In today's newsletter, we talk about startups, ESOPs, and sweat equity.


The Story

India has a vibrant startup ecosystem. It has seen consistent growth for a good while now and Indian startups collectively raised a record $14.5 billion last year — A gargantuan sum. But they are more than just fundraising machines. They are also very important cogs in the vast economic machine.

They drive growth and development across the board by influencing consumer spending, providing innovative solutions to pressing problems, and boosting employment at multiple levels. But a startup’s success is largely incumbent on their ability to attract and retain highly skilled and experienced employees. The problem — they might not necessarily have the resources to afford this kind of talent. This is especially true for early-stage companies that do not have a steady stream of income.

And right now, coronavirus has exacerbated these problems. Cash-strapped startups are facing an inexorable decline in revenues. There is little chance of seeing fresh funding or investments. And the nationwide lockdown has stifled demand completely. More importantly, it doesn’t look like it’s going to change anytime soon.

According to a recent survey by NASSCOM, 70% of startups in India will run out of cash in less than 3 months, and only about 22% will have enough cash to survive “2020”. It’s also the reason why so many startups have been laying off employees. But they are also desperately trying to hold on to talent in the event their fortunes turn.

Unfortunately, they are running out of cash and they have very few avenues to retain or hire new talent. Which brings us to the topic today — Sweat equity. More importantly how the government has tweaked an existing policy to make it easier to offer employees sweat equity.

But before we get into this bit, we have to talk about another popular term — ESOP — Employee Stock Option Plans.

ESOPs give you the right to buy company shares for a modest sum (at a price lower than what the shares are actually worth) and a startup can offer employees ESOPs instead of cash. It’s good compensation.

And they work quite well. Usually, the employee is offered the ESOP and asked to wait for a while. Then, at a specified date in the future, she can exercise the “option” to buy the shares for a modest sum. If she chooses to exercise her right, the shares will be allotted. And if the company does well in the future, these shares could potentially be worth a whole lot more.

But then there’s another alternative —  Sweat Equity. If an employee puts in the effort, management could just choose to compensate her with part ownership in the company. Remember, she is not the founder here. She is not an investor. She is not parking money. Yet, she’s being offered equity. Not options to own stock, but direct ownership.

Sometimes that can raise eyebrows. But the Ministry of Corporate Affairs allows startups to part with ownership units (shares) if they believe the employee in question put in the requisite blood, sweat and tears, so to speak.

Okay, maybe not blood and tears.

And if it’s a fully air-conditioned office, maybe there’s no sweat involved either. But you get the point.

Anyway, until now, startups were allowed to offer sweat equity for about 5 years post the date of incorporation. However, considering the extraordinary circumstances, the government has extended the limit to 10 years.

The government also said startups can now offer sweat equity shares of up to 50% of their paid-up capital as opposed to 25% earlier. Meaning startups can now afford to offer more sweat equity to their employees and this ideally should give them extra leeway to hire and retain talent. But bear in mind, this benevolence has only been extended to startups. So it’s imperative to ask one final question before we wrap up this story — What is a startup?

Do you become a startup when you rent a co-working space in Koramangala and buy a couple of bean bags? Or do you become a startup after raising Rs 10,000 from Cheeku uncle and updating your LinkedIn profile? Contrary to popular opinion, these things don’t yield the “coveted” startup status.

The only way to become a startup is to get the government to recognise you as one. And they’ll do it only if you satisfy a few conditions. You have to be young (<10 years since incorporation), you have to be working on innovative products and services, you should have the potential to generate employment and create wealth. There’s also a bar on revenue. And once the government vets you fully — then you become a startup.

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