The Why, What, and How of Employee Equity

A robust and effective employee equity plan can prove to be a useful compensation tool...

Narayan Thammaiah
Venture Partner, Accel
10
 Min Read
The Why, What, and How of Employee Equity

A robust and effective employee equity plan can prove to be a useful compensation tool when it comes to attracting, retaining, and engaging talent as a startup. Through our 25th #LearnAtAccel session, we were able to gain valuable insight into the world of ESOPs (Employee Stock Ownership Plans) and all their intricacies. During this meeting, we answered some important questions, such as:

  • How should my equity plan be structured at every level of the hierarchy and in relation to the market stage of my startup?
  • How can I seamlessly link my startup’s rewards philosophy and overall business culture to my equity plan?
  • How can my startup design a smooth, transparent, and straightforward execution of an equity plan?

In order to understand how ESOPs can be constructed in such a way that they prove to be beneficial to both employer and employee, we invited K. Satheesh, HR Center of Excellence, to share his experiences from his seven-year journey.

1. The Stage of Your Startup

Satheesh states, “When you start a company, you want to create a sense of ownership with the ten or fifteen people who are there with you at a very early stage.” Therefore, during your initial establishment phase (which he calls Phase 1), your equity plan should be about sharing ownership and creating value in the long-run. However, when moving into Phase 2, startup founders look for specialists. Therefore, the equity plan should be utilized more specifically, observing the worth of the job. Finally, in Phase 3, the plan should function primarily as a mechanism for retention.

2. Your Rewards Philosophy

Moreover, Satheesh asserts that it is vital that your ESOP be clearly and coherently linked to your rewards philosophy, whether that is compensating stellar performance, driving fairness, or generating wealth for all, among others. He uses an example to elucidate this viewpoint.

Rewards Philosophy:

Those who join my startup at an early stage and drive the company forward should have substantially more wealth than those who join at a later stage. Those who join my startup at the same time or stage should have equal opportunities to generate wealth.

Equity Plan:

If two people joined my startup as directors 7 years ago, they should…

A. Both have a similar approximate minimum to maximum range in equity value (given that they have been consistent top performers).

B. Be given a grant that is in sync with the company’s growth and valuation.

Using these factors, build a data model that calculates the equity share for each employee. In this manner, employees who joined with, for example, six months’ gap between them will see a noticeable difference in their equity plans.

Ultimately, it is more important to focus on the philosophy, rather than the actual arithmetic.

3. Flexibility

Another key aspect of building an ESOP that works for you is maintaining flexibility. When you design a very closed set of plans, you limit yourself from accessing the benefits of sub-plans and complicate the wealth generation process when growing like a startup. “Look at the long-term horizon, whether that’s three or five years from now,” suggest Satheesh. This will enable you to frame an equity plan that advances and transforms along with your company.

4. Vesting Schedules

Some may believe there is one standard vesting schedule appropriate for any company, but they would be mistaken. “Most often, what I’ve seen is an ‘everyone follows this, so I will too’ approach,” says Satheesh. However, this tactic may prove detrimental in the long run.

Different vesting schedules work better for different companies, depending on a variety of aspects, such as stage, size, profit turnaround times, employee headcount, and so on.

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5. The CTC-Equity Dilemma

Some of you may wonder, “Does my equity plan for a certain employee need to be based on their CTC?” Satheesh suggests that through an equity plan based on a percentage value of CTC would be a bad idea structurally (as an increase in someone’s CTC would also lead to a similar increase in their stock ownership), the two should be loosely tied to each other. A lower take-home salary should, in general, mean a higher equity share; in the best case scenario, a dedicated employee is likely to ask you for a higher equity share and a lower salary. Not only does this show the employee’s belief in your company, but it motivates them to drive your startup’s growth. In cases such as these, companies tend to add multipliers to the equity share so as to boost motivation and guarantee retention.

The ideal valuation looks a little bit like this.

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This diagram shows the pay scale and equity share for an employee passionate in your company’s goals. It’s important to remember that employees have different needs and motivations at different stages in their life, and their willingness to accept such an offer is dependent on where they’re at from a personal standpoint. But a potential employee who is ready to accept this offer would be the optimal hire for any startup — but they may be a little difficult to come across.

6. Units vs Value

A common mistake that many startups make when structuring their ESOPs without first consulting a professional is to offer equity in value rather than in units. But why is that problematic? Let’s take a look at an example.

Employee B joins Company A on August 1st, 2018. They are offered equity worth 10,000 INR.

An investment window opens. The valuation of Company A then increases by 40% on September 1st, 2018.

Employee C joins Company A on September 2nd, 2018. They are also offered equity worth 10,000 INR.

What happens in this instance?

A. The number of units Employee B owns will decrease.

B. There will be a difference between what Employee B and Employee C own (which may work against a rewards philosophy that focuses on fairness).

Therefore, it’s important to always offer ESOPs in units, not in value.

Now, how do you design an effective buyback plan?

Siddhartha Jain, Senior HR Manager at BlackBuck, explained how they successfully carried out a pseudo-liquidation process right in the first year of their ESOP as an early-stage startup. “The intent of this process was to keep our employees motivated and engaged in the growth journey, create belief in ESOPs, and share the fruits of our growth” he states. Because it was difficult for employees to calculate a tangible point in time when they could see rewards manifest through their equity plan, it was important for BlackBuck to undergo a process similar to a liquidation — a stock surrender. This means the company paid out a separate cash reward to all the employees who decided to surrender their stock (at a strike price of ten rupees per unit). So how did they manage to pull it off?

1. Communication

The liquidation event was announced to all equity holders within the company — even if they didn’t have the opportunity to vest their shares during this process, as BlackBuck felt it was important to create awareness about the fact that ESOP-based wealth generation was not just on paper, but a real possibility. This announcement was made after an investment window, which allowed Rajesh Yabaji, CEO of BlackBuck, to link the valuation growth of the company to both the effort put in by all the employees and their potential to collect the profit of their labor.

In addition to this, one-on-one communication was carried out by the human resources team with all of BlackBuck’s employees. These personal sessions allowed HR representatives to inform employees about all their choices: what and when they could liquidate, the legal and tax implications of liquidation, and what the pros and cons of their decision (to liquidate or not to liquidate) would be.

2. Demonstrating Intent

BlackBuck paid out all the surrendered stock at the Fair Market Value (FMV) rather than at a discounted value, which has now become the best practice to follow as it demonstrates actionable intent. Secondly, though the company was aware that there were some employees on the verge of quitting, they were still allowed to liquidate their stock. This is a fine example of a company with an appreciation for how their employees’ hard work drives their progress.

3. Legal Consultation

From ensuring the legal paperwork is correctly completed to gaining a thorough understanding of the tax regulations involved, BlackBuck underwent a series of consultations with specialists trained in the field of ESOPs in order to ensure their liquidation followed the appropriate legal framework.

4. Benefit

BlackBuck observed a twofold benefit from this liquidation process. Firstly, as expected, the process improved morale and increased job satisfaction among BlackBuck’s employees. However, perhaps more importantly, there was a healthy percentage of people who did not want to liquidate their shares and chose instead to hold on to them. “This was probably the best way to see that people still believed in the organization, they weren’t just looking at the short-term,” states Siddhartha.

To further highlight the benefit of ESOPs and explain their features, we were joined by Girish Menon, Head of People at Swiggy. Girish first gave us a look at what drives Swiggy’s philosophy when it comes to their employees — their HR team looks at them from a different perspective:

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By observing employees as adults, consumers, and human beings, Swiggy is able to move away from the traditional angle of viewing staff members as just employee codes. But how does this acronym manifest on the ground? When employees are considered to be adults, they mean that, for example, Swiggy doesn’t set a limit on the employee’s relocation expenses and prefer instead to trust their judgment. They’re also big on matter-of-fact feedback — evaluations are passed pragmatically and with actionable pointers.

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With regard to the ‘consumer’ aspect, Swiggy has high impetus on a candidate’s experience when applying for the job. In this manner, they have begun many a program to improve their experience: tracking the number of minutes a candidate has to wait for an interview and initiating an auto-approval system for requirements such as laptops, among others. Finally, Swiggy believes in design thinking, which is where the ‘human being’ point of view comes in. This means treating employees with empathy and compassion, demonstrated in how the company offers certain employees plane tickets to visit their family, for instance.

This philosophy guides their management of ESOPs as well. Swiggy divides their company’s teams into four categories and has devised an equity plan that works flexibility for each level of employment.

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At the leadership level, the team is offered ESOPs including a multiplier — which has proven to work well for Swiggy. They even have staff members requesting a higher multiplier in exchange for a lower CTC at this level, which is something they are happy to do. As many may know, the company completed their first buyback earlier this year (at a one rupee exercise price). Post-buyback, they noticed that even those in senior management roles are interested in receiving ESOPs in exchange for a decreased CTC. Moreover, they also offer performance-linked ESOPs to those in meaningful roles at middle-level management (though they don’t receive ESOPs immediately when they join). These performance-linked ESOPs are typically much higher in comparison to those offered upon joining. To Swiggy, it’s ultimately about locking in and taking care of those at the top — the ~100 employees making decisions and creating value for the company.

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When it comes to vesting, Swiggy proposes a four-year vesting schedule with a one-year cliff, which is when accelerated vesting comes into play. Because ESOPs are a long-term incentive, they do not believe in offering monthly vesting schedules as they want to retain their employees and allow them to vest only after a year. This means new hires aren’t able to take advantage of their ESOP if they quit prematurely, but the benefit also materializes quickly enough for an employee to understand the worth of their equity plan — achieving a delicate balance between two extremes. However, their ESOP structure and its vesting schedule remain discretionary and flexible for when Swiggy looks to hire someone exceptional at the leadership level. In conclusion, Girish says, “Don’t become slaves to your ESOP structures.” Swiggy’s ESOP policy remains adaptable and responsive to the employee and the situation; the policy is creative and innovative in order to attract and retain the talent that they really want.

Finally, Girish suggests taking into account the evolution and stage of your company when it comes to deciding how to deploy ESOPs. Though Swiggy has an internal team that manages their equity plan, there are numerous specialists trained in the field to help companies plan, deploy, and manage ESOPs.

The vital conclusions drawn from this insightful #LearnAtAccel session are:

  • Create an equity plan aligned with your particular stage of growth.
  • Divide your employment database into manageable categories and structure your equity plan based on those divisions.
  • Line up your ESOP in accordance with your rewards philosophy.
  • Keep your ESOP and vesting schedules as flexible as possible, especially in the early stages.
  • Loosely tie an employee’s equity share to their CTC (higher CTC, lower share, and vice versa).
  • Offer ESOPs in units, not in value.
  • Define exercise periods early on and create an ex-employee plan that specifies their rights to exercise.
  • With regard to governance, start as early as possible.
  • Always keep your ESOP transparent — communicate clearly and give employees access to the data they need to make informed decisions.
  • As far as possible, try to keep your equity plan and its deployment and management paperless.
  • Don’t try to structure ESOPs on the fly — now there are enough capable and adept specialists to work with if you hope to offer an equity plan to your employees.

‎SEED TO SCALE Podcast Series by Accel | SeedToScale Podcast by Accel

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