WHY INDIAN STARTUPS SHOULD REFRAIN FROM OFFERING ESOP TO EMPLOYEES

Having assisted quite a few start-ups in their seed fund and VC Round I have come across hundreds of discussion where the promoters and the investors mutually agree that within months of the investment round, the company should offer to ESOP to its employees. However the problem is that when you ask them about the need of ESOP and the nitty-gritty of the plan they will give you a blank face. Some even curve out a dedicated ESOP Pool in their Shareholder’s Agreement without having a single employee in its backyard! I have met people who are willing to offer ESOP to their employees without understanding it at all because ‘it sounds cool’ or much worse ‘all other start-ups are offering it’!

Well this article is not to build the basic and highlight the pro and cons for offering ESOP. I am sure there are thousands of article in the internet where one can understand the fundamentals. Instead I want to offer a perspective. A perspective which is not only against the trend but also based on hard pragmatic facts. I am trying to elaborate why a start-up should not offer ESOP to its employees. In this article I will try to give the reader why an entrepreneur should try to escape the prism of “ESOP equals to employee benefit.”

ESOP or Employee stock option Plan is simply giving options or rights to the employees to buy certain number of shares if they stay in the company for a certain period of time at a predetermined price. There are few fancy names involved over here-

1. Exercise Date and Price- It is the date at which the employees get the right to buy certain number of shares at a certain pre-determined amount called Exercise Price.

2. Vesting Period- It is the period over which shares are offered. So a start-up can offer shares in parts(say 250 shares each year) to its employees over a period of time(say 4year) rather than giving it in one go.

3. Cliff Period- It is the period between the time when offer is granted to the employees till the time when they have the right to buy it i.e. exercise date (usually its 1 year).

4. Lock-in Period- It is the period when the employee can’t sell his shares

The usual reason given by most pundits for offering ESOP to Employees-

a. It helps to retain employees

b. It helps to give the employees a sense of ownership in the start-up

c. It helps in attracting talent

d. It helps to compensate the employees especially in a cash crunch situation

Now cutting the rhetoric aside, let us try to analyse how ESOP really affect the various stakeholder in a start-up. We shall try to focus our energy in bringing out whether Employee Stock Option really serves it purpose-

ESOP & Employees-

1. Paying tax for the whim and fancies of others - In a start-up scenario valuation is arrived after the promoters and investors mutually agree to a figure. Hence, it is usually on pen and paper. But the perquisite in regards to ESOP is calculated depending on the said value. So, the difference between the Fair Market Value of the share and the Exercise Price shall be treated as perquisite as per Income Tax Act,1961. Let me elaborate this with an example-

XYZ Pvt Ltd has gone for a Series A Investment where the investors decide to subscribe to the shares of the company at a valuation of Rs 600 per share. Post this company decides to issue ESOP and the concerned employee is offered 400 shares at a valuation of Rs 100. Incidentally his per annum income is Rs 2,40,000. His perquisites for the year in regards to ESOP will be Rs 2,00,000 i.e. 400*(600-100). Now imagine the jump in the employee’s taxability just because the promoters and the investors zeroed on a particular figure of their choice!

2. Waiting for an opportunity of Capital Gain- ESOP is offered with an idea that the employee will get the stock at a lower price and as and when the start-up grows he shall sell them at higher valuations. Seldom has such idle scenario happened in a start-up. In an ecosystem where most business failed to grow after a year or two making a capital gain on ESOP is really tough especially when the valuation of the company is sky rocket and no investor is willing to buy. To add on to it there are so many different types of clauses (eg the lock in period) which makes the life of the seller much more difficult.  Also hardly any start-up agrees for buy back or for that matter go for an IPO Listing where the process of selling the shares is much easier. Leave the lights of Infosys and the Flipkarts, in most start-up you shall find it very tough to sell your shares.

ESOP and Promoters-

3. Every stock saved is every stock earned- When ESOP is offered in a start-up the promoter’s stake reduces drastically as in most cases the promoters not only loses his proportionate shareholding when ESOP is offered but also have to compensate the investors for the reduction of the holding percentage in the company. When a company grows exponentially its valuation shall also increase. Now an pragmatic businessman might think that if he takes the risk then why should he compensate for the people who is not taking the same risk as him. This is specially a point where a founder is affected as every share counts when your start-up grows. There is not only a chance of losing holding of the company to someone else but also loosing monetary value in lieu of shares. Vijay Sekhar Sharma (Founder of Paytm) recently earned more than Rs 300 crores by selling just 1% of his stake. Now imagine if he had given this 1% for ESOP Pool who would have actually lost.  

ESOP and Company

4. Tough for winding up- Thousands of start-up every year files for closure of their concern. As the shareholders tend to increase, it becomes further difficult to close the company.  If a group of minority shareholders goes for litigation against the company the whole process of closure is affected. The regulators might ask for further review of the application and the process get further complicated.

5. Too many cooks spoil the broth- The more your shareholder list increases the more it will be tough to maintain the records. Remember, for every general meeting the shareholders have to be called upon. As the amount of paperwork increases the compliance cost of maintaining the same also increases and simultaneously the risk of faulting any rules especially under Companies Act, 2013. Also the flexibility of having a closely held company and the ability of making a quick decision is lost.

There are ample such reasons which shall force one to think whether offering ESOP is really good for the business. Hence, we must conclude by saying that in the start-up industry ESOP hardly meets its objective and every start-up should avoid it. There are many other opportunities of employee engagement and benefit which the company should exercise so as to retain in-house talent but not at the cost of the promoter’s interest.

Copyright ? Soumik Kumar Sen

Printing, Publishing and Distribution Rights of this article reserved with the Author