Tech winter dulls the shine of employee stock ownership plans

FALLING tech valuations across South-east Asia have dulled the attractiveness of Employee Stock Ownership Plans (Esop) for startup employees. Expectations of making a windfall from these instruments, like in Silicon Valley lore, are lukewarm in the current climate.

Regional unicorns that have gone public – including Grab, GoTo Group and Bukalapak– have fallen in value amid weak market sentiment, and there are no Esop “jackpot” stories to excite employees. For mature startups that remain private, the prospects of doing an initial public offering (IPO) in the near term are uncertain.

Some tech workers are dissatisfied with the returns from Esop after their employers listed.

“A candidate of ours left one of the unicorns recently, disappointed that there was no upside from her few years there… Her Esop was fully vested but in her words, of ‘not much value’,” said Elena Chow, the founder of talent solutions company ConnectOne. The individual has since moved to another company that offered a higher cash salary.

Esop values may be impacted if employees have difficulty exercising their options and realising value from them, said Adrian Goh, the co-founder of tech jobs platform NodeFlair.

“In 2022, we saw several public tech companies’ market capitalisations wiped by high double-digit percentages. Coupled with layoffs, employees’ outlook on the value of Esops has diminished and many prefer cash instead,” he said.

Startups commonly provide Esop to workers as a form of deferred compensation or work benefit. They are typically granted on a four-year vesting schedule with a one-year “cliff” period, before which the employees would not be entitled to any options.

Esop can be converted into shares in the company upon an IPO, potentially resulting in a windfall, or encashed earlier if the startup conducts an Esop buyback.

In 2021, for instance, staff of Singapore fintech Nium had the opportunity to exercise a certain percentage of their vested Esop, after the startup raised some US$200 million and hit unicorn status.

In the current climate, however, a number of startups are going through “down rounds”, or fundraising rounds that lower the valuation of the company. This deals a blow to the potential upside that an employee could realise from Esop.

“Take an example of an employee given stock options with a set price of S$10 per share, but the current value of the company’s stock is at S$8 per share. In this scenario, the employee would need to pay more than the current market value of the stock to exercise their options – making it unattractive,” Goh of NodeFlair said.

In cases where Esop goes underwater, he added, employees may lose motivation to continue working for the company.

The tech winter could also make it harder for founders to design Esop schemes.

“Some founders may be dealing with a reduced equity pool and an increased cost of equity financing, which can make balancing allocation and dilution more difficult,” said Bhavik Vashi, Asia-Pacific managing director at US equity management platform Carta.

Fine print

The uncertainty around Esop makes it all the more important that employees are aware of the fine print in their contracts. One key aspect is to ensure that the exercise price of the Esop is set at a reasonable level, such that the options do not go underwater.

Casper Peh, the chief executive of Esop management provider Svested, advises his clients to set a low strike price on employee options. This could even be a nominal sum, such as S$1 for an employee to exercise all the options he holds.

“If the strike price is very low, it’s very versatile. Even if there’s a down round, although the valuation has taken a hit, the Esop will still be valid,” he said, adding that he is seeing some startups having to restructure their Esop to lower the strike price in later stages of fundraising.

Not many regional startups offer a favourable exercise price. According to a 2021 survey of 134 startups by tech investor Saison Capital and Svested, only a third offered a low or negligible exercise price. Meanwhile, 45 per cent set strike prices in line with their companies’ share prices in the latest fundraising round.

An exercise price that is too low can result in a large Esop expense for the startup, said Vashi of Carta. It is therefore crucial for founders to set the exercise price at a “healthy” level that’s neither too high nor too low.

Another key aspect to be mindful of is whether the Esop comes with accelerated vesting in the event of a layoff.

“For example, imagine that an employee has been granted options with a four-year vesting schedule... If the employee is laid off after two years, he would have only earned the right to exercise half of his options,” said Goh.

“With accelerated vesting, the employee would be able to exercise all of his options immediately upon being laid off,” Goh added. “This allows the employee to realise value from the options despite not being able to continue working for the company.”

Some startups have offered accelerated vesting in recent layoffs. When recruitment startup Glints laid off 18 per cent of its workforce, it accelerated the vesting schedules of those laid off by six months while also removing the one-year cliff.

Carousell offered accelerated Esop vesting of 25 per cent for those who had been with the company for more than six months, but had yet to hit the first year cliff.

This is still not a common practice, though. Many startups offer cash compensation and gardening leave instead to laid-off employees, said Chow of ConnectOne. In the worst case of a startup shutting down, the Esop is usually worthless.

Long-term potential

Observers reckon there is still long-term potential for more promising companies to tap Esop in talent attraction. South-east Asia is still a young ecosystem after all, and there is still plenty of “dry powder”, or undeployed capital, here, said Joel Shen, partner at law firm Withers KhattarWong.

Chow of ConnectOne said Esop remains particularly attractive for “earlier stage companies” where “founding employees have a much bigger say over the direction of the company”.

Srikanth Prabhu, vice-president of growth at equity management platform Qapita, emphasised that Esop are long-term investment vehicles, and that the market cycles tend to reverse over time.

“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 (and there is improvement) in the company’s performance,” he said.

But Carta’s Vashi said startups should also reprice their equity and explain the investment proposition clearly to employees.

“By repricing, you bring the equity value down to the market value. This recreates the upside investment thesis for employees,” he said.

“It’s the private market version of buying the dip, where you can honestly communicate to them that getting equity right now, at a depressed valuation, means they have more upside as the company grows and when valuation multiples move back upwards in the future.”

Lawyer Shen noted that in Silicon Valley, many tech workers would not want to join a startup unless they are offered Esop.

“These more mature markets are replete with stories of how people have made money from Esop. One hopes that this will happen too for South-east Asia,” he said.