Employee friendly equity policy: a win-win for employees and the startup

Think of all the great companies that you look up to and respect and you will come to realise that they have highly empowered and invested employees, who are well aligned with the company’s vision and goals. Employee Equity is one of the most powerful tools at the founder’s disposal to inspire and align employees, for, after all, ESOPs confer ownership of the startup, to the extent of shareholding, to employees. 

In my First Principles series I have tackled a varied list of topics that are closely linked to the various building blocks that together make an organisation (Read the previous posts on Solo Founder or Co-founder, Founder to Leader journey, Strategic Thinking, Organisation Design, and designing Organisational Culture). In this post, I am not tackling Employee Equity from a legal perspective; rather, I will focus on why an employee-friendly equity policy is good for the startup. 

The What

Let’s get the basics right first. 3

Employee equity is a component of the compensation provided to the employee. It is the non-cash compensation in the form of equity that grants the employee ownership, to the extent of shareholding, in the startup.

‍This type of equity compensation takes many forms, including options, restricted stock, and performance shares. We will get into this in greater detail in a bit. 

The Why

For a startup founder, the team is the vehicle that transforms an almost-chimeric idea into the reality of a startup. The importance of a good team in building a successful startup cannot be overstated. Joining a startup, especially in the early unproven days, is a leap of faith for many potential hires. At the same time, money is typically a resource in short supply. 

‍In the early-stage of a company, employee equity is a mechanism to attract good talent. For the hope and intent is that the startup will do well, its value will rise, and this early believer in the startup will be rewarded for that belief in the form of wealth creation opportunities (equity sale opportunities) at a later date.

‍As the startup grows and builds a market for itself, the employee equity should continue to help attract new talent. The idea is the company would have a track record of raising funding at higher valuation, which shows its equity has potential to grow in value. Further, when existing employees make ‘money’ from owning a stake in the company and this is clearly visible, it becomes a siren call to potential hires.

At the growth stage, employee equity also becomes a part of the Rewards & Recognition programme of a startup, acting as an incentive for better performance and encouraging employee retention.

How does equity act as a bigger driver of performance than cash incentives?

1. Equity confers ownership, so the better a company performs the higher the value of the equity.
2. The cash incentive is pre-decided and there is always an upper limit. Equity is the only way an employee can create real wealth on the job.
   

An important factor that not too many founders or startup folk talk about regarding employee equity is on how it is the right thing to do. We go back to the point of how a startup employee is taking a bigger risk and in many cases goes above and beyond to make the startup vision a reality. So, it is only right that startup employees are able to earn higher value when the startup does well and succeeds.

The How

While I am not going into the legalities and specifics of how to structure employee equity, I would like to share some thoughts and ideas to help founders plan and implement better. 

Size of the equity pool: This depends on the founders. The more the number of founders, the lesser there is for employee equity. However, 10% to 15% is an excellent employee equity pool.

Who can be offered employee equity: Employees, board members, consultants, mentors, and coaches can be offered this compensation. The definition is quite broad. We all have heard the story of Graffiti artist David Choe, who took Facebook stock instead of cash for a mural painting he did in the social media company’s office in its early days and became a multi millionaire.

What are different types of employee equity: Many equate employee equity only with Employee Stock Options (ESOPs). There are other types of employee equity; here’s a quick overview of the different types of employee equity:

1. Employee Stock Option (ESOP) schemes are the most commonly used form of employee ownership. The option granted under ESOP transfers a right to the employee, but not an obligation. Stock options are subject to vesting, requiring continued service over a specified period. Upon vesting of options, employees can exercise the opportunities to get shares by paying the predetermined exercise price.
2. Restricted Stock Units (RSU) awards an employee the right to receive shares on a predetermined date, but only if specific conditions are met or a specific event occurs. Under this plan, the employee becomes a shareholder only upon this condition being fulfilled. 
3. Stock Appreciation Rights (SARs) are not technically employee stock options, but companies often use them in a similar manner. SARs offer employees with cash payments that match the appreciation of the Company’s stock over a specified duration. Unlike other options, SARs provide employees with equity upside without exposure to any downside.
4. Phantom stock is a type of long-term deferred compensation that uses Company shares as the benchmark for calculating the value of partial payment to the employee. It mirrors or simulates the Company shares, except that it does not make an employee a real owner. The Company credits these phantom shares on its books, and so when the value of the company’s shares rise and fall, so does the value of the phantom stock.

The how and why of making the equity plan employee friendly

The why is easy to answer. A startup, its founders or investors do not lose out by making the equity plan employee friendly. Some startups have a tough vesting schedule, where an employee needs to wait and show patience to get real access to the shares, or have really short expiry periods. 

Founders need to ask themselves what is the purpose of making it difficult for an employee to actually access their shares. If an employee plans to quit, will equity that is yet to vest or is too expensive to exercise be enough to hold them back? Will an employee value the equity you offer if he or she believes that there is little chance of the equity actually helping them create wealth? 

An employee friendly equity plan is a win for the startup, as it excites the employee. There is something to look forward to. New hires see older employees make money in a liquidation event, like a secondary sale, and aspire to earn that kind of opportunity at the company. It makes your company’s stock valuable to employees. 

Coming to how to make the equity plan employee friendly, let’s look at some of the important points. 

1. Customised or Flexible plan

Many founders consider the employee equity plan a sacrosanct that needs to be strictly defined. This is far from the truth. The equity plan needs to suit your organisational needs and needs to evolve along with the company. What works at the founding stage might not work at the growth stage. It is best to have a long-term view and create a plan that can sustain the startup for eight to 10 years.

This might seem counter intuitive, but having a uniform employee equity policy across levels might not work. What works for a middle level new hire might not be an incentive for a senior leader who has grown with the company. 

For instance, food delivery platform Swiggy divides its employees into four categories and has created an equity plan that works flexibly for each level. At the middle-management level, employees do not receive ESOPs immediately upon joining but become eligible for performance-linked ESOPs later on, with these ESOPs typically being much higher compared to those offered to eligible employees upon joining.

2. Larger employe equity pool

Earlier some startups used to restrict the employee pool to single digit, in an attempt to protect founder and investor equity. That is counter productive. For meaningful wealth creation, a larger employee equity pool is necessary. Double digit equity pool should be the norm. 

3. Vesting Schedule

Some startups use a miserly vesting schedule as a deterrent to employee exit. The idea is if there is considerable stock that is yet to vest, the employee might stay back. But, haven’t we seen many instances of senior leaders leaving despite shares that have not been vested? This will result in your startup ESOPs not being considered valuable, with existing and potential employees looking at it just as a piece of paper. A four-year vesting schedule (25% each year), with the first 25% vesting on anniversary date and successive vesting happening every quarter is quite an employee friendly vesting schedule. Again, you can be flexible and work out what’s best for your startup at the stage you are in. For instance, some startups have opted for performance-linked accelerated vesting. 

4. Status of employees who leave

Mature founders realise and accept that employees could leave the startup and may not stay on forever! How you deal with an employee when they leave is as important as how you treat the employee who stays. This is also true in the case of employee equity. Unvested options lapse upon resignation and in most cases if an employee has been fired for certain reasons, even vested options will lapse. Let’s leave these instances aside for the purpose of this post. When it comes to vested shares, employees need to exercise his option, which simply means converting the option to an actual share. Companies demand that employees need to exercise their options within a specified period of leaving the company. Sometimes this can be just a few weeks; ideally it should be 90 days. Further, when there is a liquidation event there are instances when the former employee gets to sell his shares only at the end after current employees are done. Recently, Indian startups have begun offering former employees a chance to sell their shares along with current employees during secondary sale events (See Urban Company Case Study below).

5. Strike Price or Exercise Price

When an employee exercises his option, he has to pay the strike price or exercise price to the company. This could be the current market value or at the face value of the share. Strike price at face value, ideally of Rs 1 per share, makes more sense to an employee.

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In this context Restricted Stock Units (RSU) offer an advantage over other forms of options, as these shares have no value at the time of grant or until they vest, which means their face value is zero. 

6. Liquidation events

Such equity is only as good as the wealth it creates. This means employees should have opportunities to sell the equity they own. Indian startups have in recent times been proactive about offering employees such opportunities. Swiggy for instance completed a buyback in 2018 and has announced its next secondary liquidation programme for its employees, while Urban Company facilitated a secondary sale worth $5 million for its employee shareholders earlier this year. 

The Urban Company Case Study 

On-demand home services startup Urban Company, part of Accel’s portfolio, completed an employee stock sale in August this year worth $5 million. Urban Company is part of a growing club of top-tier Indian startups that are offering their employees the opportunity to cash in their employee equity. In fact, this was Urban Company’s third such exercise, having done two employee share buyback events in June 2017 and December 2018. In the latest buyback event, 180 Urban Company employees were eligible to participate. 

Employee friendly equity plan

In my conversation with key Urban Company leaders, Mukund Kulashekaran, SVP of Business at UrbanCompany, and Rahul Deorah, VP Marketing at Urban Company, they reiterated that the multiple opportunities the startup has provided its employees to capitalise on their ownership of the its shares is part of the highly employee friendly equity plan the company has instituted.

Some of the terms of the employee equity plan of Urban Company, which can be considered as best practices, are as follows:

1. An expansive employee equity scheme, where 40% of the company's full time employees, from customer service representatives to its senior vice presidents, have ESOPs.
2. A flat four-year vesting schedule, which means 25% of an employees stock options vest each year.
3. Accelerated vesting, which means employees are able to vest their options faster than the typical vesting schedule
4. An exercise price of Rs 1 a share
5. Lifetime hold or infinite hold, which means the stocks remain the employee’s once they vest even if he or she chooses to leave the company. The employee is not forced to exercise their option within a stipulated time after they leave the company.
6. Fresh allotment of ESOP linked only to performance and not to whether the employee has sold the shares he or she owned earlier.
   

Employee equity equals value

Ensuring employees get a chance to earn from their shareholding is key to the employee-friendly equity plan. You can have the best of terms but if the employee never gets a chance to sell, then equity stops getting valued.

Mukund told me that the leadership of Urban Company was clear that if wealth creation for employees is a goal then owning equity is what matters. 

“But, I think sometimes people (employees) feel the ESOP is a paper and they don't put a real value to it...the main reason we do the secondary sale is to make sure people actually see value from it and don't need to wait seven to eight years to see an outcome,” said Mukund. 

Rahul acknowledges that when employees see value from owning a part of the company they see that their interests and the company’s interests are aligned and that acts as an incentive for even better performance.

Such buyback events showcase to new hires and to those climbing the leadership ladder that equity is a valuable part of compensation. Rahul told me the equity discussion is an important part of the conversation with prospective hires. “It's a long conversation that we have and requires convincing because of the sentiment that exists in the market that equity is not valuable,” said Rahul. This is why the three rounds of employee share buyback at Urban Company becomes important as new hires and others see that employees have actually made money and the value creation is not just on paper. 

The secondary sale

Urban Company was planning the secondary sale pre-pandemic, but put it on hold when Covid-19 struck. However, once business re-started in May the company saw a quick rebound as Covid-19 was accelerating the move from offline to online, which proved to be a shot in the arm for Urban Company and the startup has now crossed pre-pandemic levels in terms of business. 

This gave Urban Company the confidence to proceed with the planned share buyback. Mukund told me that when a company is doing well the whole process is quite straightforward. 

Typically, there is a corpus that an investor or group of investors want to acquire the stake. In the case of Urban Company’s latest buyback existing investor Vy Capital was acquiring the shares. 

In Urban Company’s latest secondary sale any existing employee with vested options could participate. Preference was not given based on experience or role. The only condition is that the shares should not exceed the corpus.

‍In some cases, there is a fear of crowding out, where only a few shareholders sell a bulk of the shares, which reduces the chances of the rest to sell. Mukund said since the team size is still small, the plan was to have conversations with the employees in case crowding out becomes a serious concern. However, that turned out not to be the issue. “Usually once you do a couple of secondaries, most people want to hold back because they know value is going to increase with time. I remember Abhiraj and Varun (co-founders at Urban Company) making calls to a lot of people to make sure that people actually liquidate. It was funny that the push was more to get at least some of us to liquidate some bit rather than having to manage an over subscribed allotment,” recalled Mukund. 

Mukund and Rahul also addressed the myth that employees who make money out of such buybacks then get complacent or leave. While, there are instances of employees using the money made through their ESOP to start up on their own, Rahul reiterated that this is good for the startup ecosystem and that is how it should be. This should not be a reason for startups to hold back and not allow employees to make use of their equity. In fact, both agreed that they see greater drive and will to perform among the team, and secondary sale events act as a boost to employee morale with more employees vying to earn ESOPs.

With Indian startups increasingly offering liquidation events for employee equity, employees across multiple startups are getting greater opportunities to partake in the wealth created by startups. This is good news for Indian startups, as this is a clear competitive advantage that startups have versus larger companies when it comes to hiring and retention. Founders should make good use of employee equity. There are few other incentives that link employee performance and startup growth as strongly as equity.   

Related Article:

1. The Why, What, and How of Employee Equity

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