Start-ups need to rethink funding and staff retention incentives in this market downturn

Over the past decade and a half, a thriving start-up community had a silver bullet for attracting and retaining key talent. More cash-strapped than their multinational competition, emerging tech and life science companies offered potential recruits a compelling package: live with a lower base salary in exchange for a generous bundle of share awards (such as share options, restricted stock units or growth shares), which they could then cash out at future fundraising rounds.

This model worked very well when valuations of early stage companies increased rapidly and the appetite for investment appeared insatiable. The rationale for staff was clear: a potentially large pay cheque in 18-24 months’ time if the company proved successful, which could be many multiples of a salary at an established multinational.

For employers, the rationale of an employee equity incentive scheme is compelling. Firstly, lower fixed salaries and potentially less operational leverage make a company more agile, something that is essential when cash is scarce. Secondly, it enables closer alignment between the goals of founders and their employees, as both can share in any potential upside of the company’s success, incentivising productivity. Finally, share-based awards act as a valuable recruitment and retention tool, leading to lower employee turnover.

In a downturn, the benefits of share-based awards remain compelling for employers, arguably even more so than in good economic times. Controlling fixed costs and minimising operational leverage becomes mission-critical, as does aligning the goals of staff and founders. A 2017 US study by the WE Upjohn Institute for Employment Research showed a lower likelihood of failure among companies with employee ownership during the last two recessions.

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We have entered an era of high inflation and rising interest rates, with decreased investor appetite for companies yet to make a profit

However, incentives only work if they allow you to attract and retain the best talent, an issue that remains a key strategic challenge for businesses. We have seen recent examples of private companies raising funds at significantly reduced valuations to those available 18 months ago to prevent options from lapsing. This suggests that keeping key employees happy remains a priority.

[ Funding is biggest challenge facing start-ups, survey finds ]

The story is different for employees, for whom a downturn creates uncertainty around equity incentives. During times when valuations only went up and emerging companies were flush with cash, receiving shares or options in a company as a significant part of compensation was attractive to existing and prospective employees. Today, however, the attraction may be less obvious. We have entered an era of high inflation and rising interest rates, with decreased investor appetite for companies yet to make a profit, as well as a potential credit crunch for the wider financial ecosystem, following the recent turmoil in global banking and financial markets.

Two issues

In this changed economic environment two issues have emerged:

1. Unrealised losses: A decline in company valuations means a significant, albeit unrealised, plunge in employee wealth. In a private company, it is less obvious when the market turns against you as there is no listed share price to monitor. Even so, the recent decline of the Nasdaq has been sufficiently dramatic to spook even private companies’ employees. Dissatisfaction and cynicism around the worth of the existing ownership package and second guessing a private company’s valuation creates further uncertainty. The possible effects on employee morale should not be underestimated, particularly given that goal alignment is the most important value driver behind employee ownership.

2. Illiquidity: During a downturn, emerging companies find it much more difficult to raise investment on average. Typically, a raise provided employees with an opportunity to cash in. Now they might be required to wait for a period of time measured in years rather than months.

In this landscape, companies should be transparent about the current valuation of the company, what impact external market conditions have had and what needs to be done by management and employees to improve it. Management incentive plans should be designed with specific commercial objectives in mind to create company value through initiatives that are within management’s control. Objectives should be challenging yet realistic, to ensure they meet their objectives. There should be inbuilt flexibility to cope with downturns and illiquidity scenarios. Where feasible, consideration could be given to share repurchases when a liquidity event fails to materialise.

Tax outcomes should be given careful consideration, and for incentives designed around growth in share value – such as share options or growth shares – a realistic starting share price is important.

The downturn provides a rare opportunity to reset and issue new incentives to employees at a much reduced market value

For indigenous SMEs, the Key Employee Engagement Programme (KEEP), established in 2018 as tax-efficient share option scheme available to small and medium enterprises has had some success. However, the time has possibly come for it to be revisited by Government so that it can reach its full potential. Compared to similar schemes in the UK such as the Enterprise Management Incentive (EMI) scheme, KEEP has not received as much take-up as might have been expected. Some changes could boost its appeal to SMEs and their key staff, thus benefiting the wider Irish tech and business ecosystem.

[ Keeping key staff in times of disruption ]

While the eroded value on paper of existing equity incentive awards may be a cause for disillusionment during a downturn, especially where employees acquired the shares at a top-of-cycle valuation, the downturn provides a rare opportunity to reset and issue new incentives to employees at a much reduced market value. This gives employees the potential to participate in a much greater upside when the economy inevitably picks up.

Grit Young is strategy and transactions partner at EY Ireland