first day of FY 2018, Raghav receives a copy of the ESOP scheme, along with a grant letter. The letter states that he has been granted stock options to buy upto 800 equity shares of the company at an exercise price of $25 per share, discounted from the current market price of $62 for per share. The ESOPs vest quarterly over a vesting period (the minimum period that the employee has to serve to be entitled to the stock option) of four years. This means that part of Raghav’s 800 ESOPs will vest (i.e. become available to exercise) every quarter, and at the end of four years all 800 of the ESOPs will be available for Raghav to exercise. The caveat is that there is a cliff period of one year (a cliff is when the first portion of an option grant vests). Which means Raghav has to work with Netceptor for at least a year more before a part of his granted options start vesting and he is able to exercise them. The ESOPs have an exercise period (the period post vesting, during which the employee can exercise an option to buy the shares) of ten years. Our man continues working for Netceptor for the next two years, and receives further such option grants in 2019 and 2020.
In 2020, Raghav decides to take stock of all his ESOPs and find out how much he has accumulated in the last three years.
Raghav logs into his TOPPEQ stock connect account, which displays vital and relevant information related to his ESOPs, including critical dates and time periods. More specifically, a detailed vesting schedule helps him get an idea of how many options he would stand to gain in the coming years as well as when he would be able to exercise them. But let’s get to the specifics now.
Across three schemes, Raghav has been granted ESOPs to buy 3,440 shares, of which he has already purchased 300 shares. He can currently purchase shares worth $81,375 for only $15,000. If Raghav continues to work with his company (which he co-owns now) until the completion of the vesting period for all his ESOPs, he is likely to exercise grants worth $5,33,200 at the Netceptor’s current share price of $155 per share.
While going through the details of the scheme on his Toppeq dashboard, Raghav remembers his teammate, Anurag, who left the organisation after having spent a year and half with Netceptor. This was the period in which the company’s valuation had gone up, and Netceptor’s share price had leapt from $62 to $155. If Anurag had understood the value of stock options, especially in the long run, maybe he would have stayed back. Anurag could never get the hang of the entire process or track the key dates and events related to Netceptor’s ESOPs, and his option expired before he could utilise them.
Raghav is happy and plans to use the rewards to meet some of his financial commitments, including repaying the outstanding amount of his housing loan. He decides to exercise his 525 vested options by paying the required exercise price. This converts the vested options into shares. He is then able to sell these shares to a strategic
investor at the market price.
Transaction and Holding statement
Raghav is glad that he is set to be debt-free, and also happy that he has a stock account that has not only helped him understand the ESOP Cycle but also allows him to monitor each event and corporate action in a timely manner and attain his financial goals in a prudent manner.
It is not the best of times for startups in India. If 2019 saw them raise a massive $14.5 billion, 2020 has turned out to be a nasty curve ball, thanks to the COVID-19 pandemic. According to the tech-industry-focused publisher, TechCrunch, several global and local private equity and venture capital firms have “cautioned that the current changes to the macro environment could make it difficult for a startup to close their next fundraising deal.”
A down round, in which the pre-money valuation is lower than the post-money, could be on the cards for many startups. A startup is usually faced with a down round when it does not meet investor expectations, or is particularly vulnerable after burning up its cash. The COVID-19 pandemic, though, has put even startups that are delivering on their metrics on a sticky wicket.
A down round can be extremely disheartening for the equity shareholders and particularly, founders, who run the risk of significant dilution in their stake. However, it’s important to acknowledge that like ups and downs in life, this, too, shall pass and the future could be much brighter than you anticipate! All you need is a solid plan to navigate through these unprecedented times.
An obvious way to avoid a down round is cost-cutting, or, if the cash flow problem is temporary, bridge financing, in the form of a short-term loan, can be helpful. But what should a firm do when the dreaded down round hits home? Here’s a quick guide to surviving a down round.
Go back to the basics. Critically analyze reasons for underperformance and how you would address it. Be true to yourself.
Take bold steps. And don’t shy away from correcting your course. Seek professional help where you see roadblocks or don’t have a clear direction.
Adapt to advance. The way we operate is set to change significantly. Adjust your plans to emerging needs.
Manage your cash wisely. Regularly assess the health of your company by reviewing not only the balance sheet and income statements, but also by keeping a close eye on the cash flow statement. There are several tools and ratios to analyze if you are operating efficiently or not. Leverage them.
Stay on top of agreements for better negotiations: Know the rights of each shareholder in the company. Though most shareholder agreements provide for an anti-dilution clause, remember that it is an “option” given to protect investor rights. Hence, you do stand a chance to convince your existing investors to relinquish the same, in light of the extraordinary situation we are in. You can do this by highlighting the impact of COVID-19 where possible, along with presenting a sound and realistic workaround plan.
Maintain transparency. Keep communication channels open within your firm and with your employees.
The silver lining is that people still trust you and, hence, are willing to invest in your company during these unpredictable times. Move ahead confidently to realise your dreams.
In the start-up world, ownership in the company is one of the most important things. And a cap table is the bible that people swear by. Most investing decisions are taken based on shareholding on a fully diluted basis (FDB); hence it is important that we get this number right. One could end up having an inaccurate cap table on FDB due to several reasons – conversion ratios incorrectly applied, errors in tracking ESOPs, an anti-dilution event, and so on. Let’s discuss these in more detail
- Errors on converting a convertible instrument to equity: When convertible instruments are issued and the conversion ratios vary depending on certain events, it is easy to make mistakes. One could end up using an incorrect conversion ratio or miss out a trigger event that needs a recalculation.
- Version issues with Excel: Using Excel spreadsheets can cause version control issues, resulting in high risk of errors. Also, when complexity sets in, it is hard to keep a manual track.
- Misinterpretation of clauses: Reading through legal language in agreements is not everyone’s cup of tea. There could be misinterpretation of clauses due to lack of familiarity with legal jargon, resulting in inaccurate cap table.
- Missing audit trail for employee plans: If ESOPs are granted, it is extremely important to track each employee plan independently and make sure that the entire trail of vesting and exercising is maintained. Any error in mixing up the plans can result in significant tax issues.
- Errors on exit of an employee: If employees exit the organization, the unvested ESOPs need to be expired and the cap table has to be updated. If this is not done, the company may end up paying an ex-employee more than what he is eligible for and also show an incorrect shareholding percentage.
- Lack of control on vesting schedule: Unless you have a robust vesting schedule across plans and a strong mechanism to track options that can be exercised, employees may exercise more options that what’s due to them.
To summarise, to avoid any cap table related issues, make sure you understand every instrument type and the attached covenants clearly; you have a systematic way to track your employee rewards; and a process in place to keep your cap table updated. It makes sense to seek professional help or use software applications to have a clean and accurate cap table right from the outset.
Buyback is a commonly used instrument in both public and private markets for a variety of reasons. In simple terms, it refers to the repurchasing of own shares by a company. It is the opposite of raising funds, which results in the dilution of equity. Let’s now take a look at why companies chose to go in for a buyback and the impact it has on the company.
Purpose of buyback: A buyback is conducted essentially to either: consolidate stake in a company; provide an exit route to shareholders/founders/employees; increase shareholder wealth, or leverage available cash when there aren’t other attractive avenues to deploy it.
Outcome of buyback: Number of outstanding shares decreases; ownership of continuing shareholders increases; an increase in the Earnings Per Share results in an increase in shareholders’ wealth; and a reduction in cash balance.
The impact of the buyback of shares on the shareholding pattern can be significant. In the context of buyback by a private company, every shareholder is keen to know the effect of buyback on his ownership.
With Topper, founders and investors can track the entire cap table journey, including buybacks, through user-friendly dashboards.
Buyback on your dashboard
1. In the above example, two entrepreneurs — let’s call them Anil Sharma and Rahul Naik — founded a company by shelling out Rs 5 lakh each in April 2015.
2. They went on to raise Rs 2.43 crores in their angel round by raising additional equity. This diluted their share by 9.5% each.
3. Later, in 2019, Anil Sharma decided to exit the company. The company repurchased its shares, which led to an increase in the ownership percentage of each shareholder.
Buybacks are an important aspect of a company’s cap table and essential for analyzing future investment decisions in the company. Having the entire transaction on a dashboard helps founders and investors review the details of a buyback and ensure compliance.