The term startup refers to a company in the first stage of its operations. Startups mostly founded by one or more entrepreneurs who want to develop a product. Or service for which they believe there is a demand. These companies generally start with high costs and limited revenue which is why they look for capital from a variety of sources such as venture capitalists.
Startups are companies or ventures that are focused around a single product or service that the founders want to bring to the market. These companies typically don’t have a fully developed business model and, more importantly, lack adequate capital to move on to the next phase of business. Most of these companies are initially funded by their founders.
By its nature, the typical startup tends to be a shoestring operation, with initial funding from the founders or their friends and families. Crowdfunding has become a viable way for many people to get access to the cash they need to move forward in the business process. The entrepreneur sets up a crowdfunding page online, allowing people who believe in the company to donate money.
So many startups fail within the first few years. That’s why this initial period is so important. Entrepreneurs need to find money, create a business model and business plan, hire key personnel, work out intricate details such as equity stakes for partners and investors, and plan for the long run. Many of today’s most successful companies began as startups—Facebook, Airbnb, Uber, SpaceX, and Ant Financial—and ended up becoming publicly-traded companies.
Overview of the Indian Startup Industry
The department for the promotion of industry and internal trade (DPIIT), which comes under the ministry of industry and commerce, has recognized over 27,916 startups, as of February 1, 2020. With such impressive innovations to choose from, even investors are aggressively trying to grab on the opportunities to invest in India and its impressive catalogue of new-age startups. But as the ecosystem expands, we are seeing startups emerging thick and fast from all nooks and corners of the country.
India has a vibrant startup ecosystem. It has seen consistent growth for a good while now. As per DataLabs by Inc42, Indian startups raised over $11 Bn in 2019 (as of November 30, 2019), across 736 deals. Whereas in 2018, the startups had raised $9.57 Bn across 717 deals. Some of the biggest investments from last year included Paytm with $1Bn, Ola’s $597M, and Delhivery’s $528 Mn. But they are more than just fundraising machines. They are also very important cogs in the vast economic machine.
They drive growth and development across the board by influencing consumer spending, providing innovative solutions to pressing problems, and boosting employment at multiple levels. But a startup’s success is largely incumbent on their ability to attract and retain highly skilled and experienced employees. The problem — they might not necessarily have the resources to afford this kind of talent. This is especially true for early-stage companies that do not have a steady stream of income.
And with the COVID-19 pandemic hitting all across the world, these problems have multiplied by many a fold. Several startups are facing a severe shortage of funds due to the decline in revenues. There are very few chances that these startups are going to see fresh funding or investments. Also, the nation-wide lockdown hasn’t helped the cause either.
70% of startups in India, home to one of the world’s largest startup ecosystems, have less than three months of cash runway in the bank, and another 22% have enough to barely make it to the end of the year, according to a survey conducted by industry body Nasscom.
As startups confront unprecedented times, many are thinking of taking dramatic steps to stay afloat. Many startup businesses have been willing to diversify into growth verticals such as healthcare, Edutech, and Fintech.
It’s also the reason why so many startups have been laying off employees. But they are also desperately trying to hold on to talent in the event their fortunes turn. Unfortunately, they are running out of cash and they have very few avenues to retain or hire new talent. Which brings us to the topic today — Sweat equity. More importantly how the government has tweaked an existing policy to make it easier to offer employees sweat equity.
But before we get into it, we need to understand a similar term i.e. ESOP. An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.
Alternatively, ESOP can borrow money to buy new or existing shares. Also, the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
Faith in Employee Stock Options (ESOPs) has increased with many companies allowing employees to divest their part of holding in secondary transactions. Many Indian startups like BYJU’s, Unacademy, Rivigo, CarDekho, Paytm, Razorpay, Meesho, Zerodha, and Bounce have expanded the ESOP option to furloughed employees or those whose pay has been cut during the ongoing economic crisis bought upon by the Covid-19 pandemic.
ESOPs, give you the right to buy company shares for a modest sum (at a price lower than what the shares are actually worth) and a startup can offer employees ESOPs instead of cash. It’s good compensation. And they work quite well. Usually, the employee is offered the ESOP and asked to wait for a while. Then, at a specified date in the future, she can exercise the “option” to buy the shares for a modest sum. If she chooses to exercise her right, the shares will be allotted. And if the company does well in the future, these shares could potentially be worth a whole lot more.
But then there’s another alternative — Sweat Equity. If an employee puts in the effort, management could just choose to compensate her with part ownership in the company. Remember, they are not the founder here. They are not an investor here. They are not parking money. Yet, they are being offered equity. Not options to own stock, but direct ownership.
Sometimes that can raise eyebrows. But the Ministry of Corporate Affairs in India allows startups to part with ownership units (shares). They believe the employee in question can put in the hard work and who bring in their expert knowledge. Also, know-how as well as the technical expertise that adds to the business value of the company. Therefore, in order to keep them involved and motivated towards the company, the companies go the extra mile to reward them by giving them sweat equity/ESOPs.
The government has allowed Indian startups to issue sweat equity within 10 years from their incorporation or registration (as against the earlier 5 years). This amendment is aimed at empowering startups to help them attract and retain key talent.
The extended timeline can benefit startups such as the technology sectors which sees rapid changes on a daily basis necessitating hiring and retaining of key talent.
The government also said startups can now offer sweat equity shares of up to 50% of their paid-up capital as opposed to 25% earlier. Meaning startups can now afford to offer more sweat equity to their employees. This ideally should give them extra leeway to hire and retain talent. But bear in mind, this benefit has only extended to startups.
Vishwanathan Iyer is a guest writer at Investocracy, news, and media platform focusing on startup news from Africa and Asia. He has total work experience of around 10 years across various sectors in India.