ESOP Academy 14: Employee Equity Holders vs. Investors - What's the Difference?

Written By:
Amit Majumder, CFA
March 27, 2023

Do you become an investor when you receive ESOPs?

If you receive equity at your company, you are likely not holding shares, as other instruments like options are more popular, especially in early-stage startups. Even when you exercise your options and receive the underlying shares certain rules and restrictions may still apply to you. So what to make out of this situation – should you be see yourself and expect to be treated as other shareholders of your company and how do you compare to external investors? Do you have the same rights as them, or will you get preferential treatment? Will they?

There are a few factors to consider, and this week we will explore how you can think about the privileges and obligations you have as an employee equity holder, and how you stack up against external shareholders.

Different classes of shares 📊

Many differences between employees and other investors will come down to the type of shares they hold or are entitled to. This is especially true for unlisted startups, as capital structure in private market companies tends to be a lot more complex with multiple classes of equity securities.  Here are the common types you may come across:

  1. Ordinary shares are the most common type of shares given to employees. Ordinary shares often give you a voting rights and a right (but not obligation) to receive dividends on your shares.
  2. Unsurprisingly, not all ordinary shares are identical. Some companies may have various classes of ordinary shares (e.g. “Class A” and “Class B”), which may have different shareholder rights associated with them.
  3. Preference shares are often issued to outside investors like Angel Investors, Venture Capitalists, or Private Equity firms. As the name suggests, these shareholders may get preferential rights – and that comes in a form of priority over ordinary shareholders to claim company’s assets. This comes in handy for the investors at the time of exit or liquidation.
Tip: Confused what you actually hold? Check your offer letter and plan rules you received at the time of the grant of your ESOPs. These documents will outline the underlying security class you will be entitled to receive in future subject to vesting conditions and other restrictions.

Shareholder rights: voting and dividends 💵

Your ability to enjoy and exercise your shareholder rights will depends on not only on the equity instrument you hold, but also the underlying security class of shares as we have learnt just now. Are you able to vote at your company’s next general meeting? Will you be entitled to receive a payment should you company declare a dividend?

The structure of your ESOP will dictate what restrictions may be imposed throughout the vesting schedule, and at which stage you may be able to convert your derivative instruments (options, rights) into the underlying shares. External investors are not subject to the terms and conditions of an equity plan of the company, and their experience, as a result will be different. Be sure to understand the plan design and the company’s capital structure.

External investors also have a document that governs their relationship with the company. It’s called Shareholder Agreement, and outlines their rights and obligations, as well any privileges and protection they will enjoy.

Employee securities trading policy📄

Whenever you are employed at a company, you agree to adhere to the rules outlined in the company’s policies. And this includes the securities trading policy. Companies tend to be conservative to avoid even perception of a possible conflict of interest, let alone insider trading. For that reason, your ability to transact in your equity may quite restricted.

You should be aware of any trade pre-clearance approvals, as well as company trading blackout periods and designated trading windows before you engage in any transactions in your company’s equity. Luckily, employers will most likely roll out an equity management platform that will help streamline the administrative part of all of this and make it easier for you to understand when and how you are able to enter into various transactions.

Valuations and transparency💲

As we have learnt, your ESOPs most likely have the underlying entitlement to the ordinary shares in the company, whereas outside investors likely hold preferred shares. What if I told you that despite you and them holding shares in the same company, they may not be worth the same? How is that possible?

Preferred shares can hold a higher value, as they enjoy the liquidation preference over ordinary shareholders. For that reason, the price achieved at the time of the last fundraise does not directly translate to the current value of the shares you may be entitled to through your ESOPs.

To better understand your company’s valuation, and as a result the value of your holdings, check out your employee holding account and/or have a discussion with your employer. Unfortunately, private markets have greater information asymmetry compared to the listed environment, and some companies are not upfront about their share valuations with their employees. Next week’s article will be dedicated to this very topic and will aim to shed more light on how to deal with the uncertainty around valuations of startups and your ESOPs.

Listed companies 📈

Things are a little less complex for listed companies, where capital structure tends to be simpler with majority of investors holding a single class of ordinary shares. In addition to that, employees have easy access company’s financial information and disclosures. This near real-time access to company’s latest share price, announcements, financial reports, and research makes a difference and helps investors and employee make informed decisions. Experience of you as an employee in a listed company is more alike to those of regular investors. However, some differences still remain – predominately dictated by the rules of the equity plan you participate in, and the equity instrument you hold.

External shareholders’ view on employee equity ✅

When employee equity schemes are created, they often need to be approved by the shareholders and/or the Board of Directors. Whilst this may sound like a tricky hurdle to overcome, investors generally hold employee share plans in high regard thanks to the many benefits they provide not only to the employees themselves, but also to the company. After all, it’s in investors’ own interest to enable the company to attract and incentivise top talent to help boost its future prospects and performance.

This is especially true for early-stage companies, where investors include specific clauses in the term sheets at the time of funding rounds mandating a portion of the company’s shares to be reserved for employees. This is often referred to as a “pool” or “option pool”. The pool serves as balance of shares that are put aside to be used to satisfy settlement of employee exercises and issuance of shares to employees in both immediately and in future, providing flexibility to allocate ESOPs to both existing employees and any future hires.

Despite the various differences between employee and external investors – they have a lot in common, and the drive to help the company success is one of them.

Thinking like an investor 🤔

Based on the discussion above, it sounds like being granted ESOPs doesn’t really necessarily make you a full-fledged investor due to the nature of instruments that you hold and the rules that govern the - at least immediately. That may be true, but thinking as an investor, and treating your ESOPs as an asset class in your overall investment portfolio can be right approach.

It pays (and possibly literally) to employ the same investment approach to analyse the prospects and challenges your company may face, as any external investor would do, or as you would when you consider investing your money into other companies. You may even be in a better position to assess the company potential than most thanks to your understanding to the company’s product, industry, and the competitive landscape.

The decisions you make when you negotiate and transact on your employee equity will have a long-term impact on your investment returns. Sure, you may not be able to immediately enjoy the same rights as external shareholders in the company but employing the same mindset in evaluating your company from the investment opportunity lens can be a recipe for success in management of your overall portfolio.

Amit Majumder, CFA

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