Structuring incentive plans – ESOP, Cash and Balanced Scorecard

Structuring and designing an effective incentive plan is key at the early stages to help promote retention as well as high levels of motivation among the team. From cash versus equity, how much equity is apt at each stage, bonus plans, to measuring employee performance through a balance scorecard, in this episode of Matrix Moments,Avnish Bajaj, Founder & MD, Matrix Partners India, outlines simple thumb rules to keep in mind when structuring your employees incentive plan.

Salonie: Hi and welcome to Matrix Moments. This is Salonie. And I am here with Avnish Bajaj, Founder & Managing Director, Matrix Partners, India. In today’s episode, we are going to be talking about how to structure incentive plans at the early stages. And this is a topic that I know founders spend a lot of time thinking about. And have even, Avnish, asked you at our events as well as others from the Matrix team about how they should go about structuring this. So, how does one think of ESOP versus cash at the early stages? And how do should they think about it in terms of keeping it flexible for it to change across stages?

Avnish: Thank you, Salonie again for having me. Great to be back. I think over the next few weeks, we are recording a bunch of these tactical type of episodes. And I have come to realize that sometimes our episodes end up being a bit too gyani. And from the events and stuff that there is enough of information that we have that we should put out there which hopefully will be helpful to the founder. So, that’s the context. It’s not like we know the right answers on some of this stuff. But some of these are actually stuff that has been solved before. So, the idea is to help the founders not have to reinvent the wheel.

So, cash versus stock. When I started Baazee, I used to tell people this whole ESOP story. And let’s say they were making X lakhs in their previous job. And they would say, really excited and everything. And then finally ask for an increase on their last cash comp. So, it was like all of that is great, but give me my cash. It’s changed. It’s in my view in the early stages of changing a lot more.

What’s been the big event last year? Flipkart exit. Lots of Flipkart millionaires - actually even Baazee when we exited there was this concept of Baazee mafia. We had ESOP all the way down believe it or not to the office boy. And I still remember that the office boy made 2 lakhs and his salary used to be maybe 4 - 5 thousand at that time. So, it’s always a multiple of your annual income is the way you have to look at it, and we will come to that.

So I think the market is changing. Because of the recognition of the wealth creation possibilities of ESOP, it’s less of a sell. In some of our companies and God bless those founders like Ashish at OfBusiness business, they have been able to attract talent at one third, half, one fourth of the cash comp the person is making. That’s really the proof of the pudding that the people are really believing in that stock. We have a number of our new founders who are obviously founders, so I guess one can argue they know the value of the stock a lot more. Yet, people surprisingly struggle with this saying - so, cash versus stock? Obviously, one wants to say go more for stock. But if you ask me, if I had to start a company again, I would never lose a person. I wouldn’t set the Ashish benchmark, which I have told Ashish, which is you have to take a big salary cut to join me. Maybe a modest salary cut. Sometimes people are at different stages in life, but they have to be able to value equity. So, I think people have started valuing equity.

The founders struggle with how much equity. What should I give. And I actually - this is what came out in that event. There are actually some very simple rules of thumb that one can use. And my view is, are you hiring a co-founder-ish person or are you hiring beyond that? If you are hiring a co-founder-ish person, we are talking percentage of company. Typically, CTO is 3 - 7%. Co-founders is somewhere in that range. Maximum would be maybe high single digits. And this is not the original starting co-founders who would have 20 - 30% each or whatever.

Then, there is the next level. And the next level simple rule that I tell people is think of it as a multiple of CTC. And I will give the logic for that. So, let’s call it a range of one to five times your CTC you should get in stock equivalent. And let’s a take a midpoint of three times. Typically, ESOPs are vesting - and we will come to that question as well. ESOPs vest over four years. Typically, you are going to tell a person who is joining you that by the next round, the company the valuation should double or triple.

So let’s say I bring somebody in and I give them three times CTC. And the company valuation doubles or triples. That means they are value equivalent to six to nine times CTC, spread over four years. So that means they are getting almost 2X their CTC every year in variable comp. That’s like a very good benchmark.

Now by the way this is only one round. Now another round happens, it multiplies. So for me, depending on the seniority if it is more junior, it’s in the range of 1X CTC. And it keeps going up as the person becomes senior. And then if they are very senior co-founder material, then it is a percentage of the company. But, that’s typically how I have seen it work. And then you can back into percentage of the company also. The other day I was advising a company whose market value let’s say is 200 crores. They want to bring somebody who is 70 / 80 lakhs or a crore. Now if you give this person 2X CTC, let’s say you are bringing - you are not going to be able to pay that market salary. So, we convince the person to come in at 60 lakhs. Now if you give them three times or 3.3 times CTC, that’s 2 crores. That’s one percent of the company that is valued 200 crores.

So I think these are the kind of rules of thumb that actually work pretty well, and very easy to dumb down and explain to the employee. Boss, you are getting 2X your CTC. Company doubles, that’s equal to 4X your CTC. Over four years, that’s like getting 1X CTC every year. That is able to then make it much easier for the person to understand.

Salonie: What would you say are some of the key elements that should be included in an ESOP plan? And within those elements, what should an employee be okay to trade off or not?

Avnish: It’s actually some stuff that the founder has to think through when they are designing the plan. But at the most basic level or at the most commercial level, it is what is the grant/exercise price. So if a company is starting out and is worth 100 crores, am I getting stock at 100? Am I getting stock at zero which is called par value. Or am I getting stock maybe if the company is raising money at 400, are you giving me stock at the next round? And this is very important because if I am getting stock at 100 and the company becomes 200, then my gain is on that extra 100.

If you are giving me stock at par value and the company is at 200, I am making money on that 200. So what typically happens and this varies with the stage of the company, obviously logically just give it at par because then most employees are in the money. It’s not that easy because this is in the accounting parlance considered a compensation expense. So, unfortunately or fortunately most of our companies end up being loss making. So, it doesn’t matter. But, these accumulate over a period time. That’s one reason.

Second, you are not really creating an incentive for that person to create value because if the company is 1000 crores when they are coming in and you are issuing it at zero, they are already in the money. What is the incentive for them to create 2000 and 3000? So it’s a tricky balance. So my advice - and by the way there is a potential temptation for the founder to say I will give it at par because if I gave it at par and there is so much value, I need to give lesser. If I give it at a higher price and they are only going to get it on increment, I have to give more. So, I think that’s a little bit of a temptation that founders have to be cognizant of.

I think the way to do it like I said it’s not one size fits all, but start with par value because the company really - who knows what the value is. As the company scales, you need to start giving it closer to the last round price at which the company raises money. So I think grant price being critical.

Second is vesting period. Now in all our term sheets, we encourage the founders to say let’s have a standard one. Four-year, vesting. One year, cliff, which means if somebody leaves within the year, they have nothing. But after that, I encourage them to have monthly vesting. Now there is a debate on whether it should be quarterly. I have found that if companies are increasing in value and employees become aware of that value, sometimes they are timing their exit from the company based on when they vest. If you are vesting every month, they don’t know when to leave. And that’s part of your objective of having a stock option plan, which is retention. So I prefer that.

I prefer equal vesting. But I have also seen (9:20) companies which have what is called the 10, 20, 30, 40 vesting, which is 10% in year one, 20% in year two, 30% in year three, 40% in year four. As a founder, I would love it. I just don’t think it’s very employee friendly. But as a founder, essentially what you are saying is the longer you stay, the more you make. I think it’s one of those terms that’s maybe 20% of the companies get away with it. If I couldn’t get away with it, would I do it? Maybe. But those are kind of the different ones.

By the way, there is also a little bit of a debate around whether it should be four years or five years vesting. So, I think the market is increasingly four years. Then there is exercise period. So when somebody is leaving the company, do they get to keep their options which are vested? Do they get to exercise them immediately? Now to exercise an option, you have to pay money. And by the way that has a tax implication. So this is a hotly debated topic.

When we sold Baazee, we actually had - so I will tell you the logic from an employee’s perspective is obviously to say when I leave the company, give me infinite timeframe to exercise, so that I don’t have to put money. I don’t have to do that. I can see that logic. The reverse logic for the company is you have all these people who may have - let’s say a company takes 10 years to exit. They have all these people who have left. You can’t even track them. I remember when we were selling Baazee, we had to track people to all kinds of places in Bihar and this and that because eBay wanted us to get release from everybody. So, having very small ownership spread all over, not keeping track, it creates serious overhead. So I don’t have a clear answer on this. I advice founders to have a strict exercise period. And this will come to overall objective. I think the most - the best ESOP plans are designed with certain terms, but they have this overall concept of an administrator that can change those terms on a case by case basis. In most cases, the administrator is the board of the company. And the board of the company is the founders and the investors. So my advice to founders is take a certain view like in this case I encouraged people to say 90 to 180 days post-exit, people have to exercise.

Now, you can decide if somebody is a good leaver, bad leaver. These are standard terms in employment agreements. And as an administrator, we can make an exception. But by rule, it should not be that a company of 10,000 people which over a period of time let’s say 5 - 6000 people have worked, you have track where they are because my philosophy and my principle is that, which I was mentioning in the context of Baazee, that it should be very deep and wide, the ESOP issuance.

If you do that and then you have so many people outside who may have kind of orphaned ESOPs, it can be a problem. So, I think with that philosophy probably have a little bit stricter exercise policy. And by the way, I have also seen cases where people have left and they have realized that there is good value to be had in the company, they have exercised.

Salonie: One of the things we didn’t touch upon is a balanced scorecard which is a tool that a lot of founders use to evaluate employee performance. Is that something you all would have used at your time in Baazee or…?

Avnish: Yes, we actually did and the - sorry to interrupt, but the interesting thing is - so this is Robert Kaplan and we should put a link to his book both balanced scorecard as well as strategy focused organizations. I actually - and often I find that this there is a chance that founders look at this as management jargon. I think that is a mistake. I think building companies is very hard, but at least the science of it is not rocket science. You have to have a vision. You have to have a mission. You have to have a strategy. You have to have an organization to backup that strategy. You have to have systems, processes, everything to backup all of this. This is part of the systems and processes on the HR front. So, it forces you to be able to translate your vision and mission and strategy into measurable KPIs, key performance indicators. So, I actually believe, and it has happened in the last few deals we have done, founders have come back with a proposal of saying I want 2 lakhs a month, 1.5 lakhs a month, 3 lakhs a month. Something like that, right? I have actually - I am a big believer in having balanced scorecard, having key KPIs clearly defined. It forces you to think clearly. It forces a founder to think clearly. It forces everybody to know about the strategies and be aligned and have a variable component.

I think variable pay is a very important of a performance driven culture. Depending on level, junior levels can be even 10%, but that concept is important. So I believe in 10, 30, 50, 100 which is what portion of your base will you get as variable. And at the highest level, it should be almost 100% of your base. And to me now if you are putting that in place, with a balanced scorecard that balanced scorecard should have three to four key indicators that you are measuring the company on by definition the founder on. For a company, it could be for example, revenue, burn, organization building, NPS, and then weight these appropriately. It could be that we say revenue is 30% important, burn is 30% important, and the other two are 20:20 for example.

Then, also incentivize the company to beat plan. So, typically for me the perfect incentive plan will have a balanced scorecard which aligns with the company’s strategy. Will have variable pay depending on level - and every level will have some kind of a variable pay. And they will get paid out on a 80 to 12 percent range, which means if you exceed targets, you actually get paid more. And below 80% of your target, you don’t get the variable pay. So to me that’s almost the perfect incentive plan with one more tweak which is half of the variable pay should be paid in cash, half in stock.

So when we talked about ESOP upfront, you always talk about it as a onetime grant. Actually, it shouldn’t be. When you hear about Sundar Pichai and Satya Nadella and all these guys making tens of millions of dollars, they are actually getting it in stock compensation. And I think a company should continue to issue stock. And to me actually that creates the ultimate - the whole point of an ESOP is alignment of incentives. And I think that creates the ultimate alignment of incentives because people keep getting rewarded with more ownership along the way.

Salonie: Sure. Thanks Avnish. Thank you for tuning in. And you can find the transcribed version of this podcast on matrixpartners.in. You can also follow us on Twitter and LinkedIn for more updates.