Funding Winter & its Implications on Startup ESOPs

No matter which part of the globe you are on, the funding winter is here and expected to last for a few quarters as investors seek to reprice valuation expectations and are being extremely cautious of deploying large ticket funding into startups. This is also mirroring the public market sentiments as tech-led companies have seen steep corrections in their valuations over the last year owing to the uncertain global macroeconomic and geo-political challenges. Will this have an impact on the value of Equity Compensation instruments? Let’s understand this further.

Implications on ESOPs?

Given that Employee Share Option Plans (ESOPs) are benchmarked to company share value, the implications on employee equity holders are similar to those of other shareholders in terms of reduction in the unrealized value of the awards they hold in proportion to the decrease in the market value of the company. So, in a short answer, yes, there is definitely an impact on the underlying value of ESOPs, too.

Having said that, it is important to note that employee equity plans, by design, are long term incentives as well as investment vehicles as they include vesting schedules, the period of time it takes employee to earn their awards, that may last years. As such, as the market cycles tend to reverse over time and thus ESOP holders of companies with good future prospects should take a long-term view on their positions and consider holding onto their options as the value can appreciate once the global macro situation improves coupled with the expected growth in the company’s performance.

In most early stage startups, this must be the case, as the ESOPs and related instrument are offered at a very low exercise price compared to the fair market value (i.e. share price) of the shares and thus despite the depreciation in the notional value, the options would be still in-the-money and hence the employees have nothing to lose in holding the options while awaiting a liquidity event in the future.  

Are my ESOPs underwater, i.e. out-of-the-money?

However, where employee received their equity compensation options at an exercise price closer to the share price might have been in the recent past, such ESOPs might be out-of-money as the share price would have likely fallen below the exercise price which means it’s cheaper to buy the shares in the market instead of exercising the option at a price higher than the share price.  

This is however possible only in case of listed companies. In most startups, liquidity is not available and hence it makes sense to stay put retaining the options until a future liquidity or exercise event once the share prices have appreciated.  

Impact on ESOP Design and Allocations

While the market is in investor’s favour from a valuation standpoint, we don’t see a severe impact on the design of ESOP schemes in case of startups as the demand for good quality talent in building good businesses still remain and equity in-fact offers a cashflow friendly instrument to founders to attract and retain talent.

We have observed this at the onset of the COVID-19 pandemic and the start of the bear market in public equities. The heightened levels of uncertainty provided many companies an opportunity to leverage ESOPs and other related instruments to compensate their employees in lieu of cash expenditure.  

Many companies opted to convert variable cash bonuses into deferred equity awards, or even give employees an option (no pun intended) to sacrifice part of their fixed pay into equity to manage their costs. For employees, their take home pay may be reduced in the short term, but they may get the benefit of share price upside following the vesting of their additional equity awards in future.

Employee Perception on ESOPs during the Downturn

We see the employees generally having a negative perception towards ESOPs quite strong, especially in case of fast growing companies with good business models. On the contrary, similar to common investment philosophy of buying at low prices, the current environment can provide considerable upside for employees for companies that are able to position them to weather the current storm and set up a strong foundation for long term growth. Employees working in growth companies recognize this fact as they have seen this play out over the long term in tech startups in the Silicon Valley.

In fact, we see ESOPs are a very optimal instrument in these challenging times to enable founders to optimise their cashflows while retaining talent who are aligned with the company’s long term objectives. Founders can offer top-ups or additional milestone based ESOPs as a means to recognise their belief in their employees and motivate them to create value for the organization.

Company Measures to Retain Top Talent

Companies can adopt a number of measures to ensure their ESOP schemes are attractive and in-line to contemporary standards espepcially. as seen in people-centric and employee-friendly companies.

To suggest a few measures:  

1. Founders can look to top-up employee ESOPs more frequently, typically as part of annual appraisal cycles. Going further, founders can also give an option for employees to take a certain proportion of their pay revision in form of ESOPs, thus empowering the employees.

2. Structurally, founders can also opt for more frequent vesting schedules – quarterly and monthly are increasingly preferred by employees vs. annual cycles.

3. In jurisdictions that allow this, founders could also choose to offer a favourable exercise price which is either zero priced or deep-discounted ESOPs to offer an upfront unrealized value to employees.

4. Apart from these, founders can also commit to or signal to doing frequent liquidity programs through company led buybacks or market secondaries to provide opportunities for employees to realize their value at the time of their choosing.

5. Lastly, but most importantly, the founders’ role is to continuously over-communicate to their employees regarding ESOPs over employee townhalls and digital systems that help manage ESOPs. Helping employees understand equity compensation is crucial in success of any scheme.

Beyond ESOPs, it’s important for founders to inform their employees of the impact of the current global situation to avoid surprises and align objectives as they navigate these challenging times. It’s also founder’s responsibility to re-align/restructure their workforce in an organized manner over time to take on the market challenges while not needing to resort to drastic measures such as lay-offs.

What happens to the ESOPs for Retrenched Employees?

While it’s unfortunate to see many startups having to let go of employees to cut costs given the funding squeeze, the treatment of ESOPs in such a situation depends on the ESOP plan design and how friendly or otherwise it is for employees.

In our experience, commonly the treatment of ESOPs is decided based on the amount of ESOPs vested or earned by the employee as at the date they cease employment. We see most companies adopt a middle ground which is fair to the employees in terms of giving an opportunity to employees to exercise their vested options while cancelling their unvested options. This also enables startups to conserve their unvested pool for future purposes.

Companies that are employee friendly provide further concessions in terms of offering an extended period (say 5 to 10 years) to employees to exercise their vested ESOPs. This enables the employees to retain their vested ESOPs and participate in future liquidity programs, thus eliminating any upfront tax implications while leaving the company.

An important rule to keep in mind that impacts both companies and employees in Singapore is the Deemed Exercise Rule. The regulatory framework prescribes that when foreign employees cease employment and leave the country, the taxing point for their outstanding awards is accelerated the point of cessation of employment, regardless of the vesting schedule or any selling restrictions. That means that expats working in Singapore that may are affected by layoffs will need to prepare to manage a potentially substantial tax bill without an ability to immediately cash out their awards to fund it, whereas the companies will have to obtain the Fair Market Value for the awards to calculate the tax liability and have an obligation to withhold taxes in relation to their departing expat workers. 

Having said that, the ESOP plan design is an important consideration here - a well- designed scheme should provide the company the ability and flexibility to adjust the treatment where appropriate. Our recommendation to startups is to consider all potential scenarios, including layoffs, when they put their ESOP plan in place initially to ensure the scheme is future-proof.

Schedule a consultation with us to plan and design and launch your ESOP plan.