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Employee Stock Options (‘ESOPs’) have been a favoured route of offering employees an option to participate in the growth prospects of their company. Traditionally restricted to the technology sector, today ESOPs are a part and parcel of even the most traditional businesses including financial services and consumer companies. Most companies which are backed by institutional investors (private equity or venture capital) have a stock option plan in place. Primarily used for employee retention and motivation, stock options provide employees with a chance for wealth creation rather than income generation.
Sounds like a win-win deal? However, anecdotal evidence demonstrates that the efficacy of ESOPs is limited, especially in private unlisted companies. The primary reason is that employees don’t have a tangible way of valuing their ESOP holding and hence may not ascribe too much importance to them. In addition, on vesting of the ESOPs employees not only need to pay the exercise price but also need to pay the entire perquisite tax applicable on the options on an upfront basis. All this while there is no liquidity or tangible market value for the shares. The issue is magnified as the cycle to go for an IPO has become longer for most private companies. This limits the attractiveness of the instrument for the employees, early angel investors and the promoters. The other challenge facing promoters is that several employees leave organisations with vested shares. This results in the shareholding getting dispersed and promoters not having control over the shares. This could potentially lead to disruptive situations when the company is taking any significant corporate action like a fundraise, IPO or strategic sale. The distributed shareholding could lead to the ex-employees potentially creating obstacles to a probable transaction which can be a significant impediment to the transaction.
Given the omnipresence of stock options across businesses, strategically promoters must balance the objective of wealth creation for employees while concurrently not compromising on the flexibility to take corporate action. Globally, the market for ESOPs in private companies is relatively liquid and broad. Platforms like SecondMarket (which has since been acquired by NASDAQ) started by providing liquidity in large technology companies. They eventually migrated to full-fledged trading platforms for unlisted equity. In addition, there are several private equity funds that purchase secondary shares from employees and early stage investors. This provides a vibrant ecosystem which creates a liquidity option. In India, stock options are just becoming significant as the value of the underlying private companies is increasing. Most traditional PE funds are constrained to evaluate these trades due to small ticket sizes and the lack of any rights associated with these shares. However, increasingly HNIs and family offices are tapping this market very actively. We are also witnessing the emergence of institutional capital willing to tap these opportunities. As the focus of these participants is largely on economic returns, they are flexible on the rights available and are quick in deal closures.
Given these liquidity options, increasingly promoters are coming forward with offers to buy shares off their employees. By providing employees with partial liquidity (say 25-30% of their holdings), employees get cash in hand for unlisted shares which serves as a great motivational and retention tool. More importantly, when some employees quit organisations with vested shares, companies can tap into such funds/ HNIs/ family offices to buy out these shares. This controls the distribution of shareholding to a select tangible group and is more consolidated which is critical for any company planning a liquidity event.
Just providing stock options is not adequate. It is important for companies and promoters to provide periodic liquidity avenues against these shares. Companies need not use their own capital for this purpose but can now tap wider avenues, such as institutional capital to unlock latent value.