ESOP Valuation in Startups
Since startups are now struggling to raise capital and cutting thousands of staff, ESOPs (employee stock ownership plans) have suddenly gone out of fashion. Employees are more concerned about saving their jobs than the hypothetical valuation of their ESOPs.
But if you’re looking for startup jobs, remember ESOPs are a proven way of creating employee wealth. In any venture-funded startup, your salary will have two components: A cash element and an ESOP bit.
So what does it mean when a startup offers you ESOPs worth $50K (Rs 40 Lakhs) or any such number?
Most people believe ESOPs are company shares or equity. They are right, but not exactly.
ESOPs are a contract (a type of financial derivative called stock options) that gives the owners (employees) the right to buy a fixed amount of the startup's shares at a pre-agreed price. You pay this money to the startup (called exercising ESOP) to get these shares.
Stock Options have one major feature – a strike or an exercise price.
Let's say $10 is the strike price of an option. If the CMP (current market price) of this share is $20, you can buy it at $10 (strike price) and sell it for $20 in the market. You make a cool $10 profit. We say the option is ITM (In the Money).
But if the CMP is $5, you won't exercise your option because you don't want to pay $10 for a share when you can buy it for $5 in the market. This option is OTM (Out of the Money)
CMP > Strike Price = ITM
CMP < Strike Price = OTM
Now back to the ESOP valuation. Let's say your startup raised venture capital at a $100 M valuation. It has issued 1 M shares. So the CMP (value in our case because this stock is not listed) of each share is $100.
If the company offers you ESOPs at a $10 strike price, the theoretical value of each ESOP is $90 ($100–$10). So, if your offer letter says you get $45K worth of ESOPs, you get 500 ESOPs. Each ESOP gives you the right to buy one share at $10. Since the current value of each share is $100, you can, at least in theory, buy the share at $10 and sell it at $100. Remember, these are unlisted shares and finding buyers is difficult.
ESOP Value = 500 x $90 ($100 – $10) = $45K
Most startups in India arrive at the CMP of the share using a revenue multiple. If the startup's valuation in the last round was $100M at a $20M annual revenue, the valuation multiple was 5 ($100M / $20M). Now if the current revenue is $30, the company will consider a $150M ($30M x 5) valuation for its ESOP calculation.
At 1 M shares, the CMP of each share becomes $150. And if you get 500 ESOPs, the ESOP value is 500 x ($150 – $10) = $70K.
Most startups follow this approach to value ESOPs. If the last funding round happened recently, they can use the last round's valuation as CMP. But there is no hard and fast rule. A lot depends upon how the management values its shares.
So when you get a job offer, try to understand how the management values ESOPs before you accept it.