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Keep Esop for risk allocation, not asset allocation

by WOOWinvest
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Keep Esop for risk allocation, not asset allocation

The Indian startup ecosystem has come a long way, it has affirmed the belief that startups can grow, scale up and attract large pools of venture capital money. On the other hand, it has created a tremendous amount of wealth for founders and the members of the core team of many startups through Esops (employee stock ownership plan). This has created a rush of senior employees looking to make Esops a large part of their investment strategy.

However, there is always more to this than what meets the eye. It reminds me of an acquaintance who was working with a rapidly growing startup and had been allotted Esops on multiple occasions. He had almost 70% of his net worth tied with the Esops. Things went southwards and the startup failed to raise new funds required for further growth. Ultimately, the startup was acquired at a much lower valuation than that at which it had raised money in the last round. Due to a clause of ‘liquidation preference’, which all early-stage investors have in the term sheet while investing in a startup, all the founders and members owning Esops realized only a meagre amount for their holdings.

As a multi-family office, we come across situations like this every other day where Esops are a substantial part of the financial portfolio of many senior management professionals. It goes without saying that on the risk-return metrics, Esops are high-risk, high-return and highly illiquid investments. Hence, we suggest looking at it from two angles: risk allocation to ensure that there is a balance between lowly correlated asset classes (and Esops will naturally fall under the category of equity risk investments) and risk tolerance as the value of Esops may not appreciate as envisaged or may take longer to monetize. They should not be considered for any key liquidity requirement.

A common argument in support of owning a disproportionate number of Esops in the portfolio is the individual’s know-how of business and industry. So, why not own a large part of the business in the form of Esops in the portfolio when it appears to be natural? A simple answer to this is risk management. The way any business would not want to be over-reliant on a single customer, regardless of how great that customer is for the business, the same way your portfolio should not be overexposed to Esops.

Also, the notion that established businesses—that have crossed hurdles of product market fit and customer adoption—don’t have any risk is due for a big change. Down rounds are becoming a normal thing; a lot of unicorns are delaying their IPOs or the valuations have changed for them drastically. Therefore, one may not consider Esops in their asset allocation but in their risk allocation.

Business creates wealth and Esops are a tool to participate in that. Your investment portfolio is to protect the wealth you have generated, especially during market downturns. Esops create returns in multiples and hence there is a natural urge to have a larger allocation towards them. However, your investment portfolio is meant to be a vehicle that delivers consistency of returns and a pool of money that you can dive into during times of need. One needs to be cognizant of the following:

– Create a capital pool that is protected from the fortunes of the business or startup you are working with.

-A large part of this capital pool is highly liquid and available.

-Prudent diversification across lowly correlated asset classes and geographies is there in the portfolio.

-Efficient taxation while exiting these investments and transferring to the next generation.

Esops are undoubtedly a great tool to participate in the growth of the business, but one should be mindful of not making the fortunes of the overall portfolio dependent on it.

Rahul Bhutoria is director & co-founder at Valtrust.

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