Whether to opt for stock options in a Start-Up as a professional?

What is a Start-up?

Start-up is defined as a company that is in the first stage of its operations. These companies are often initially bank rolled by their entrepreneurial founders as they attempt to capitalize on developing a product or service for which they believe there is a demand. (As defined by Investopedia)

Of the various factors to be worked on, the major one is getting talent on-board in the budget allotted. In context to this, one of the trends followed by the start-up firms is to offer equity options to the employees being recruited.

Why do start-ups opt for equity options?

The main reason for taking this option is that the start-ups have limited cash. Unlike the biggies, who have good amount of cash per employee, the start-ups have limited cash component for the entire set up and can’t compete with the big firms. This is also a method by which free money is generated by undervaluing the common stock at low strike prices. The key for the usage of this method is to attract talent / top recruits at the higher positions of the company.

From the employee perspective, this is a gamble, to make it big or lose upfront. It could be millions or zero depending on the performance of the start-ups. Start- up equity options are offered to employees giving a blend of the salary component and the stock option.

Employee Stock Options (ESOPs) have become famous thanks to all the startups who are putting in every effort to make their ventures successful. Earlier, ESOPs or stocks were granted to seniors of the company to acknowledge their contribution in the growth of the company. However, nowadays ESOPs are provided to newly recruited employees, as the founders have limited funds in the beginning.

There are various factors that need to be considered before accepting stock options as a part of the compensation specially for a start-up.

Majorly when stock options are offered in a start-up, it would be a private company. Also, one has to see the reputation of the people starting the company. It could be a fresh entrant into the industry. Or on the other hand, it could be a set-up by an established entrepreneur in the market.

There are two scenarios that are to be considered:

• The start -up is by a budding entrepreneur
• The start -up is by an established entrepreneur

In the first case, it could be a venture by any common man like you or me, wanting to make it big in the industry. There are different factors that have to be considered before accepting or rejecting the offer.

In the second case, it could be a leading player of the industry wanting to start a venture of their own. This could be a retired person like Mr. Narayana Murthy (of Infosys) who would feel like making a mark in the industry on his own name. In this case, there is a brand that carries weightage for any prospective employee to take up an offer and negotiate terms. Accordingly, the terms would be concluded with a different focus and objective.

What is to be considered?

Salary negotiation : When an individual is offered stock options combined with the salary, it could be possible that they have to accept a below market salary. This could be, to compensate for the options been given instead, or it could be because it is a start-up that is non-profit making. You need to see the percentage of stock options and salary component. This would indicate how much is at stake in relation to the success of the start-up.

Stake offered: Many start-ups depending on the position offered, do give a stake, ranging from 1-2% of the start-up. Here, the conversion terms laid down by the company are to be analysed carefully.  Generally, percentage offerings take place in private firms, thereby the growth expected has to be chalked to analyse the viability of the offer.

Conversion criteria: Shares in a start-up are different from shares in a public company because they are not fully vested. For example, if one is granted 2,000 shares at four-year vesting, an individual would receive 500 shares at the end of each of the four years until it was fully vested.

One has to remember that it is an investment decision and a cash salary doesn’t always stand equally as against equity, so it is at the discretion of every individual to determine what risk one is willing to take.

Whether to accept or reject the offer?

Of the two scenarios mentioned, in the first one it is required to be noted that:

• It is a complete risk for the acceptor with regards to the success or failure of the venture.
• This would be done in compromise to higher salaries offered elsewhere.
• The cash component in hand would be lower than a 100% salary job offered.
• The amount of effort expected should be compensated by the offer made.
• If a stake is given, what are the responsibilities to be borne for the offer?

Only after analysing all of these, if one still finds the offer to be lucrative then the individual can think of taking up the offer.

In the second scenario with an established entrepreneur, you should note the following:

• Here the compromise on the salary would be compensated with the experience that one would gain under leading players of the market.
• One will get to learn quite a bit with the ones who have already been in the market.
• The expectations from the job would be higher than the others.
• The future prospects with the experience from a positive entrepreneur would be bright and high yielding.

One has to see the kind of personal development that can take place by working with experienced employers. The lower salary and risk taken could give higher returns going forward.

Based on the inference from the two scenarios, it is an individual’s call to take up or reject the offer, based on the comfort zone at personal levels.

Suppose the CTC offered is Rs15lacs with Rs10lacs in fixed compensation and Rs5lacs worth of stocks. Primarily, because the stocks are never vested immediately, as the leading hands want the employee to stay with the venture for a reasonable amount of time to be entitled to the benefits. Secondly, immediate value of the stocks is just an indicative number.

Remember that startups need to be successful before the numbers chalked become actuals and of any real value.

Factors to be taken care of:

• Employees should ensure that all the documentation is in place.
• They should also consider the present value and future value of shares.
• Proper Exit Mechanism should be in place.
• When the shares get allotted, check whether they are taxed as salary or perquisite.

Advantages of taking up the stock option

• The employees do get a sense of ownership in the company. It helps in getting them in line with the other shareholders of the company.
• Equity compensation is getting a piece of the company, one of the defining aspects of working at a startup.
• It is a way to hire good talent.
• It encourages the team to form a serious relationship with the startup.
• It creates a monetary incentive

Disadvantages of taking up the stock option

• When the ESOPs are exercised, the founder’s shareholding gets diluted.
• Lower than expected performance could hamper the expected values from the stock options.
• The risk to stock options is not being up-to mark in terms of the company growth. If the company does not perform the employee investment is at risk.
• As the employee does not influence the stock options, the result of the plan has no value for the employee.

Conclusion

While established companies use stock options as a retention tool for the top brains; startups use it as a tool to hire talent, as they cannot afford to pay very high salaries. Thus, ESOPs a good tool for startups, is a bet for the employees. Employees should be convinced about the growth of company and then take the appropriate decision to be a part of the compensation.