When are your ESOPs worth, if ever?

Part 2 of ESOP Fables where we find out when will we see liquidity. And will we?

In the previous post, we measured the worth of our ESOP. Read it here if you haven’t:

What are your ESOPs worth, if any?

In this one, we find out if and when that worth materializes. This game has two levels. 1️⃣ First, will the company be able to generate wealth for founders and employees? 2️⃣ Second, when the liquidation event occurs, will you, specifically, get anything out of it?

Let's not discuss "Will the startup even succeed?"

A pessimistic and realistic answer is No. This worldview is rooted in reality but does not help us evaluate the worth of our ESOPs. Let's consider what happens when startups do succeed.

When do ESOP holders make money in a privately owned company?

The three most popular scenarios are:

1. Acquisition by another company

2. IPO — going public from private

3. Stock buy-back or sale, usually before or during fundraising

Ask a corporate finance person, and they can probably tell you five more scenarios, but the above three are most likely. Always remember that when it comes to liquidation, Investors > Founders >= Employees. This is the nature of capital flow, risk management, and wealth generation; you cannot fight it. 

The surest path to liquidity is rapid growth. 

If your startup grows so fast that there's no time for anything, you will likely hit one of the cases above. If you're on linear growth, then the timeline for all 3 gets stretched a lot — this may still work for the founders, as they are in it for the long haul, but it may not work for the employees. Here's a picture worth a thousand words

Acquisitions and IPOs come with cooling periods.

Almost always, employees and founders have to wait a specific time period, say one year, before they can liquidate their stock. The reasons for this cooling period vary from SEC approvals to board mandates. But almost always, there's a waiting period. If, in this period, the acquisition falls apart, the company stock tanks, or growth stops, oops, bad luck! The two most notable examples are the Adobe & Figma acquisition, which did not pass antitrust scrutiny. And Grab & GoJek—despite doing everything right, both fell considerably after their IPOs and are currently on a slow path to recovery. 

Let's return to our example. The cash component was 40L, and the total ESOP grant was ₹1Cr ($120k). It's worth 0.1% of the company, making it a $120M startup. The company will become a unicorn and IPO at $1B in four years. Your ESOPs got diluted by 50% and are worth (1 - 0.5) * 0.1 * $1B = $500k. 

• Scenario 1: The company continued to grow during the cooldown and is now $2B. Great news: you're a millionaire and can liquidate for $1M. Some will say HODL at this point, but either way:💰💰

• Scenario 2: The markets rejected the company, now at $300M and falling. Your $500k reduced to $150k. 😩 🐻

Stock Buy-Back is limited to a fraction of your total holding.

You can only sell a limited portion of your vested equity during a buy-back. This ensures everyone is vested in the longer-term outcomes and doesn't tap out.

You're making money in a buy-back because an investor with an astronomically higher budget and risk appetite than you is putting their money and collecting risk for a much higher reward later. This should show you that maximizing buy-backs is always a good idea. You don't need to take that risk; you already have other ESOPs that allow you a higher reward later. Liquidating protects you from total failure later, gives you sweet, enjoyable liquidity, and elevates your financial well-being. Take. That. Buyback.

"So you say, Swanand. But <so and so..> company bought back stock, but my friend got nada. Zilch." 

Glad you brought that up. 

ESOP policy: The bridge between you and liquidity

Employee-friendly ESOP policy makes all the difference in the world. That, and founders who are comfortable sharing wealth with those who helped make it.

What is a friendly ESOP policy?

A friendly ESOP policy fundamentally does two things:

1. Align employee incentives to the company by rewarding tenure

2. Does not take away an earned reward — considers vested ESOPs to be sacred

Practically, that translates to exercise windows, vesting schedules, exit policies, and many other things.

Vesting Schedule: The magic glue to alignment

Gradual vesting, with an initial cut-off called a cliff, is the most crucial aspect of the ESOP policy. It brings everything together. You earn your ESOPs just as you earn your salary — through tenure. The longer you work, the more you make.

The good, bad, and ugly vesting schedules

• The industry standard is four years of monthly vesting, with a one-year cliff. You get 25% at the end of Year 1 and then 2.0833% each month thereafter: ((100 - 25)% / ((4 - 1) years * 12 months/year). You are 100% vested by the end of Year 4. You do not get a dime if you leave within a year of joining.

• A worse schedule is yearly vesting. You get 25% at the end of each year you spend. 25-25-25-25. My most meaningful stock grant followed this pattern. It wasn't ideal, and all of the C-Levels, including me, wanted to change it, but we never acted on it.

• Another worse example is promising ESOPs as a part of compensation but granting them much later. This delays your vesting for no reason. Genuine companies offer accelerated vesting for tenure already spent.

• The worst is extending beyond 5 years or backloading stock vesting. Amazon famously does a 5-15-40-40 vesting. But remember, Amazon is a cash-rich public company that can always reward you early in various ways. But if a startup delays your vesting? Hell no. Run away. Some BigTechs are a class apart. Consider Google, who has started a  38-32-20-10 vesting schedule now. They do monthly or quarterly vesting depending on the amount and your negotiation leverage.

Exercising ESOPs = tax implications

Your startup should never take back vested stock, even if you exit or the startup exits. And yet, when you leave, many companies often give you a limited time to exercise your vested options. See the "Bad" column in the last row in the table above. Now, you have two options: say goodbye to years of hard work and future rewards, or take a tax hit and exercise the options. It's too late to fix this — you had to check the ESOP policy before joining. The best you can do is request the company to extend the exercise window.

Current employees will get better treatment than ex-employees

Duh. No brainer. When you leave a company, you yield your leverage, and the company has no obligation towards you other than what the ESOP policy mandates. There have been cases where ex-employees weren't allowed to participate in buybacks. Also been cases where ex-employees were able to liquidate on IPO Day 1, as opposed to waiting until the cooldown period. It's safe to assume you will fare better as an employee than an ex. But you already knew that.

Be wary of exits; yours and the company's

• I will repeat the caution. Leaving a company can undo your hard work — the industry is rife with golden handcuffs. Double-check your ESOP policy, specifically around leaving clauses. There are cases where the company takes back vested stock upon leaving, commonly called a "clawback." It is an ugly practice that may have made sense in a low-trust environment and in specific cases, but I detest it as a general practice.

• Similarly, when a company itself exists, say, to another startup or a Private Equity firm, every aspect of this exit will be to generate value for shareholders. That's not you. It's the investors, then the founders, then you, the ESOP holder. Many founders have fought for their employees and gotten them a good deal. I was lucky enough to work with such founders repeatedly. But you need to know if the founders you're working with can fight for you. They would have shown signals already; sit back and think about it.

Putting it all together

• The 3 most common scenarios of making money through ESOPs are acquisitions, IPOs, and Stock Buy-Backs. They happen when the startup is growing rapidly.

• If your ESOP policy isn't favorable, you might lose out on liquidity and benefits. Look into vesting schedules, leaving and exiting, and exercising parts of your policy. Read your current policy, interpret it, and determine its essential elements. Understand that you will not be able to change much, but if you're a valued employee, you can always push for reforms. Startup founders and company leadership always want to make it better for their employees; they will hear you out.

• If you're evaluating a new offer, get hold of the ESOP policy before accepting. This might be tricky but insist on it. If you have trouble, contact me, and I can suggest friendly, tested ways to be heard.

• Finally, craft a solid employee-friendly policy if you are a founder or leader who can grant ESOPs. The long-term benefits of doing this are immeasurable. The only way to win is by getting lucky or collecting competent people who act as a team in each other's best interest.