ESOP payouts, buybacks plummet among Indian start-ups amid funding winter

As the so-called start-up funding winter lingers on, employee stock ownership plan (ESOP) payouts among fledgling companies have hit the skids. Employee earnings from ESOPs have come down from the highs of almost $400 million in 2021 to less than $100 million this year, according to equity management platform Qapita.

While the funding slowdown has had no significant impact on the issuance of ESOPs, a liquidity crunch has caused the once-overflowing well of ESOP buyback programs to run dry.

Start-up funding in India hit new heights in 2021 when investments reached a total of $44.5 billion. Since then, capital has become much harder to come by. Total funding fell to almost half in 2022 at $26.6 billion, while start-ups raised just $2.8 billion in the first quarter of this calendar year, according to data from Tracxn, a market intelligence platform.

ESOP buybacks, the primary method of liquidation for employee-owned stocks, have followed the funding trend as companies look to reduce cash burn and improve their margins. Both 2021 and 2022 combined saw a record quantum of ESOP buybacks to the tune of more than $700 million, on the back of the increased venture capital and private equity investments at the time.

In 2022 alone, over 40 companies announced ESOP buyback programs. In contrast, only 9 companies have announced programs until May 2023 so far, data from Qapita signposts. Furthermore, fewer companies are disclosing the quantum of their liquidity programs while offering ESOP top-ups or accelerated vesting instead of cash increments.

“With funding winter going on, the Indian start-up ecosystem has been facing ESOP liquidity challenges,” says Manish Khanna, co-founder, of Unlisted Assets – a technology-driven platform for buying and selling unlisted shares. “Most of the start-ups are increasingly focussing on conserving cash and maintaining liquidity. For this reason, we have not seen many announcements on the ESOP buyback front.”

ESOP holders in Indian start-ups, which are mostly unlisted companies, typically liquidate their shares through company-led programs and not through an open secondary market. In the absence of frequent ESOP buyback programs, the liquidity options for employees are limited.

“Companies are also exploring alternative liquidity mechanisms, such as third-party sale programs by finding investors willing to do a secondary purchase of shares. However, in the funding winter, the number of investors willing to purchase secondary shares is also lower,” says Ravi Ravulaparthi, CEO and co-founder, Qapita.

Moreover, most of the ESOP inventory gets traded in the market at a discount to a fair valuation. With lesser exit options, the discount goes up and becomes steeper if there are fewer buyers in the market.

“The price at which ESOP holders liquidate their options is typically benchmarked at the last funding round. Most liquidity programs in 2021 and 2022 were offered on par with their previous funding round,” adds Ravulaparthi.

Employees who have converted their ESOPs to shares, he says, can sell their shares in the secondary market. “In such cases, the shares are trading at discounts to previous rounds.”

Regardless, while start-ups have rationalized their growth strategies to cut down costs, the trend of issuing ESOPs, industry watchers say, has kept its pace.

“During funding slowdowns, ESOPs work as a good tool for companies as there is zero cash flow impact for them, which helps conserve valuable cash,” says Shravan Shroff, co-founder, ESOP Dhan.

ESOPs are a cash flow-friendly instrument. So, in a difficult funding environment, the issuance of ESOPs should witness an increase.

“Anecdotally, we have seen companies (both listed and unlisted) looking at ESOPs to incentivise their talent and allocating more ESOPs,” adds Ravulaparthi.

The liquidity challenge is, however, expected to remain so going forward until macroeconomic headwinds subside.