Share-based compensation: Challenges for startups
- Dominik Konold
- Knowledge
- June 15, 2023
Share-based compensation is standard practice for most publicly traded companies when it comes to retaining employees and attracting talent. With appropriate structuring, this form of remuneration represents a liquidity and equity-friendly alternative to classic bonus payments, especially for growth-oriented companies such as startups. Both for listed companies and start-ups, (capital market) legal and tax issues are major obstacles in the course of the structuring and implementation of corresponding programs. In addition to these hurdles, the following problems arise, especially for startups, in order to be able to exploit the full potential of share-based payment programs.
Valuation
Whether for purposes of determining the issuance volume or for external reporting : Determining the fair value of the instruments granted within share-based payment programs is essential. Valuation methods such as the discounted cash flow (DCF) and the multiple method (multiples) are often used in this context. The DCF methods are based on the payment surpluses of the integrated corporate planning. These are discounted on the valuation date using an interest rate appropriate to the risk and maturity. As part of the multiple method, the valuation is based on the financial parameters of comparable listed companies. An approach tested in practice is to use the valuation of the last capital increase as a basis. This measure is then calibrated to the current reporting date using the multiple method. For this purpose, a corresponding multiple (e.g. EBITDA multiple) is calibrated with a premium or discount in such a way that it exactly reflects the valuation achieved there at the time of the last capital increase. The premium or discount is then kept constant and the key figure used ( e.g. EBITDA) is updated to the current period in order to determine the current value of equity or the share price.
Structure
- Equity vs Cash: The granting of subscription rights to real equity shares (equity-settled) such as shares has enormous advantages, especially for startups from a liquidity point of view. Furthermore, in the so-called equity settled case, accounting according to the current accounting standards is either not mandatory or equity-neutral. These advantages are offset by the fact that the issue of real equity instruments is associated with corporate law hurdles and is viewed critically by existing investors due to dilution aspects. A solution to this dilemma is the option for the company to contractually grant itself the option of servicing the subscription rights in cash or in real equity shares. The exercise of the right to vote can be structured at the sole discretion of the company or depending on certain events, such as conversion into a public company.
- Performance metrics: In order to achieve an incentive effect that is as targeted and/or ambitious as possible, many companies resort to linking the exercise of subscription rights or the amount of the payment to the achievement of certain performance indicators. For example, financial indicators such as EBITDA are combined with share-based indicators and non-financial indicators such as ESG (environment, social, governance). The targeted control of the incentive effect that is envisaged is offset by the complexity and the associated lack of transparency. In the case of startups it makes sense to limit yourself to a few key figures or to divide the remuneration instruments into individual packages. In addition to the share-based component, only one additional key figure is defined for the respective package.
Volume
One of the biggest challenges is determining the appropriate level of share-based payment. Startups need to strike a balance between providing incentives, maintaining sufficient equity for future rounds of funding, and ensuring control by founders and early investors. When determining the correct volume, the following points in particular must be considered:
- Enterprise Value: The first step in determining the right volume is to determine the current enterprise value. This can be done by valuation experts, the use of a valuation model (see above) and the use of digital solutions.
- Growth prospects: Startups typically have high growth potential. When determining the scope of ESOP plans, it is important to consider the company’s growth prospects to avoid creating too large a difference in the economic returns from employee ownership among groups of employees.
- Benchmark studies: In the case of long-term programs with a large number of beneficiaries, it makes sense to validate the volume using relevant benchmark studies or to use the expertise of remuneration consultants. Share-based compensation programs have proven to be a real alternative to classic bonus payments for startups. The challenges and risks in the course of structuring and implementation should not be underestimated. These can be managed with reasonable effort by taking into account simple principles (e.g. reducing complexity), consulting experts and, in particular, using digital solutions, so that nothing stands in the way of the success of your share-based payment model.
