Esop fables: A cautionary tale for those joining startups

Singapore

WHEN Bob* joined his first start-up, he was promised a substantial amount of stock that could be worth millions in a few years. He bought into the start-up's vision and took a 40 per cent pay cut from his previous role.

A few months into the job, the company introduced a strike price 100 times the industry standard, along with a 30-day exercise window. This meant that Bob would have had to pay more than a quarter of a million dollars just to exercise his options. If he chose to leave, he would have had to cough up that sum in a month from his last day, or give up his options.

To make matters worse, exercising his options would have landed him a tax bill of about a million dollars. He could not afford it.

Like Bob, a number of start-up employees in South-east Asia are left with no choice but to give up their stock options because predatory terms in their employee stock ownership plan (ESOP) contracts have made them too difficult to claim.

Some have to shell out up to hundreds of thousands of dollars upfront just to exercise their options. Others have to contend with spotty documentation or long vesting cycles designed to keep them at the company for a long time. Without any certainty of future liquidity, these unfavourable terms have made their ESOPs more of a golden handcuff than an employee benefit.

Typically, ESOP schemes have a one year cliff, followed by equal annual vesting over four years. This means that if an employee leaves or is let go before the first year is up, he will not have any options.

If he stays on, he will vest 25 per cent of his options each year. By the fourth year, he will be able to claim all of his stock options.

Although it is normal for exercise windows to span a few years, the better schemes have lower strike prices to give employees more stock buying opportunities.

But in some start-ups, terms and conditions are harsh on employees who want to leave.

One top executive who used to work at an e-commerce startup said the company had a 10-20-30-40 "balloon" vesting cycle.

Employees were given only 10 per cent of options in the first year, 20 per cent in the second year, and so on. An employee who is even one day short of the three-year period would walk away with only 30 per cent of the shares promised as compensation.

The founder of a software start-up, who has been working in the tech industry for more than six years, said: "(Working in a) start-up is tough, and requires a lot of personal sacrifices. If people leave after one or two years, you can't blame them.

"By doing a 10-20-30-40, the startup is basically strong-arming its employees to stay for at least three years. If not, they would not get a meaningful amount of equity."

The same company also required employees to exercise their options the day they leave. Several others, including Bob's former employer, give employees a very short window after their departure to buy those shares. If employees do not do so by the deadline, they forfeit the options.

The founder of a fintech start-up who declined to be named said there is "no good reason" for the company to institute such a short exercise window, "unless they really want to make it tough for the leaving employee".

Another problem is taxation. If their start-ups have been successful, employees have to pay a substantial ESOP tax - which can go up to millions of dollars - on the increased value of the stock.

"If you could sell a portion of your shares to pay the exercise price plus tax on them, that would still be okay," said one long-time employee of a logistics start-up. "But you can't. So unless you have a lot of spare cash on hand or want to walk away from very valuable equity, you stay."

At the root of many of these difficulties is that ESOPs do not have good liquidity.

Choo Haiping, 1exchange's chief executive, told The Business Times that since ESOPs are derivative options of a stock, they can be "complex and feature terms that may not be as compelling to potential investors when compared to a plain-vanilla stock".

1exchange is a market for trading private equity securities.

There is thus a growing need for liquidity among startup employees, and companies have felt increasing pressure to return cash to staff.

Recently, this has come either in the form of share buybacks or through secondary deals.

Two people, who asked not to be named, said Grab used to have an informal, internal forum where employees could find buyers for their shares among fellow team members.

Some former Grab employees even set up a public Facebook page and a crowd-source platform in 2019 to find buyers for their shares. The initiative has attracted more than 163 buyers and 26 sellers to date.

Other potential alternatives for companies that want to enable such secondary trading include private exchanges like Capbridge's 1exchange or Fundnel, which list private companies' exercised shares and structured products.

Such private exchanges have not quite caught on in Singapore, but appear to be gathering steam in the United States.

Recently, the Nasdaq private market announced that it has joined forces with the likes of Goldman Sachs and Morgan Stanley in hopes of creating a deeper, more liquid private market.

Either way, anyone joining a startup - no matter how much they trust founders to do right by them - would do well to raise questions about terms such as vesting and cliff periods, termination clauses, exercise windows and strike prices in ESOP contracts with their employers, observers said.

They added that employers can do better and have more conversations about ESOPs with staff too, and not treat it like a taboo subject.

"Be upfront and have a chat with folks who have never traded ESOPs before," said the software start-up founder. "At least tell employees what their options are and then let them make the decision."

*Names have been changed to protect identities.

• Have you been on the receiving end of some unfair ESOP practices? We would like to hear about it. Please email btstartups@sph.com.sg if you have a story to share.
• Garage is BT's startup vertical. Read more news, analyses and opinions at bt.sg/garage.

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