The good, the bad and the ugly side of employee stock option plans – Livemint

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Employees at the Flipkart office in Bengaluru. Photo: Hemant Mishra/Mint

The Walmart-Flipkart deal has brought the issues surrounding employee stock options back to centre stage. There have been murmurs in the past, but not on this scale. So it’s a good time to step back and take a broader view of stock option plans in general and what start-ups should do to minimize disappointment and angst.

Any plan has to be fair to both the company and the employee. Most plans are created by lawyers who do not necessarily understand the finer nuances of how teams at start-ups collectively and collaboratively create value. The founders need to bring in this insight and balance.

Most disappointments have centred on one or more of the five aspects of a plan, namely, the differential treatment for employees and ex-employees, acceleration of vesting schedules on change in control, liquidation or cash-out logic, treatment of unvested options, and participation in secondaries. For those unfamiliar with this territory, options vest when certain conditions are fulfilled that allow the employee to exercise the options and purchase the company’s stock. The term secondary is used to denote purchase of shares by an investor from an existing shareholder rather than from the company.

Plans need to define how vested options will be treated in the case of both employees and ex-employees. The most commonly accepted clause on this is that employees need to exercise their vested options within 30-90 days of leaving the company. From a company perspective, forcing an exercise after departure is considered fair because the primary purpose of options is to retain employees. It also protects an employee’s time served by allowing her to buy out options she has earned during her stay. However, some start-ups choose to give departing employees the same rights as current employees, based on a belief that vested options are for past effort. In such start-ups, it is not mandatory for departing employees to exercise vested options. Having made this choice, it is then unfair to create a difference when there is a liquidity event. This has been the big source of angst for ex-Flipkart employees.

When redBus was acquired by Ibibo, some senior leaders did not make any money because none of their options had vested and there was no acceleration clause in the agreement. I would not attribute the absence of such a clause to any sinister motive on the part of the founders, but plain ignorance of the implications. At both TaxiForSure and Bigbasket, this clause was missing, but we introduced it, and the founders and investors were happy to do it. This clause benefits current employees because the acceleration of vesting applies only if you are in employment.

Liquidation of vested options is another contentious issue. When the cash-out is complete, there is no problem. The problem is when the cash-out is partial or when the options are rolled over to equivalent options of the acquiring company. If a public company acquires a private one, this issue does not arise. But it appears that in Filpkart’s case there has been a problem on this front too, with the liquidity partial even for vested options. This is perceived as unfair by employees.

Unvested options can be treated in two ways in an acquisition. When IBM acquired Daksh in 2004, Daksh’s investors allowed 40% of the unvested options of employees to vest immediately. This was generous on the part of Daksh’s shareholders, because, by doing this, their share would reduce. This foresight and large-heartedness quickly created a positive sentiment for the acquisition. Unvested options can also be converted into equivalent options of the acquiring company if it too has a stock option plan. In most cases, however, unvested options stand forfeited.

The last point is whether employees with vested options get to participate in secondaries (in a large fund-raise). In some start-ups, founders get to sell some shares. In my opinion, employees with vested options must also be allowed to liquidate some of these in such secondaries.  Finally, it is important to clarify the philosophy and intent upfront, build it into the contract, and, finally, honour it in letter and spirit when the rubber hits the road.

T.N. Hari is the head, HR, at Bigbasket and co-author of Cut The Crap And Jargon: Lessons From The Start-up Trenches

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