Bait or boon: The good, the bad and the ugly of startup employee stock option schemes

WHEN Zoe's (not her real name) employer wrote to her to offer her shares in the early-stage startup she worked for, she felt appreciated and valued. It was just words in an e-mail with a couple of lines; the terms stated were not clear, and in no way resembling a contract or formal agreement she could endorse.

A contract was promised, however, and so she responded to accept the shares with thanks. She says she decided to leave it at their assurance, trusting them to deal in good faith - besides, how does one press their bosses about matters like this when one still reports to them, is paid by them and has their performance rated by them?

Unfortunately, a few years down the road, the company "decided they no longer found (her) useful", and her worst fears materialised. She saw nothing of what her bosses had originally said - about how much they valued her contributions, for instance - translated into action.

From her experience, Zoe tells The Business Times that she learnt to see that a job is just a job, and an employer is just an employer. "At the end of the day, there shouldn't be any illusions about being in a second 'family' or whatever."

As she came to realise, when it comes to employee stock ownership plans (ESOPs), it's best to leave nothing to chance. First of all, employees should at least ask for "some form of agreement for stock option compensation in writing", says Ian Lim, head of TSMP Law Corporation's employment and labour practice. "Verbal promises, even if sincere, may end up misunderstood or misremembered a few years later."

Mr Lim also notes that employees should be careful of what conditions the ESOP contract sets for their potential future departures from the firm. For instance, they could try to make sure that their ESOP contract does not have more "onerous restrictions" than their employment contract, restrictions that might prevent them from joining competitors, or bringing clients or colleagues along, he adds.

And unlike bigger listed companies and multinational corporations - where stock compensation schemes are typically tagged towards performance - startup ESOP schemes are often geared more towards staff retention. Workers should thus look out for any unfair terms - such as skewed vesting cycles and day-long exercise windows - that could be altered to make them stay.

ESOPs as a form of remuneration hasn't been as developed in this part of the world, says Marcus Wong, co-founder and chief commercial officer of ESOP management platform Svested. "In terms of best practices, you might not see many of those in South-east Asia. Hence, there is often the disconnect between what is promised versus what is delivered."

But otherwise, ESOPs are still a tool that can align interest and attract workers who see the shares as a potentially rich payday. More startup founders in South-east Asia are realising that, and a good number are considering ways to make their stock compensation policies friendlier and more accessible to incentivise workers.

Firstly, some are moving to guide workers in navigating the ins and outs of ESOPs, since many individuals have never received compensation in the form of stock options before and might not know how it all works.

Vidit Agrawal, co-founder and chief executive of early-stage fintech startup GajiGesa, spends about an hour every month fielding questions from employees about vesting schedules, latest share prices, plans for more options and many others. He also explains the different terms in the ESOP contract in detail.

This is all part of the startup's ESOP education sessions for its team members, to help them understand the value of their options.

Mr Agrawal says these sessions have also helped him to retain talent: "Some of our senior Ieaders and engineers are asking for more ESOPs. I also see more of our staff talking about their stock options and enquiring about our latest market price, which is good as they see value in it."

While there are some leaders and founders who have designed ESOPs well to attract and retain talent, it is also the responsibility of those who choose to join startups to ask how the scheme works, says Johnson Chen, founder and CEO of private markets platform Capbridge.

"Many employees now might not know how ESOPs work, but sensibly, both founder and employee should have accountability and really make sure the mechanics of the grant are well understood, because the more people understand how their staff incentive scheme works, the less risk of being unfairly treated."

Building a generous ESOP pool can be a great way for startups to attract talent, especially top-level senior executive types, observers say. Since startups might not be able to match the salary of these top executives, they sometimes can try to sweeten the deal by offering more in stock compensation for a potential upside. Key hires could become millionaires from cashing in their stock. Typically, companies allocate anywhere from 5 to 15 per cent of their equity to ESOPs.

The size of the ESOP pool will vary from company to company, depending on the company's hiring requirements and staffing requirements, says Joel Shen, a partner at global law firm WithersKhattarWong.

For example, a company that is going to hire some very senior executives might have a larger ESOP pool, he said. This is to allow them to attract talent through equity while still saving cash in the short term.

Nium, for instance, after its Series D round now has about 22 per cent of its shares allocated as ESOP. When asked if investors might be hesitant to allow such a huge ESOP pool due to dilution, chief executive and co-founder Prajit Nanu tells BT that the responsibility falls on founders to advocate for their employees. If investors can see the big picture, they should be on board too.

"I think it's a win-win for both the founder and the venture capital (VC) firm," says Mr Nanu. "It's a pool of equity that can be allocated at any point of time to help the company hire the best talent. We will never be able to compete with the likes of Alibaba, Tencent, Facebook and Google on base salary. But how we can excite people is through a stellar stock option compensation plan."

Mr Nanu says that having good investors on board is also crucial when pushing for a better ESOP scheme.

"Our early investor Vertex has been very helpful, always guiding me and saying that we need to make our ESOP more supportive for employees. Even when I proposed a 10 per cent buyback, they said 'fantastic, go ahead and do it'."

But he admits that there can be investors that would be hesitant. Mr Nanu recounts how one shareholder was complaining about the upsized ESOP pool and buyback. "In the end, I told the shareholder that the company will buy his shares back, it doesn't need investors like him."

Nium has some other employee-friendly terms in place. For instance, staff vest 12.5 per cent of their options right after they complete the first six months, half the time of a typical one year cliff many startups have implemented. Their options are then vested equally every six months for the four-year period.

Additionally, Mr Nanu says Nium does not have any restrictions on its exercise window, so that employees will not have to fork up the cash right after they choose to leave.

Such conditions would mean that an employee could walk away with some options, even barely after passing the standard probation term.

But Mr Nanu does not see this as an issue: "An ESOP pool is for employee welfare and as a founder, you can't be concerned about it. If you're worried that you gave somebody a million dollars and he's not functioning up to task, you could just pause the vesting schedule until he hits his performance targets.

"I have some ex-colleagues who have become millionaires now, and I don't feel bad about it. I'm just happy about the fact that we could be at a point where some colleagues could make money from their time here."

Founder and chief executive of fintech Syfe, Dhruv Arora, echoes a similar sentiment: "Our team members are a key part of the reason the company is now 10 times bigger than it was, so they should get that benefit."

Post its Series B round, Syfe has more than 10 per cent of its shares as ESOP. Mr Arora says this was set up so every employee has some "meaningful equity" in the company. The company has also drafted up fairer terms such as a low exercise price of 10 cents and a multi-year exercise window.

Platforms which help with startup's ESOP management - such as Svested, Qapita and Carta - are also taking off. These allow greater transparency, since employees can see the details of their ESOPs such as the number of options granted, the number of options vested, and their vesting cycle.

However, Svested's Mr Wong said that platforms can only help with the administration and management of ESOP, but they do not help companies with the setting up of the ESOP.

To set up an ESOP, founders can download draft legal templates online, ask fellow founders or engage a lawyer to draft a legal document customised to their needs. They can also approach platforms like Svested which provide commercial advisory on how startups can structure their ESOP.

"The question founders need to ask themselves when setting up an ESOP is, which method would be best - in terms of price point and comprehensiveness - for their employees and their needs now and in the future?" Mr Wong adds.

Even as more startup employees are compensated with lucrative piles of their company's stock, oftentimes they cannot cash it in because the shares do not trade publicly.

So, some mature startups have arrived at a solution: They are giving employees some controlled opportunities to sell part of their options or shares.

For instance, fintech startup StashAway offered to buy back up to S$4 million in employee options, as part of its US$25 million Series D round. Similarly, in September last year,

Carousell allocated a few million dollars for an ESOP buyback, on the back of its US$80 million fundraising deal led by South Korea's Naver Corp.

There is a growing need for liquidity among startup employees, and the ability to have some cash on the table will help staff realise the value of stock option compensation.

Mr Nanu recalls how just last week, his staff had just gotten the cash from the company's recent US$18 million buyback during its Series D fundraising and were expressing their thanks. His e-mail inbox was pinging non-stop. This allowed them to place a downpayment for their house, or help pay for their wedding, they told him.

Mr Nanu says Nium has just minted 50 new millionaires, and is looking to take that to 200 in the next 12 months. It currently has about 600 employees globally.

He tells BT: "I always thought that the time I would feel the happiest is when I bring the company public or when I sell the company. But when I read all of those e-mails and messages, I was overwhelmed ... All these strong emotional statements, it makes you feel that you're on the right path of treating everyone in the right manner."

Other potential alternatives for companies that want to enable secondary trading include private exchanges like Capbridge's 1exchange or Fundnel, which list private companies' exercised shares and structured products. Funds such as Indies Capital have also been buying startup secondaries from founders and early employees as an investment play through its funds.

As GajiGesa's Mr Agrawal puts it: "Giving employees liquidity doesn't mean they leave. Sometimes they want to buy homes, cars or even invest in other startups. Providing some liquidity for them to do that is a good move."

READ MORE

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• South-east Asian startups explore early stock option cash-out to retain talent