Although expectations of recession have lifted to a certain extent in recent weeks, forecasts for a slowing global economy during 2023 still remain and commentators anticipate further contraction of corporate budgets and companies continue to announce personnel layoffs, particularly in the technology and financial sectors. In a market environment that is trending downward enterprises are naturally thinking about efficient cost management with one of the most significant costs being employee compensation. However, for startups that are already lean, retention of key staff while finance is scarce can be critical.
Share-based compensation (“SBC”) is a useful remuneration option for lean startup companies as it incentivizes employees, aligns them with shareholders, and at the same time preserves cash. However, SBC impacts the company’s capital structure and can present challenges if the company valuation declines. Here are a few considerations to bear in mind:
The two most common SBC structures used by startups are restricted stock units (“RSUs”) and share options.
1) RSUs are a grant of company equity at “fair value” that vests according to a predefined timetable. The RSUs are funded via the company’s profit and loss account at the time they are granted. The key advantages of RSUs are:
- No cash outlay for either company or employees
- The RSUs always have a positive value, even if the company’s value declines in a down market
2) Share options give employees the right to purchase shares in the company equity at a fixed price that may be exercised at any time in the future after they vest and before they expire. The options are funded via the company profit and loss account at fair value on the date of grant spread over the vesting period. The key advantages of share options are:
- No cash outlay for the company
- Cash outlay for employees is deferred till exercise
The main disadvantage of share options is that they could expire valueless if the company’s value declines in a down market.
A market downturn affects RSUs and share options differently and remedies differ. RSUs will always have a positive value albeit significantly lower than may have been expected at the time of grant. Management could consider simply issuing more RSUs to compensate employees for the shortfall. The exercise price of the employees’ share options could be higher than fair market value in a down market rendering the options valueless. Management could consider repricing the options (although there are complex rules associated with this) or alternatively issuing new options.