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Finance / Equity / Stocks / ESOPS Questions

ESOPS, Restricted Stock, Stock Options, and Phantom Stock

The Truth About My ₹1 CRORE SALARY Package - YouTube

Restricted stock gives the employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.Stock options provide employees with the opportunity to buy shares at a fixed price for a set period, while phantom stock provides cash bonusesfor good employee performance.

These bonuses equate to the value of a particular number of shares.Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.

  • Once an ESOP scheme is approved, aLetter of Grantshould be issued to the employee informing him how many options are being granted to him, what the vesting period would be and how the exercise price will be determined, should he choose to exercise the vested options.
  • In the event an employee wishes to exercise any of his vested options, he should make anExercise Applicationto his employer company pursuant to which his options would be converted into equity.

https://yourstory.com/2015/09/esop/amp

https://www.investopedia.com/terms/e/esop.asp

Equity offer questions

  • What percent of the company do these shares represent? - Your percentage of ownership means more than your number of shares
  • What is your total preference stack? - The more owed in liquidation perference, the less your equity is likely worth
  • What's the minimum price you would exit for? - Gives reference point for valuing your potential payout

https://angel.co/blog/30-questions-to-ask-before-joining-a-startup

https://dev.to/flippedcoding/10-questions-you-should-ask-in-a-web-dev-interview-1c2d

The important thing is to have realistic expectations about how much money my equity could turn into.

https://www.trica.co/equity/blog/evaluating-esops-questions-that-cxos-should-ask

https://superops.ai/startup/esops-101-blog

  1. What percent of the company do these shares represent?

Your percentage of ownership means more than your number of shares

Percentage of the company that the ESOP pool represents

  1. What is the my preference stack? (What is the total preference) (Classes of preferred shares) (multiples 1.5x?)
  • dilution
  • What was our most recent valuation?
  • What is our current yearly growth rate?
  • How much would the company need to sell for before my equity has value?
  • If your most recent valuation is close to or exceeds the needed sale price, your equity offer has value. If the needed sale price is much higher than the company's most recent valuation, though, you have something to consider: Based on its current growth rate, how many years would you need to stay before its value comes close to that needed sale price? Are you comfortable investing that much time?
  • The more owed in liquidation preference, the less your equity is likely worth
  • it had investors and board members whose equity was protectedby high liquidation preference - a guarantee that they get paid first and at least a certain amount when the company sells. When startup investors make millions in a sale, but money runs dry before reaching employees, a bad preference stack is often the cause.
  • Liquidation preference give investors the protection they need to make the high-risk investments that startups thrive on.
  • If there had been a 1x liquidation preference in place, the investor would be guaranteed to get $3 million back.
  • The more money a startup raises, the harder it gets to fetch a high enough acquisition price.
  1. Preemptive rights - What are preemptive rights and who has them? - Preemptive rights allow common shareholders to maintain their proportional ownership in a company by buying more shares in the event that the company issues another offering. These are sometimes issued to holders of common stocks. Holders of preferred shares typically also have other protections against dilution.

  2. While the first company offers you 1000 options out of 1,00,000, the second offers 500 out of 10,000. You have more skin in the game in the second company but you have to ask the founder why the ESOP pool is so small? Is he or she averse to sharing equity with early team members? When will the ESOP pool be expanded? These questions will help you better understand the founder's vision.

  3. Total money we have raised, and how much it's liquidated the shares?

  4. Annexure 1 > point 3 > "provided the Participant is in the employment of the Company at such time", what if the employee is no longer employed after some vesting? How will it be handled?

    • What if you decide to leave the company before all your options have vested? Is there a policy for accelerated vesting in the time of a merger? Can you exercise your ESOPs early? Is there a possibility of a potential buyback in the upcoming years?
    • Let's say I own shares at the company I am working for. I decide to leave. What happens to my shares?

Generally, you have 90 days to buy the vested shares. Once you buy them, your shares will remain with you until the company goes IPO, secures a round of funding, or gets acquired. If you don't do so, all your vested share units will lapse. There will be nothing you can do about it.

There's a catch here as well. Just like your favorite jar of peanut butter, your stock units have a shelf life which is usually 10 years from the date of purchase. If you buy the shares but the company doesn't go public, secures the next round of funding, or gets acquired, your purchase options will expire. But most companies that are doing well get approval from the board to push the expiry by another year.

  1. Red Flags

A Small ESOP Pool At An Early Stage Startup

Founders, with a wealth-sharing motive, will always create larger ESOP pools at an early stage. If an early-stage startup has an ESOP pool that is lesser than 10% of total equity, you might reconsider your decision of joining the startup

Formal Grant Letters Are Not Issued

Ensure that a formal grant letter will be issued when you join. If ESOPs are just promised verbally, there might be a possibility that your grants will be delayed or you will face complications while completing the ESOP lifecycle

  1. How is Equity Linked Upside different from Stock Options?
  2. What will be the Mode of payment of the Equity Linked Upside?
  3. How will taxes be calculated and when?
  4. In what cases will the unvested grant be accelerated?
  5. What's the minimum price you would exit for?

Gives reference point for valuing your potential payout

best estimate of the Company's valuation upon an exit?

  1. Secondaries

At the time of a funding round, the investors will buy a small portion of the vested common shares from founders and early employees. This is done to give them a partial exit and keep them motivated to scale the organization. The recent stories of secondaries in Razorpay, Zerodha, Paytm, and Ola are encouraging signs for employees.

ESOPs

Wealth creation through ESOPs is a major reason why people join startups. But most people struggle to correctly evaluate job offers that also includes ESOPs

Here is a framework that should help:

For an employee to make meaningful money through ESOPs, 2 things must happen:

  • Growth in company value
  • Employee friendly ESOP policies that ensures employees make money when company grows

a) Growth in Company Value

This is where employees need to think like investors

Just like investors are particularly wary of what valuation they are coming in, entry valuations should matter for employees too

ESOPs are allotted basis the current valuation

The likelihood of a 10x growth in your ESOPs if you are joining a startup valued at 100 million $ is much higher compared to joining a startup already valued at 5 billion $

If you happen to join a startup just after the company raised a round which you think was overvalued, the chances of your ESOPs growing reduces

One mistake that people often make is comparing the allotted ESOPs from 2 companies at different stages. A 75 lakh ESOP allotment in a 1000 cr valued org with chances of a 10x growth could be a better offer than 2 cr ESOP allotment at a 20000 cr valued org with lower chances of future growth

The second thing to judge is the business model and the likelihood of the business to grow( very important for Seed/Series A/B startups)

Access to data is a challenge, but basic secondary research and asking the right questions and metrics in the interviews should help here

b) ESOP Policies

The startup ecosystem is full of stories where employees didn’t make money despite the company growing and having multiple liquidity events.

Here are the things that should matter most while evaluating policies:

1. Vesting Schedule

The standard is 25% vesting after every year. Any schedule which has higher vesting towards the later years is a red flag

Vesting should never be performance linked

If performance is bad, it is management’s responsibility to fire

2. Vesting on Leaving/Startups Exit

If you exit, you should retain all options that has vested

If a startup gets acquired before all your options vest, there should be accelerated vesting

3. ESOP Communication

There should always be written communication( preferably through ESOP portal)

Verbal communication for ESOPs is a huge red flag

4. Strike Price

Strike Price should be as low as possible( Re 1 ideally). This maximizes the value creation for the employee

5. Holding/Exercise Period

Converting options to shares is a major tax liability exercise. With limited exercise period, it becomes impossible for employees to exercise as it means paying up to 40% real taxes on notional capital gains in an asset class that is not liquid

Ideally, holding period should be infinite for vested options, even after exit

This enables employees to wait for liquidity events without incurring upfront taxation to be paid out of own pocket

Warrant

A warrant in finance is a contract that gives the holder the right to buy or sell a company's stock at a specific price within a set time frame. Warrants are used in both debt and equity financing, and can be a high-return investment tool.

Here are some things to know about warrants:

  • Holder's rights - Warrants give the holder the right to buy or sell shares, but they are not obligated to do so. If the holder chooses not to exercise the warrant, it will automatically lapse.
  • Expiration date - Warrants have an expiration date after which they are no longer valid. Warrants typically have long expiration dates, sometimes lasting five, ten, or more years.
  • Strike price - Warrants have a strike price, which is the price per share at which the holder can buy or sell the stock.
  • Issuance - Companies often issue warrants as part of share offerings to attract investors.
  • Dilutive effect - When warrants are exercised, the company issues new shares, which can dilute the ownership concentration of existing shareholders.
  • Trading - Warrants can be bought and sold like other exchange-listed securities.

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