Sometime ago, I sat down and wrote down a letter to our employees trying to explain what exactly it means to own stock options in a startup. Context is that from my practical experience of talking to hundreds of startup employees, ESOPs are one of the least understood and most under-appreciated aspect of startups here in India.
So here goes (with some minor edits):
I am really happy to welcome you as a co-owner of Akosha. It is both a recognition of your efforts and a huge responsibility.
First, let’s get the basics out of the way.
1. If you are not familiar with ESOPs or venture capital, please watch video recording of my talk on venture capital (internal link), because without understanding capital appreciation, you may find it difficult to grasp the value of getting ESOPs.
2. There was a traditional thought process that employees shouldn’t really value stock options. The reason for that is that all the way till 2011-12, apart from a few success stories like Infosys etc., people hadn’t really seen meaningful wealth creation for employees. All this has changed forever in the last 2-3 years and in the coming years (unless we hit a bust), we are likely to see a lot of wealth creation for founders and early employee-stakeholders. That is also the reason why you will find that most senior management folks value stock compensation while sometimes junior employees can be lazy in understanding them or risk averse towards them.
3. ESOP creation is more complicated than it seems. There are 4-5 ways of structuring (equity/preferred, stock appreciation plan / options etc), changes in the new Companies Act and lots of different tax rules applicable on employees and the company, decisions regarding acquisition, winding up or the company or IPO etc. Here are some of the things we kept in mind while creating it:
– we need to keep it as simple as possible for everyone
– the plan should be fair to employees, the company and any potential acquirer
– the plan should ensure that under no circumstances can one person’s behaviour impact the overall exit for rest of the company and employees
– we need to ensure that overall unfairness should not be there (i.e. handle cases of death, unethical conduct, illness etc.)
– any tax liability should only come when there is a corresponding cash event for a person (i.e. you should not have to pay real cash in tax unless the upside of the stock is also in cash).
4. The exact ESOP options granted to each employee is a subjective determination by the senior team. While deciding this we looked at your experience, performance, current market salary, market adjustments, your alignment with the company’s goals, your thinking/flexibility, attitude etc. Every time, we’ve tried our best to be fair and reasonable and generous.
Here are some of questions that people are likely to ask around ESOPs:
1. What is a stock option?
A stock option is a share in the company. As the value of the company increases, the value of the shares of the company increases. A stock is granted by the company by issuing a grant letter.
2. What is the vesting period?
Stock options are granted over a period of 4 years with a 1 year cliff (which means that if you leave before the end of the first year, you don’t get any stock). Post the end of one year, the stock options vest 25% each year till the end of year 4. The vesting happens monthly. In many companies the vesting happens 10%, 20%, 30% and 40% over 4 years. We went with 25% yearly. This applicable for the current grants but might change in the future.
3. What is the exercise price?
To keep things simple and give the maximum value to you, we have kept the exercise price at Rs.X per stock option. It is the price will be adjusted against any sales proceeds at the time of sale of your shares to an acquirer or during an IPO.
4. What happens to my stock options in case I leave the company?
All stock options which are vested will remain with you. All stock options which are unvested will lapse. You will not be required to exercise any of these options at the time of leaving, unless the context otherwise requires.
5. How did you calculate the number of options in my case?
Whatever amount of ESOPs was promised to you during your discussion with your reporting manager, we simply divided it by the valuation of the company as specified to you on that date. Then we calculated the number of ESOPs.
Let’s say, hypothetically, a company has 10000 shares and the total value of the company is Rs.10,00,00,000 (Rs.10 crores). If you are promised ESOPs worth Rs.1 lakhs, you will get 10 options.
Different people are granted ESOPs at different stages depending on context, performance, when they joined etc. The earlier you are part of the company, the better the outcomes for you.
6. That’s okay, but the number of options sounds really low. My friend got XXXX options!
Yeah, we spoke to our consultants. One of the things that a lot of companies do to make the options look more meaningful is to simply do a share split (i.e. split a Rs.10 share into 10 shares of Rs.1 each) and then issue the options. Materially it doesn’t change anything.
So in the above example, let’s assume that the company is worth Rs.10 crore but the number of shares in the company were 10,00,000 (i.e. 10 lakhs instead of 10,000). So suddenly, you will end up getting 1,000 options (instead of 10 options) though economically nothing has changed.
Instead of artificially splitting the stock, our advisors told us to not do it and keep it simple.
7. What kind of returns should I expect?
No one knows. If we work hard and succeed in building a great company, the upside can be immense. But make sure you don’t spend real cash or change your lifestyle based on this.
8. When will I see the money?
Money or liquidity as it is called will only come if and when either of the following happens – a) when someone buys us; b) we IPO. Both events are not predictable and usually involve a long and arduous journey to get to.
I hope I have answered most of your questions but there are bound to be more questions. A lot of the people are still not clear about ESOPs and please don’t hesitate in asking questions. We’ve retained faith in you that you would have to confidence to ask us if you have any questions.
Now, the responsibilities bit.
Our goal is to include as many people as possible in equity ownership – we want to change many lives and create wealth for everyone. However, this comes with responsibilities.
– we expect you to have a very long term outlook. Companies take 10-15 years to build and a lot of learning and wealth creation is loaded towards the back i.e. it happens in the later years. Patience and perseverance are your friends.
– we expect you to put the company before yourself. It is sometimes tough to do this but this is expected in a lot of different ways.
– we expect you to be wise. Wisdom is difficult to define. It includes not falling for short term gains, being loyal, having the ability to talk about issues, having the right mental models, being calm in face of adversity and sifting signal from the noise.
– we expect you to have fun. Work is the most underrated form of having fun and I truly believe that. People who have fun at work are generally the happiest. If you not having fun, talk to someone and fix it.
– we expect you to be honest. As owners, you think and behave honestly both with other owners and with yourself.
You will find enclosed the following documents:
1. ESOP grant letter specifying the number of options granted to you; and
2. ESOP Plan document containing the detailed terms and conditions of your grant.
That’s it. Let’s enjoy this ride together.