In an effort to lessen turnover rates, large companies and start-ups in Southeast Asia have started turning to Employee Stock Ownership Plans (ESOPs) to retain and incentivise staff. There are many reasons why companies should adopt ESOP. Its benefits include promoting a sense of ownership and accountability among employees while improving a company’s brand image.
However, despite its many benefits, the decline in tech valuations all over Southeast Asia has led to a lack of excitement among start-up employees who have ESOPs. In the current climate, employees’ expectations of making a windfall from ESOPs are lukewarm.
In this article, we will discuss what start-ups need to consider when ESOPs go underwater.
What happens when ESOPs go underwater?
During economic downturns, companies may face financial challenges and consider ways to manage their cash outflows, including employee compensation. In some cases, companies may convert cash bonuses into deferred equity awards or offer employees the option to choose between cash compensation and equity.
These equity awards may have relatively short vesting periods, which allow the company time to turn things around. While employees may experience a reduction in their take-home pay in the short term, they may benefit from the share price upside following the vesting of additional equity awards in the future.
However, in current market conditions, where company valuations have reduced, some of the previously issued equity options may be “underwater” or unattractive, which could minimise employee confidence in equity compensation.
What do start-ups need to consider when ESOPs go underwater?
Before taking corrective action, companies must carefully consider the size and timing of the corrective action, the impact of setting a precedent, and the impact on other stakeholders.
Once all aspects are considered, various alternatives are available, including maintaining the status quo, repricing option grants, issuing fresh grants within the current scheme, or exchanging current options with new grants with new terms. A win-win solution must be constructed for this corrective action to be successful. There is no ‘one-size fits all’ approach to this complex decision, which means companies must carefully consider their options and balance the needs of their employees and other stakeholders to navigate economic downturns.
Additionally, in order to keep the options from going underwater, it is imperative to set the exercise price of the ESOPs at a reasonable level.
Founders should set their employees’ options at a low strike price. It could be a nominal amount, such as $1, so an employee can exercise all options. Doing this will ensure that the strike price remains versatile, although it is very low. The ESOP will still be valid even if the valuation takes a hit.
For employees, in the event of a layoff, it is crucial to know whether the ESOP comes with accelerated vesting. For example, if an employee is laid off after two working years after receiving options with a four-year vesting schedule, he would only be able to exercise half of his options. Accelerated vesting would allow the employee to exercise all options promptly after being released, allowing employees to realise the value of options even when they are no longer working for their company.
With the pandemic causing immediate cash flow stress, start-ups are turning to ESOPs as an alternative compensation tool. When used effectively, ESOPs can be beneficial for both employers and employees. However, companies must be aware of the factors to consider during an economic downturn.
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*The above represents our opinions and views and does not reflect the position of any entities mentioned.