16 October 2014

Conference: Investor Relations & ESOPs For Startups

Held on 11th October at IIM-B, this conference was about building long-lasting investor relationships and creating employee stock ownership plans. The session began with the guest speakers Mr.Cherian and Ms.Neela introducing ESOP's to us.

The Panel

  • M.J. Cherian (Co-Founder and CEO of Keynote ESOP)
  • R. Natarajan (Nats) (Managing Director & CFO)
  • Mr. TC Meenakshisundaram  (Founder & Managing Director of IDG Ventures India Advisors)
  • Neela Badami (Works with Samvad partners. Gold Medalist at National Academy of Legal Studies and Research (NALSAR) University of Law, Hyderabad)
  • Vivek Subramanyam  (CEO, iCreate)

Stock based compensation for startups

ESOP's are not the only option. There's also Restricted Stock Units (RSU's which are free in USA, but in India you can't give it for free because of regulations of face value), Stock Appreciation Rights (SAR) also known as Phantom stock, Employee Stock Purchase Plans (ESPP) and Restricted Stock Awards (RSA, which doesn't really work in India (like for example TCS giving shares at one rupee each)).

ESOP's can either be setup by the company board or the company can setup a trust. The trustees would basically hold shares of the company and they'd ensure that shares are issued to employees in accordance to the exercise. For listed companies, this used to result in shady dealings because the company could play around with the share price, but now SEBI has caught onto this and disallowed incorrect practices.

These options go through a lifecycle of Grant, Vesting, Exercise and Sale.

It's very important to pick the right kind of people to reward with stock options. Pick people who value it. Stock options are given over and above the compensation you're already paying them, and the minimum benefit of it is that it motivates them to stay in the organization. Figure out what value you're giving the employee with each option you grant.

Grant objective
You basically give out stock options as a past performance reward or in anticipation of future performance or as a joining bonus.

Grant price
You can give it at fair market value, face value or at a discount to fair market value (problem is that due to volatility, people might get disappointed when they see the stock value suddenly go down, so giving it at a 70% or 40% discount is a wiser option). Costs on when it's given at fair market value is lesser and easier on the book than when it's done at face value.

How do you earn a benefit out of it? Once you give out a stock option to an employee, there's no way to check if he/she is performing well etc. It's no use because once you give the stock option, it's done. So don't link it to the performance of the employee.
Instead, link it to the performance of the company. The problem here is if there's a lull in the industry, you have to retain employees and keep them motivated.

Exercise and sale
When it's time to exercise options, you have new partners coming in, and it's very important to protect yourself, your company and your employees while you structure your stock options. Have a clause that says if the person has to leave the organization in one year, the person gets accelerated vesting.
Having new partners can lead to deal breakers. Eg: If you're having a trade sale and all employees have to be ready to sell, it becomes a problem when some of them decide not to sell. You need to have drag-along clauses in the agreement to avoid this problem. Investors are terrified of the fact that there are shareholders over whom they don't have any control over (employees). The drag-along clause implemented has to be highlighted upfront to the employee so that there's no heart-ache later.

Being aware
When offering a stock option, the board structures the stock option. You need to have a detailed plan document which covers all terms you had in mind while you went through the entire exercise. The thought process that goes into designing each scheme is important and specific to you. It's important to know that if you took a decision, then why you didn't choose anything else.  It's important that you understand the stage of life of your company (do you see any liquidity? Top-line growth where profitability is not in the immediate future). For legal sanctity, you need an agreement where the employee says he's understood everything.  Document and communicate shareholder approvals, board approvals. Plan and document employee agreements, talk about progress and wealth. Employees should know what the annual profit of the company is. They should know the top-line, bottom-line, revenue drivers and hence the potential value. Most of the technical employees and even finance employees aren't aware of the overall financial picture of the company. It's very important for entities to talk about this and inform their employees.

In short, you just want to reward an employee with money. It's not rocket science. You let them know the expectation and they ride the wave and get what is projected to them, without them investing a single rupee. Keep the exercise period as long as possible for an unlisted entity since you don't know when you'd get liquidity, and you don't want the employees to lose their options because they didn't want to invest money at that point in time.

A note on regulations
Some regulations have changed since April this year. Keep constant track of changing regulations.
  • You always have to get prior approval from shareholders. 
  • You can only cover permanent employees. You can't cover promoters and independent directors anymore. 
  • You need a minimum of one year from grant to vesting. The employee can't sell for one year.  There's a lock-in period.
  • The minimum price cannot be zero. It has to have a face value. 
  • Get a good company secretary and get to know the compliance requirements of the new companies act, especially wrt the issuance of shares. The act has been passed in the wake of corporate scams and mistrust, so the requirements must be examined or they might become non-compliance issues which can become embarrassing when you're raising money from VC's etc at the next stage.
  • Be aware when dealing with foreign exchange. Check for any RBI compliance involved.

The panel discussion

Investor relations
Mr. Vivek began by telling us about how his story with investors began, where they took a call that the reason they're taking in investing in you to build a business, one simple way to keep the relationship good is to be completely transparent. Ensure investors get clarity on what is going good and what is going bad during challenging times too.
Mr. Natarajan also began by saying that the fundamental word for the relationship is trust. Before, during and post investment, the trust and transparency factor is very important. From the time the term sheet is signed and the deal is closed (around 40 to 60 crucial days), transparency is important because several deals may get conked off during the period. The entrepreneur has a responsibility to the investor, because it's their money coming in. Both parties should believe that they're working to a common goal.

In the USA, the founder is willing to hire a CEO and report to the CEO. Unfortunately, it hasn't yet caught on in India because the founders feel that they need to be the CEO. Here, the founder thinks that he/she needs to own the majority. In the USA, the founder sometimes only owns 10% of the company and yet goes on to make the company successful (reminded me of the first Spiderman movie where the founder of Oscorp is asked by the board to leave, and he disappointedly and angrily says "...I created this company...do you know how much I had to sacrifice?!!!"). Anyway, Mr. Natarajan feels that Indian entrepreneurs need a change of mindset for the investor-investee relationship.

Mr.TCM explain why trust is important, giving an example where in his company where a regulatory issue came up (which is a huge risk) and they called up the investor and informed them of it. After the initial shock, it turned out that informing the investor held them in very good stead. They consulted an independent entity and took a decision to complete the transaction with Mr.TCM's company. If the information was not disclosed and later discovered, the distrust it builds for the next five years is just not worth it. Nothing you say will be believed. When you're in doubt, go ahead and communicate. Over-communicating is also ok.
The investor is not the only one who has decision power just because he/she has the money. Even the entrepreneur has as much of a choice to choose which investor to deal with. But take a well informed choice. Don't reject someone just because they're asking tough questions. Sometimes people who won't ask tough questions won't guide you either. Strike a balance.

Mr. Natarajan says that just the way investors do the due diligence on entrepreneurs, the entrepreneurs should also do the same to the investors.
As for ESOP's, give it only to employees who value it. In a startup, you can't pay a market salary. You pay a salary and compensate the rest with an ESOP. So the ESOP has to hold some value and meaning for an employee to stay in the company. He/she should really trust the option too. Founders should be ok with distributing stock options to employees, but it should have some value. There's no point being a 100% owner of a zero value company. The founder have to realize that they're also stakeholders. Founders seem to think they're the owners only.

You shouldn't live with the fear that the investors will take control of the company. The focus should be on creating value. The employees need to feel they're part of the team and what they're doing increases value and enriches the company. The feel for the cause has to be really high. There are stories about how the watchman and driver in the company got a share. Those make nice stories, but reality is that you should give it to those who believe in the power of ESOP's and the sense of purpose. If the employee gets a 20 or 30% hike from some other company and goes away, the ESOP has no meaning.

Mr.TCM says that ESOP's have never been fully utilized in almost all companies.

Questions from the audience

What are the quantitative and qualitative elements which define the valuation of a company?
It's a question of what an investor believes can be created going forward, looking at the market. The theme, it's differentiation and the dynamics of competition. It's on the basis of what we can create and what would be the value later.

About vesting, if promoters move out, will the stock remain with them or will it only be for the vesting period?
For promoters also it will be under vesting. If he leaves, the un-vested part will come back to the company. The logic is if you as a CEO leave 2 years from now, we need to hire another CEO and give him stock. Where will that come from? In the US, they vest on a monthly basis. In India it's on a yearly basis.

What's the difference between shares and stock option pool. Will creating the pool be a dilution on the overall shareholding pattern?
As options are exercised, it would dilute. You don't have to alter the shareholders agreement. You can pass a shareholder resolution and go ahead with the creation of the pool.

While hiring employees, we based ESOP's on tenure. But in the presentation you showed that it also depended on the employee and company performance. So can the conditions be altered to include performance?
Yes. You can put a performance matrix which can be communicated on an annual basis. When you give a stock option, never tell that I'll give you 0.5% of the company or 3% of the company etc. You should only tell them the number of shares you're giving them. The employee can sue you if they think they owns 3% of the company and they realize that it isn't actually true. There's no such thing as somebody owns 3%. Nobody owns 3%. He just has 4000 shares. He does not hold 3% forever. Another mistake companies make is promising that at exit, the shares will be at a certain price and this is the gain that the employee will make. Never give these in writing. It'll come back to bite you at a later date as a legal obligation.

In a startup environ, people prefer to hire young managers or employees. They don't really appreciate ESOP's. Does it really make a difference to keep aside 10% of shares for them?
That's the exact segment of people for whom you shouldn't keep it aside :-)  Set it aside until you prove the leadership and the company scales. You're already paying them what they want, so you don't really need to use ESOP's. Eventually it can be used, as they understand the value of it. For some employees like sales people, it may not make sense to give stock options. He has to be earning his commission rather than thinking about the stock options. He has to earn a certain amount every month. If this is a guy who is earning Rs.15000 or Rs.20000 a month, he's not going to stay with you for that perfect tomorrow which would buy him a yacht later. He's planning to buy a bike right now for which he needs a Rs.2000 EMI every month. He'd like to buy that bike right now than be on the yacht later. Besides, the yacht is just a promise which may not happen. The entrepreneurs themselves haven't yet bought their yachts yet :-)

When you open a new company, how do you decide the number of shares to start with? When the pool gets exhausted and a new investor comes in and wants shares, where do those shares come from? How does that impact the existing shares?
Typically people keep Rs.10 as the start value and then put the number of shares. Reason is that if need be, they can split it to Rs.1. The recommendation is not to start off with Rs.1 because then there's not much leeway to go down further. If you've exhausted the pool, you can always create more of a pool. The founders and investors would contribute more as long as it creates value. If the shares are over, you have to increase the authorized share capital and there's a process for it and experts who can help with it. It will never be a problem as long as everyone agrees. Reducing share capital has to be in compliance with rules. It's a criminal offence, so employ a good company secretary.

What is the optimum pool size?
There is nothing called 'optimum'. Typically, it's 10% for a startup. When the company becomes very big, the pool can become smaller.

In a company, is there a thumb-rule to decide who gets how much of the company?
Typically it's been rather democratic because it's difficult to say who contributes how much. Investors don't determine that. It's about how co-founders find an equilibrium amongst themselves. There's no right or wrong in it. It's also good to document the intersay relationship between owners, to avoid heartache later and gives a good, professional impression to the investor too.

Is sweat equity part of the ESOP pool? How is it given it to promoters?
Sweat equity shares is separate from ESOP. As a promoter to get sweat equity, you have to value the intellectual property or product or service he gives and that's accountable as an asset in your balance sheet which can be monetized over time. You'll have to put a value to it and technically you're issuing shares in lieu of cash so you have to have an asset against which the shares are issued.

When you take a seed or equity fund, the promoters will be working for a salary much lesser than a market salary. So how is that compensated?
The promoter has to work for a salary lesser than the market salary; that's why he's a promoter :-) It's part of life. That's why there's no sweat equity. Equity is for the sweat :-)

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