Introduction

If you are an angel investor, a venture capitalist or a private equity investor actively investing in companies that you think could be the next Unicorn or you are a founder or a CFO ready to raise your next round of funding, then this article is for you.

All investors understand that after the idea and the funding, the team is all that matters. And a big part of ensuring a strong team, which is motivated and aligned to organisational goals, is issuance of equity (read Employee Stock Options Plan or ‘ESOPs’). Thus, most rounds of fundraising typically involve the investors insisting upon and understanding the ESOP scheme of the Company, in particular:

• The size of the current ESOP pool;

• Percentage of the pool which has already been granted to employees as options; and

• How much is expected to be granted with the current funding round?

Where no such scheme or pool exists, most investors insist on creation of an ESOP pool and putting in place an ESOP scheme.

However, despite ensuring the existence of an ESOP scheme and looking at the macro financial aspects indicated above, if the scheme details are not scrutinised closely, from various practical perspectives, issues may arise at a later stage. This article discusses 4 such issues (out of a much longer list!) that investors should examine in an ESOP scheme of the Company they have or are investing in. Equally, these are the points any founder or a CFO should consider when putting an ESOP scheme in place.

Issue 1: What happens to unvested options in case of an acquisition or change in control?

Consider a case where a 5 year-old start-up recently put in place an ESOP scheme to reward those who had been with the Company since inception and also incentivise the new members of management, who have just been just hired. One year into the scheme, the Company gets acquired or a major stake sale takes place, leading to change in control. But unfortunately, none of the employees who had been with the Company since inception or even the new members of management, who helped get this deal, made any money out of this transaction as their options had not vested and there was no ‘Acceleration of vesting’ clause in the ESOP scheme. (Refer link for real life example reported on this issue:

https://www.livemint.com/Companies/tBeYdNTIP6rXT7c7d5qLSJ/The-redBus-sale-A-cautionary-tale.html).

On the flip side, what if the scheme allows for complete acceleration of unvested options in such cases? Suddenly, the number of shares increases, not to mention the increased and immediate accounting cost for the unvested options, which will depress the reported PAT. Both of these may act to materially depress the Earnings Per Share (EPS) and hence reduce the return for the investors, all else being same.

Clearly, both the extremes may be undesirable for both the Investors as well as the founders as they do not want the scheme to be unfair to employees and they do not also want the EPS of the Company to be impacted with a 100% acceleration.

The right answer, for such a problem, may thus lie somewhere in between the two extremes and would ideally depend on various aspects such as how long the Company has been in existence before an ESOP scheme is introduced, is it a scheme to incentivise and retain employees or also to reward employees for their past efforts, who are the key employees and is there merit in changing their vesting terms, what level of drop in return are the investors willing to accept if such an event was to happen, say, within the next 1 year?

Issue 2: What happens to vested options of ex-employees?

Traditionally, most companies have had a clause that on leaving the Company, the employees must exercise their vested options within a stipulated period (say 30 to 90 days) even if no liquidity event is planned in near future. However, such a clause tends to cause a cash strain on the employees leaving the Company as they would have to pay exercise price and tax on the difference between fair market value and exercise price (as per the current tax regime) immediately whilst the actual liquidity event may still be years into the future. As a result, most leaving employees choose not to exercise their options. This clause was therefore not seen as fair to the employees, especially those who served the Company long enough and may have potentially completed their full vesting period.

To be fair to the employees, the companies started changing this clause to allow exiting employees to continue holding the vested options for a long period post their exit and be able to exercise at the time of a liquidity event, same as the existing employees of the Company. Pinterest, a social media web and mobile application company, was probably amongst the early ones that allowed its employees, who had been with the Company for 2 years, to retain their vested stocks for a 7 year period after leaving the Company. (Source: https://www.businessinsider.in/Pinterest-just-made-a-deal-with-employees-that-could-rock-the-startup-world/articleshow/46670004.cms)

However, the issue does not get fully resolved here as other aspects such as treatment in case ex-employees join competition whilst still holding the vested ESOPs, parity between existing and ex-employees in terms of the proportion of options that can be exercised at the time of liquidity event etc. also need to be considered when opting for the second approach.

As such, there is no right or wrong answer on this one. Rather it is about debating these clauses at the time the scheme is put in place to ensure the investors, founder and employees are aligned on how their ESOPs will be treated in such a case.

Issue 3: Presence of any cash settled share-based transactions by the Company?

Whilst ESOPs form part of a Company’s capital table, cash-settled schemes (such as Share Appreciation Rights (SARs) and Phantom Stocks) do not. Lately, a lot of Indian companies have started entering into such schemes (i.e. cash settled share based transactions), primarily with their consultants / advisors, as Indian Laws do not allow giving ESOPs to non-employees. These schemes are sometimes also seen as a way of rewarding the promoters whose share may have diluted considerably due to subsequent funding rounds.

If your Company or the Company you are investing in has such a scheme or is planning to launch such a scheme, it would be useful to understand the following two crucial aspects:

How the same is likely to be settled? Cash-settled schemes tend to be of two types:

- those which are settled on completion of particular period or achievement of a particular milestone; or

- those which will be settled on the happening of a liquidity event.

 

Where settlement of such schemes is not conditional on the happening of a liquidity event, a large cash strain may be created for the organisation in meeting these obligations. Even when the payments are linked to happening of a liquidity event, the Companies often, inadvertently, provide for settlement of vested units upon exit of the employee, in keeping with the traditional way of requiring ESOPs to be exercised when the employees leave the Company.

However, in case of cash-settled schemes, allowing for settlement of vested units upon exit results in cash outflow for the Company even without a liquidity event happening. This unintended consequence could well be avoided by examining the scheme rules in detail to ensure consistency of intent across all possible company and employee related scenarios.

How the same are being accounted for? These schemes are treated as a liability in the books and hence a provision is required to be created for same and revised each reporting period to reflect the fair market value of these schemes. Over time, these provisions can become substantial, depending upon the quantum of such schemes in place.

Thus, as an investor or as a founder / CFO, you should be aware of not only the current impact of these schemes on the reported profit but also how the provisions are expected to build up in future based on the business plan of the Company and hence the estimated impact on the future reporting profits of the Company.

Issue 4: How are ESOPs being accounted for?

A lot of start-ups fall under reporting requirements of Guidance Note on Share-based payments (2005) issued by Institute of Chartered Accountants of India, as their turnover may be lower than that required for adoption of Ind AS (the IFRS converged reporting standards applicable to listed companies and non-listed companies that meet a certain turnover criteria). The said Guidance Note gives an option to the companies to choose between accounting for ESOPs on intrinsic value basis or fair value basis. Given the option, most companies tend to adopt the intrinsic value approach as it results in lower accounting charge. In fact, in cases where the exercise price of the grant is same as the estimated fair value of the underlying share, there may not be any cost charged to the income statement under the intrinsic value approach. This is, however, different from Ind AS 102 on Share Based Payment transactions, which mandatorily requires accounting of schemes on fair value basis and therefore results in a higher, and a more realistic, charge to income statement of giving out ESOPs.

Notwithstanding the benefits of an ESOP scheme, the accounting cost to the Company is an equally important factor to consider as it impacts the reported profits of the Company. In particular, companies tend to make ESOP grants on a frequent basis and hence it is essential to understand the expected on-going reporting costs on account of issuance of ESOPs. Similarly, if the Company is growing and soon likely to transition to Ind AS, the charge to income statement because of issuance of ESOPs may change considerably, including allowing for a large one-time charge for all the unvested ESOPs, which may have been accounted for an intrinsic value basis till date.

It is therefore essential that you are aware of the current accounting treatment for ESOPs and what that means for the valuation of the Company. If the current accounting treatment is based on intrinsic value, it will be useful to consider the PAT and other metrics after allowing for the cost on fair value basis, which is the norm for accounting of such schemes internationally.

Conclusion

ESOPs and other forms of share-based payments is a growing area in India. With the influx of start-ups, some form of share based compensation would be required to attract and retain the right talent, at an early stage of the organization. However, it is also a technical area which requires due consideration and diligence in coming up with a right scheme for the Company. The factors to consider are not only financial but are also related to legal issues, HR and other operational practicalities that surround the scheme. This article highlights only 4 such aspects that, in our opinion, every founder and investor should know about the ESOP scheme of their company / portfolio companies to avoid issues at a later date. Watch this space for more insights on ESOPs.

Should you have any comments or thoughts or feedback, please feel free to share write to us. We would love to hear from you!

 

 

Vichitra Malhotra, FIAI Founder and Consulting Actuary
v.malhotra@veritas-india.com
+91-9372876627

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