Keep Esop for risk allocation, not asset allocation

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India’s startup ecosystem has come a long way, it has affirmed the belief that startups can grow, grow and attract vast pools of venture capital. On the other hand, it has created enormous wealth for founders and core team members of many startups through Esops (Employee Stock Ownership Plan). This has created a rush of senior employees looking to make Esops a big part of their investment strategy.

However, there is always more to it than meets the eye. This reminds me of an acquaintance who worked with a rapidly growing startup and had been awarded Esops several times. He had nearly 70% of his net worth tied to Esops. Things went south and the startup failed to raise the new funds needed for future growth. Ultimately, the startup was acquired at a much lower valuation than it had raised at in the last round. Due to a “liquidation preference” clause, which all early-stage investors have in the term sheet when investing in a startup, all founders and member owners of Esops only realized a meager amount for their holdings.

As a multi-family office, we encounter situations like this every day where Esops represent a substantial part of the financial portfolio of many senior professionals. It goes without saying that on risk-return measures, Esops are high-risk, high-reward, and highly illiquid investments. Therefore, we suggest looking at it from two angles: risk allocation to ensure there is a balance between low-correlation asset classes (and Esops will naturally fall into the equity risk investment category) and risk tolerance as the value of Esops may not appreciate. as expected or may take longer to monetize. They should not be taken into account for any key liquidity requirement.

A common argument in support of possessing a disproportionate number of Esops in the wallet is the individual’s business and industry savvy. So why not own a big chunk of the business in the form of Esops in the portfolio when it feels natural? A simple answer to this is risk management. The same way a business wouldn’t want to be overly dependent on a single customer, no matter how good that customer is to the business, the same way your portfolio shouldn’t be overexposed to Esops.

Also, the idea that established companies – who have cleared the hurdles of product market fit and customer adoption – are risk-free is due to a big change. Rounds down become a normal thing; many unicorns are delaying their IPOs or valuations have changed dramatically for them. Consequently, Esops cannot be considered in their asset allocation but in their risk allocation.

The company creates wealth and the Esops are a tool to participate in it. Your investment portfolio aims to protect the wealth you have generated, especially during periods of market decline. Esops create multiple returns and so there is a natural need to have a larger allocation towards them. However, your investment portfolio is meant to be a vehicle that provides consistent returns and a reserve of money that you can dip into when needed. You should be aware of the following:

-Create a pool of capital that is protected from the fortunes of the company or startup you are working with.

-Much of this pool of capital is very liquid and available.

-Cautious diversification between asset classes and low-correlation geographies is present in the portfolio.

-Efficient taxation while exiting these investments and transferring them to the next generation.

Esops are undoubtedly an excellent tool to participate in the growth of the company, but care must be taken not to make the fortune of the entire portfolio depend on them.

Rahul Bhutoria is director and co-founder of Valtrust.

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