ESOP Academy 9: Value Creation, Behavioural Finance and Risk Management

Written By:
Amit Majumder, CFA
October 20, 2022

How to value your ESOPs?

Probably worth something, right? After you, ESOPs have a reputation for being a great way to generate wealth in the long run. Well, let’s have a look at the following scenario.:

Your company’s current share price is $1.00. Today you received 1,000 options. The exercise price is $1.00. Your options are subject to vesting conditions, and they expire in 10 years. How do you value them?

Let’s think back to the basics. An option is a right to buy a share at a fixed price. Let’s imagine you could exercise them immediately - you could acquire 1,000 shares for $1.00 each and your shareholding would then be worth $1,000. So you need to part with $1,000 in cash to receive $1,000 in shares. Seems like a straightforward one-to-one trade.

-$1,000 + $1,000 = $0. Sounds like your options are worth nothing.

If I was to offer to you to transfer your 'worthless' options to me, just so you wouldn't have to worry about all the complexity, would you say yes? After all, they seem to be worth nothing using the logic above!

Your answer would probably be an immediate “no”.

There is a reason why you wouldn’t give away your options that at a quick glance seemingly don’t have any current value. Perhaps without realising it, you applied the option pricing model methodology in your mind. Whilst if you were to exercise today, they would be no financial benefit to you, with time, the share price can go up. You understand that there is an upside potential – a chance of a significant pay-out in future if things work out in your favour. For that very reason – your at the money (i.e. share price equals exercise price) options have value, even today. The more time and volatility (think uncertainty) there is, the more room there is for a potentially favourable scenario to play out. There are other factors that come into play that will impact the value of the options one way or the other, but understanding how much time there is before expiry of an option plays a role is a good starting point.

So, it’s probably fair to say that your ESOPS are not worthless. Does it make sense to hold on to them for a long term to help you generate wealth? Isn't that the whole purpose of equity compensation?

Concentrated Positions in ESOP

By staying loyal to your employer over many years, you will naturally build up a pretty significant stake in the company via your (often) annual equity grants. This can result in you accumulating a concentrated position, meaning a large portion of your overall assets are tied up to a single investment. Concentration of one’s portfolio in their company’s equity can lead to a potentially inappropriate construction of the overall investment portfolio.

Why does this occur? Employees can often underestimate risk of their company’s equity, as they have strong confidence in their company’s performance, feel comfortable and familiar. This, as a result, can lead them overestimate the potential returns.

It may also be tempting to assume the early success of your startup will continue, but extrapolating past returns may not always be the best approach in evaluating the future prospects of your investment.

Employees also may have an element of trust in their employer, and as such they may feel safe retaining a significant interest in their company, where their day-to-day roles contribute to the overall success - a sense of having control over the outcome.

The way the ESOPs are often designed, also make participation attractive. ESOPs can sometimes be issued at discount at FMV or at even nil strike price, so you get the full upside of the share price performance and reduced downside risk.

All these factors can lead you to be overexposed to small number of risk factors linked to the success of your employer. Whilst you might be looking to utilise ESOPs to help accumulate wealth, there also seems to be conflicting pressure due to increasing risk exposure at the same time? Let's explore this dilemma further.

Holding on to your ESOPs for dear life

It seems like employee equity plans by design are long-term investments. For most plans, you will need to wait for at least a year before some of your ESOPs even vest. So you might naturally start thinking about holding on to your ESOPs for a long haul. What you might not appreciate, is that there are several biases that may push you towards that approach. Let’s introduce some of behavioural finance (a fascinating area to read more about) concepts to understand why that might be the case.

  • Illusion of Control

It is reasonable to feel more comfortable in situations where you appear to have more control over the outcome. At work, especially at a startup, every employee’s contribution can have a significant impact on the success of the company. Naturally, thanks to this perceived control, the employees may overestimate their ability to dictate the success of the company, choose to remain invested, and underestimate the risk involved at the same time.

  • Home Bias

Strong familiarity with local investment opportunities can lead investors to have a larger concentration in domestic equities and other asset classes. You can draw a parallel of this concept to employee equity. Investing in your own company can be perceived as an easier thing to do – you are familiar with how it operates from the inside, what the company’s goals are, and you are already “invested” in it – you are working there after all, so you probably don’t thing the company is going out of business tomorrow. What easier place to invest in than your own company, since you already have a lot of information available to you to make the decision?

  • Status Quo Bias

People may tend to prefer to stick to the current state of play. With ESOPs, where you have been getting them annually for a while, haven’t transacted yet, and things seem to be going pretty well, why would you change anything? No need to fix what's not broken, right? You might just decide to and keep things as is. That’s the status quo bias.

  • Regret-aversion bias aka FOMO

Why would you cash out early to give up a chance of a massive payday when your company gets acquired or goes public? You see all those success stories in the news. What if you are currently in the process of creating the new unicorn and that rocketship will get you to the moon? You can this way of thinking can lead employees to hold on to their stake for the fear of missing out on potential profit opportunities in future.

As you can see, some or all of these factors can influence decision-making of employees and lead them to end up with concentrated equity positions and expose themselves their wealth to significant risk in an event of negative company performance.

To cash out or to hold?

Holding on to your ESOPs can be a great wealth generation opportunity, but building up the stake in your company can also lead to increased risk of your investment portfolio. So what should you do?

When executives and directors sell their stake in the company, it is commonly perceived as a negative signal to the market participants. After all, why would they sell – do they not believe in the company’s future? Many employers have employed the same mindset.

Sure, loyalty is important, but holding on to your stake in the company may not always be the best decision for you. Building up a highly concentrated position may well play out in your favour is the company does extremely well, goes public. That potential is great, but there is downside risk.

Often your likely main sources of income (salary, wages, cash bonus) is already tied up to the fortunes of your employer. Equity in your company shares many of the same risk factors, so you magnify your risk to both upside and downside. When things go well for your company, you will benefit tremendously, but if your company is in trouble, risk of layoffs, reduced wages growth and/or significant reduction in share price may all result in a significant financial burden on you all at once. Just think about the “classic” collapse case study of Enron, where many employees relied not only on salary and bonuses, but also had company’s stock in their holdings and 401k. As you can imagine, the impact on their overall wealth was quite grim.

One of the main risk management considerations when it comes to concentrated position in your company's equity is that in the worst-case scenario, investment losses due to poor company's performance may also possibly further amplified by possible loss of employment.

This is the whole point of diversification. You try to balance the risk and reward of your portfolio. So next time you consider taking some money of the table by cashing out on your ESOPs, don’t think of it as being a reflection on your lack of loyalty to your employer or suggest that you have no faith in the company’s future growth prospects. For some people, that may be the appropriate step in their risk and portfolio management strategies. For others, continuing to have the same level of exposure to their company may also be a wise choice, if it represents a smaller portion of their overall portfolio that is well balanced and diversified not only in terms of asset classes, but also the risk factors the investments are exposed to.

As with any investment, it is important to consider the overall investment objectives, and how each decision you make increases the likelihood of achieving them.

What will your employer tell you about the above risks?

Employers traditionally have been reluctant to encourage their employees to sell and cash out. At times, they tone down their communication at the time of vestings and exercise windows as not to prompt you to transact. This is often due to a flawed view that employees should stay invested and committed to their companies at all times. But the times are changing.

Companies now realise the important of financial education and commit more resources to helping their employees out on their equity journeys. Companies with strong culture often lead the way in this. With increasing awareness of importance of ESOPs and their role in employees' wealth creation journeys, you can expect to see better communication strategies from employers, as well as structured liquidity programs giving employees an ability to cash out on a regular basis. These trends are most welcome and are here to stay.

Education is critical in helping employee equity holders understand ESOPs and how to manage them. After all, this is why ESOP Academy even exists!

So, what should you do then?

If you were hoping to get a clear answer of what you should do with your ESOPs, you won’t get it here. Should you cash out at the earliest opportunity or hold on to every single share you can get your hands on? Both options can be valid and appropriate.

The takeaway here is that you need to be aware of the various factors that may influence your decision-making process. Just like with any investment you hold, consider it as part of your entire portfolio.

Is 80% of your income derived from your salary and wages, 15% from your ESOPs and the rest from your savings and other investments?

What if your employment income is only 35% percent, ESOPs another 15%, and the remaining 50% is coming from your side hustles, passive income, and various investments?

I will leave it to you to ponder on what your approach might be for these hypothetical scenarios. I do recommend checking out more literature and introductory articles on wealth management, portfolio management, risk management behavioural finance. The more information and knowledge you absorb, the better position you put yourself in to make a more informed decision in relation to your investments, with ESOPs being one of them.

What’s next?

We have started with the basics of ESOPs and have now ventured into some of the practical insights of how various factors may impact your equity journey. We will continue with this theme. Next week, we will explore what happens to employee equity when your employer various corporate actions including when your company gets acquired, and what you might need to keep in mind if that happens.

Amit Majumder, CFA

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