Can Over-optimism In ESOP Be Detrimental To the Financial Health Of a Portfolio?

ESOP allows employees to buy a set number of company shares at a set price after the vesting period has expired

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Record investments totalling $36 billion found their way into Indian startups in 2021, this in turn triggered the focus on employee stock option programmes (ESOP) for their employees. Startups tend to provide a high-growth environment to employees. Yet, the quality talent crunch across industries has made them actively pursue strategies to hire and retain talent; ESOPs are emerging as one of the most preferred and accepted alternatives. ESOPs also align the interest of the employees and the company.

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ESOP allows employees to buy a set number of company shares at a set price after the vesting period has expired. The objective is to retain the employees for a certain number of years before they exercise their stock options. This ensures a better retention ratio of valuable team members. Once the vesting period is over, the company facilitates a buyback exercise in which employees can liquidate their shares and create wealth.

The latest IPO and investment boom in the new-age companies has created a new class of wealthy non-founder employees with a significant stock option haul. In December 2021 Flipkart created an ESOP pool of INR 17,000 crore. It was followed by Oyo, Zomato, Paytm, and Nykaa, according to data from executive search firm Longhouse Consulting. In November 2021, PhonePe conducted an ESOP buyback worth INR 135 crore. Similarly, early this year, B2B e-commerce platform Bizongo announced its first-ever ESOP monetisation programme, worth INR 30 crore. While the pool size was set at around INR 38 crore for 102 eligible former and current employees, only 70 per cent of employees opted to liquidate ESOPs. This buyback had come on the heels of the platform's entry into the unicorn club and fundraising of around INR 87.5 crore in the Series D round led by Tiger Global Management, among others.

This huge potential to generate wealth has also created a rush of senior employees looking to make ESOPs a large part of their investment strategy. The portion allotted to ESOP at times was even to the tune of 70 per cent of the total financial net worth. In such a scenario, imagine if things go southwards, and the startup fails to raise new funds that are needed for further growth or has a down round. That means the startup maybe acquired at a much lower valuation than the valuation at which it had raised money in the last round. Due to a clause of 'liquidation preference' which all early-stage investors have in the term sheet while investing in a start-up, all the founders and core team owning ESOPs will end up realizing a paltry sum for their ESOP holdings.

On the risk-return metrics, though ESOPs offer high returns, they are also high on risk and illiquid investments. Thus, instead of asset allocation, ESOP should be included in the category of risk allocation. This is to ensure that there is a balance between uncorrelated asset classes (and ESOPs will naturally fall under the category of equity risk investments) and risk tolerance as the value of ESOPs may not appreciate as envisaged or it may take longer to monetize. Its allocation should not be considered for any key liquidity requirement, instead, it should be part of the satellite allocation.

The disproportionate number of ESOPs in the portfolio is usually justified with an argument that an individual's know-how of the business and industry should be given prominence and while doing this balancing the risk management factor is overlooked. The portfolio overexposure to ESOP is similar to being over-reliant on the only customer while running a business.

The 'down rounds' are commonplace now as a lot of unicorns are either delaying their IPOs or facing lower valuations as funding sources dry up. The notion that established businesses that have crossed hurdles of product market fit and customer adoption don't have any risk, is due for a change.

The investment portfolio is meant to deliver consistent returns and a pool of money that can be used at times of need. ESOPs do create returns in multiples, yet it is equally important to safeguard the portfolio from the unprecedented risk that the fortunes of the business may cause.