Not offering stock compensation to talent? You’ll lose out on human capital

One of the battles almost all entrepreneurs today face is the war for talent.

With the market heating up as a result of tech giants offering highly competitive salaries (up to S$16,000 / month for lead engineers), early stage entrepreneurs need to step up their game with competitive and well-structured employee stock compensation.

This isn’t surprising when we look at what’s taking place industry wide — a recent report revealed that tech talent salaries between Q1-Q3 2021 in Singapore grew by an average of 10%, far outpacing the 3% forecasted annualized pay increment across all sectors.

(Source: The Business Times & NodeFlair, 6 Oct 2021)

A quick primer on stock compensation

Stock compensation exists in different forms (we’ll discuss that in a bit), but all share the fundamental principle of offering employees ‘skin-in-the-game’ and the potential for lucrative up-side in the long-term.

Stock compensation uniquely serves two functions — conserve cashflow for startups and compensate employees in alignment with the company and shareholders’ interests. It is not uncommon for investors, especially growth-stage investors, to include the setup of a well-structured employee stock compensation strategy as part of a fundraising round. After all, a significant proportion of capital is typically spent on talent attraction (up to 3–4x of revenue at Series A/B stage), and well structured stock options can bring more ‘bang for the buck’ by attracting top talent with less reliance on cash-based compensation.

“The median public SaaS company spends 140% of revenue on payroll 4 years before IPO and slowly decreases the ratio to 125% during the year of IPO…At the Series A, a venture-backed SaaS startup in the Bay Area with $1M in revenue is likely employing somewhere around 20–40 people, and spending $3–4M per year on salaries, implying an OER (opex-to-revenue ratio) of 3 to 4. At the Series B, the business might be at $5M in ARR with 80–120 people and spending about $14M on salaries, again producing an OER of around 3.”

— Tomasz Tunguz, Redpoint Ventures

ESOP, RSU, Phantom Stocks: explained for humans

There are broadly three ways to structure stock compensation: Employee Stock Option Plan (ESOP), Restricted Stock Units (RSU) and phantom stocks.

1. Employee Stock Options (ESOPs): an invitation to put your skin in the game

The most common option among startups in Southeast Asia is ESOP, where employees are given an option to purchase stocks in the company in the future, at a predetermined price (alternatively called exercise or strike price).

Key characteristics of ESOP are:

• Employees do not actually own the company stocks, hence do not have voting / information rights as shareholders do. Instead, they own options to purchase the stock, only when there is a liquidity event.
• There are select instances where companies choose to buy-back employee shares before a liquidity event (e.g. fundraising or exit). This increases the attractiveness of ESOP to employees because there is a clearer path to liquidity, independent to the liquidity of the company. This, however, is contingent on the availability of capital and shareholders’ approval, hence is less commonly seen especially in early-stage companies
• With ESOP comes cliff/vest periods. The most common cliff period is 1 year, and vest period is 3 years
• Cliff period: If you leave the company before cliff period, you are not entitled to any shares
• Vest period: If you leave the company during the vest period, you are entitled to a pro-rated portion of your shares
• ESOP becomes valuable for employees when the valuation of the company (and hence, stocks) rise. For instance, an employee is offered 100 share options, and the options entitles him/her to purchase shares for $1. After several years of hard work (and luck), the company undergoes a trade sale and is valued at $100. The employee then realizes the profits of $99 ($100 — $1) at the point of trade sale, without ever ‘owning’ the stock on a cap table
• ESOP is most often offered to founders, founding team members (first 50–100 employees), and senior-management (at growth stage companies)

2. Restricted Stock Units RSU: giving stocks to employees with strings attached (not too many hopefully!)

RSUs are principally similar to ESOP, with one key difference. RSUs are direct stock grants to employees, not options. Essentially, the company “gives stocks” to employees. There is no exercise/strike price.

Key characteristics of RSU are:

• Like ESOP, RSUs usually have vest + cliff periods
• Unlike ESOP, RSUs can have more restrictions such as limitations on sell-windows, who the permitted buyers may be, performance milestones, etc.
• Most often, these stock units do not have voting or information rights

Companies offering RSUs need to determine the set of restrictions with clarity and communicate them before issuance — for example, will employees have the option to receive RSUs as stock or as cash-equivalents, or will you only offer either?

3. Phantom Stocks: plain ol’ cash, without the equity hassle

A phantom stock plan offers deferred cash compensation without offering employees any stock or stock options. Think of phantom stock plan as a ‘tracker’, where the reward is closely correlated to company stock performance.

The most important consideration of phantom stocks is to consider whether the up-side is capped. Often, companies that pursue phantom stock options place a limit to the potential up-side an employee gets to enjoy, turning a stock compensation plan to a traditional ‘performance bonus’. This can potentially impact the attractiveness of the compensation among top talent.

A good summary of the three options has been summarized:

(Source: Svested)

From golden handcuffs to golden egg

Beyond structuring stock compensation, it is also the responsibility of founders to explain to employees how it works, and be transparent and honest. More can be done to make ESOP standards less opaque — in a recent article, several startup employees shared that stock compensation plans had “predatory terms”. In such instances stock compensation terms made it “too difficult to claim”, turning what was a golden egg to golden handcuffs.

Key questions founders need to answer and explain to employees (or even prospective candidates, before they join) include:

• What are the principles behind the stock compensation plan? When we say “retention”, how many years does it look like for us?
• How many stock options, RSUs or phantom shares are you eligible for?
• What is the vesting schedule and cliff period? What do those mean?
• What is the exercise/strike price?
• Under what circumstances do you exercise those options / RSUs / phantom shares?
• When you exercise, do you need to shell out any cash? If so, how long do you have to gather the money?
• What are the personal tax implications if the company does a subsequent fundraising round, especially after you have exercised the shares?
• What does liquidity look like? What is optimistic, and what is likely to happen?
• Are you allowed to pursue secondary liquidity on exchanges?
• Under what termination circumstances would you be eligible for stock compensation or otherwise?

TLDR: Why stock compensation in Southeast Asia is exciting, today

Despite the extensive considerations, it is still worthwhile to invest in competitive stock compensation to supplement cash-based components. Within Southeast Asia, there is growing awareness among talent that:

1. Joining a ‘unicorn-of-tomorrow’ is not a far-fetched dream but a reality (nineteen from this year alone!)
2. It is possible to share in the growth of the company, in addition to cash-based compensation
3. Probability of value realization (turning shares to cash) is increasing, with additional liquidity options for companies such as SPACs and secondary exchanges
4. The potential up-side is tangible and lucrative with marquee publicly-listed tech companies stock prices performing well (In comparison, details on private M&A activities such as trade sales tend to be less public)

It is beautiful to get in early — from US$12 in 2018 to ~US$350 in Oct 2021. Early employees of SEA probably had exercise/strike prices of <US$12 if they joined before 2018

So, you want to get started with stock compensation…

To respond to the growing demand for stock compensation, founders need to set out a clear compensation strategy. If you are a founder thinking of, but have not implemented, a stock compensation plan, here are some thought starters:

Speak to your investors (aka shareholders) first:

Any and all stock compensation matters typically need approval from shareholders. Hence, securing the buy-in of your investors (angels, VCs, even friends and family) is critical. You can also get advice from them, especially if their portfolio consists of tech companies further along in maturity. Key alignment topics include:

• What is the total number of stock offered to employees?
• How will this pool change over time, or through significant liquidity events (e.g. next round of fundraising)?
• What are the restrictions of the stock? (Cliff/vest, performance-milestones, etc.)
• What are the principles behind determining stock awarded to each employee?
• What is the authorization process for issuance of stock?

Work towards the Goldilocks principle by speaking to fellow founders:

• Not too much, otherwise current shareholders are diluted excessively (to maintain the stock pool), or the existing stock pool is exhausted rapidly (over-index on employees who join early)
• Not too little, otherwise the compensation is not sufficiently attractive to attract top talent

Know the paperwork:

As fundraising is to term sheet, SSA, SHA and share certificate, stock compensation is to grant letter and option certificate. It is best to consult a lawyer on what your specific needs might be, but in general, there will be 2 key documents:

• Grant letter — Contains the details of the stock compensation, to be shared with employees. This should contain the number of options granted, the exercise price, and the vesting period.
• Options certificate — Outlines the specific terms under which stock options can be exercised or RSUs awarded. This is typically given to employees once the grant letter has been signed

As we enter the golden age for startups in Southeast Asia, stock compensation is how we can stay competitive in the war for talent, but also share financial up-side and create better inclusion for our employees.

If you are keen to continue this conversation or have ideas/questions, hit me up at qinen@saisoncapital.com