I have a question regarding compensation for key employees in early stage start-ups. From an employee and company standpoint which one is better? Shares or stock options? For example: Consider an early stage venture that has total share capital of say Rs.5Cr (50L shares at Rs.10 par value) post first round funding. They would like to hire a senior professional as the CEO. The CEO will take a huge pay cut in lieu of 10% equity (with a 4 yr vesting period) in the company. I can think of two ways to implement this:
1. Allotting shares to the CEO: 10% equity would amount to about 5.5L newly issued shares and new share capital of Rs.55L. However this would be a huge expense on the company’s books (even though there is no cash exchange. The company gives 55L to the executive and he/she gives it back by purchasing 5.5L shares). Is there any way the company can allot shares without incurring the expense on the books? Can shares be transferred from existing shareholders to the executive?
2. Stock options: The company can issue 5.5L stock options with a strike price of Rs.10. In this case what are the rights of option holders (ie the executive)? Is he/she eligible for dividends, bonus share grants, voting rights etc?
I am sure people in venturewoods must have faced this issue. Which is a better option?
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Deepak, even if the current owners are fine with transfering the shares they have to be purchased by the CEO right? and that’ll cost Rs.50L which is a considerable amount. Can the shares be transfered free of cost? can you pls send me the NSE link w.r.t stock options? also are the rules applicable to private firms?
Krish, you are right. We are trying to hammer out the MOU, however we want to execute the stock comp the correct way, so that we wont have any complications (for the company or the CEO) later on.
Alok, yes thats another big problem. Thats why we are trying to figure out the right way to give the stock comp.
Srinivas, you can assume a 25% dilution with the promoters holding the rest.
Vamsi.
At an early stage, keep everything simple. The terms of stock compensation etc., is best summarized in an MOU signed between the founders and the CEO. Bonus, Dividends are all a far cry since the primary concern is one of the startup coming of age. That’s where the test of the CEO and his team lie. That’s when a startup stock – till then bearing a valuation that is entirely arguable – assumes some real value. Focus on valuation, FBT, TDS etc., at an early stage is not just cumbersome, fraught with arbitrariness and risk, it robs the enterprise of precious startup steam.
Have some basic understanding on compensation, set performance benchmarks and focus on hitting the market. Don’t waste too much time haggling for option structure. There’s no fun in holding 1/3rd stake in a startup that never takes off.
Please note that when you pay your exec 55 lacs in the first option, she has to pay income tax on the same as well.
The last budget introduced a huge problem for stock option plans – that the employers pay Fringe Benefit Tax when the option vests. This seems to be not on issue, and not on exercise, but on vesting. For public companies, not a big problem as they have a market value and the FBT rules indicate that the difference between the market value and the strike price on the day of vesting is the value on which FBT is payable (30% plus all the surcharges)
Now the company can recover this from the employee. Again in public companies, no problem.
What about private companies? They have to get their company valued by a “class 1 merchant banker” (read: big fees). And this is not a one timer, it’s for every vesting. Plus, how do you recover the FBT from an employee at all? the shares aren’t traded, and if hte value is huge (let’s say a VC came in and provided a big chunk of money at a big ticket valuation) the company is liable to pay a lot of money for an intangible benefit. Yeah, i know, silly law, but it’s the law.
So RSU (Restricted Stock Units) are better. For that you need to create a separate entity – could be a trust or a separate company owned by the founders. The company allocates shares to say the new CEO, and the trust has the right to buy back the shares at par. The right dissolves over four years (say after year 1, itt becomes the right to buy back 3/4th the shares and so on) This is a good policy and the reason the company can’t buy back its own shares is that there are some restrictions on the buying back of any shares by a company itself.
Still you will have to do the 55L transaction to the employee (and which is compensation so take out 33.99% of it as TDS, paid to the government)
Of course if you have no problem with the current owners diluting then yes of course you can sell your shares. Just transfer 5 lakh shares to the new CEO from current owners (get a share transfer form and do the regulatory paperwork) and pay some stamp duty and you’re done.
(Btw, is there a person who can help with this stuff in Mumbai? I need to do some of this myself)
And if you’re still going the stock options route: for dividends and bonuses the strike price and quantity should adjusted accordingly. No voting rights. If you want to see how the NSE does it, let me know, I can send you a link.
Vamsi,
I would like to know two things – what is the dilution you have done during first round funding and what is the stock holding percentage of promoters post funding.
Once this information is available I can suggest a very practical solution.