Understanding your Employee Stock Options (ESOP) better, and financing options available

by Sandeep Kumar | June 1, 2021

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Employee stock options today form an integral part of the compensation structure in small and large startups. As a rule of thumb, startups allocate between 5% — 10% shares to the ESOP pool, and it keeps on getting topped up in each funding round. On average, unicorn startups have between 4% — 7% of their total valuation locked in ESOP pools, allocated to employees over a period of time.

As a consequence of the spurt in startup valuations and a large number of IPOs in the last two years, a large number of ESOP holders have become millionaires in the past few years, and many more are in line. Recently, with the IPO of Freshworks, more than 500 employees who were offered ESOPs have turned crorepatis ($125,000). Freshworks founder Girish Mathrubootham said that more than 76% of employees have been issued ESOPs in Freshworks.

Unfortunately, two key issues have also emerged from the growing pool of ESOP holders.

· Lack of understanding about ESOP structure, when to exercise, tax implications on exercise, and several other factors

· Lack of funding available for ESOP holders to be able to exercise their ESOPs and participate in the growth of their companies. This is especially applicable to employees who are leaving a startup after having worked for a long number of years and need to exercise their options before leaving the organization.

As per our estimates, between 70% — 80% of vested ESOPs in unicorn and soonicorn companies go unexercised every year, leading to billions of dollars of lost value for startup employees. There are four primary reasons why startup employees are unable to exercise their ESOPs:

· Lack of faith and unwillingness to take a big risk with own capital

· High tax obligations that employees are in most cases even not aware of

· Lack of funding required to exercise the ESOPs

· Lack of understanding, delay in approvals, and transparent communication from their companies

We at Torre Capital have seen more than 2,000+ shareholders in the past 12 months who are paper rich and cash poor and have made several wrong decisions when it comes to their private shares ownership.

Hence, we created structured financing products that enable startup employees and other shareholders to gain access to necessary funding required to either exercise their options, pay tax obligations, or get liquidity by partially selling their shares.

This article is written to help startup employees to understand their ESOPs better, and also how they can secure the necessary capital for their needs.

Problem at hand

Employees in late-stage companies typically wait till IPO to exercise their options face exorbitantly high exercise costs as well as large tax bills. If you join a startup and receive ESOPs as part of the compensation plan, your first step should be to understand all the terms clearly, understand how exercise works, how much will you need to pay for exercising your ESOPs, how much tax do you have to pay on exercise and how does it change with company valuation, and what kind of returns you can expect in different exit scenarios. Understanding all these points in detail helps you evaluate your ESOP grant correctly and plan in a manner that you do not end up missing out on benefits at the end of your employment period. We have seen employees working for startups for 5–7 years, and then not be able to benefit from their hard work when they move to another employer.

There are a few key concerns to address:

When to exercise? Of your total ESOPs allocated, you are vested a certain percentage every year, likely between 20% — 25%. You have the option to exercise as soon as your shares vest, or you can wait as long as you are employed with the company to exercise your options. Most employees do not exercise their shares as they vest, and instead wait for confirmation of an exit event before they look at exercising their options. The problem with this approach is the increasing tax burden upon exercise keeps on increasing as you defer your exercise to a future date.

Tax obligation is calculated as a factor of the total notional profit (Current Fair Market Value of a startup — Exercise Price) and charged at your personal income tax rate. Look at the following hypothetical example to understand your tax obligations.

Total Options granted: $100,000

Per-share price of option grant: $1

Vesting period: 4 years, 25% per year

Employee tax bracket: 30%

Calculation of tax obligation

At year 5, your shares are worth a cool $2 Mn, for which you have paid a total of $340,000 in exercise price + taxes.

However, let’s say you exercise everything on 31 Dec 2024 at a company share price of $20. Your tax obligation in that case would be $592,500 instead of $240,000. Your total cost of exercise increases to $6,92,500 instead of $340,000. This is 2X of what you would have paid if you exercised your options as they vest instead of waiting till Year 5. Not only that, but you will also need to have this amount of cash at hand, which is not always readily available. In case you leave a company at the end of 4–5 years, you also have the additional time limit of 60–90 days in which you need to exercise your ESOPs or they expire.

Should I exercise? Exercising the company’s stock options has the potential to significantly boost your earnings, however, you also run the danger of losing the money you put in. Should you even exercise the shares of your startup, or let it go? This depends on multiple factors:

· Your belief in the company’s growth story and its potential to return significant returns in the near future

· Your intent to stay with the company and for how long?

· Time to an exit event — is there a visible exit event on the horizon in the next 2–3 years?

· Company’s track record of ESOP buyback

· Your liquidity situation

At the end of the day, you should run multiple scenarios to understand what is your opportunity cost, and what potentially could be the positive outcome if things go well for your organization.

Through this article, we seek to help startup employees understand the benefits and pitfalls of ESOP programs and how to handle them correctly. We will also talk a little bit about structured liquidity solutions that Torre Capital can offer you and your organization to make exercising ESOPs a simpler, risk-free strategy.

Why are ESOPs given?

Employees are granted stock options for a variety of reasons. Stock options are more frequent in start-up companies that can’t afford to pay their employees significant wages but are willing to share in the company’s future success. In such cases, stock options are given to employees as part of their remuneration package. In some cases, the employee is also given stock options, which he can exercise at a later date/s, to ensure his long-term commitment. Employee stock ownership plans (ESOPs) assist to build a sense of belonging and connection among employees in addition to giving monetary benefits.

When a stock option is provided to an employee under an ESOP program, you do not pay anything on Day 1. However, you need to understand that ESOPs are options that provide you an opportunity to buy your company shares at a fixed price at a point in time. As the company’s valuation grows, its share price increases, and you have an incentive to buy the shares of the company at historical prices. Important to note that ESOPs are not free, you do need to pay an exercise price and applicable taxes to get your shares. You can also opt to not exercise and let your options lapse; in which case you are not given shares of the company. The ESOP scheme spells out the terms and conditions under which an employee can use his rights. After a specific lock-in time, which is usually more than a year, the employee’s option can be exercised.

What is ESOP vesting?

ESOPs are given to the employee as an incentive to perform well and stay with the company. Vesting enables the employee to exercise the portion of the shares that become eligible to be bought by the employee at the agreed exercise price. The length of time that an employee must wait to be able to exercise his ESOPs is called the vesting period. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. A common schedule is vesting over 4 years, with a 1-year cliff. Vesting cliff means the employee gets 0% vesting rights for the first year. 25% vesting rights at the end of the first year and so on. After the vesting cliff (generally 1 year) expires, ESOPs are eligible to be bought by the employee at the agreed-upon exercise price. The “vesting date” is the date on which an employee becomes eligible to exercise his right to purchase shares. The rights may vest fully or partially over the vesting period depending on the company policy.

For example, on 31 March 2018, an employee is granted 1000 options, which can be exercised in three phases: 20% at completion of the first year, 30% at completion of the second year, and 50% on completion of the third year from the date of the grant. So, in this scenario, the vesting date for 200 options is 1 April 2018; for 300 options is 31 March 2020, and for the remaining 500 options is 31 March 2021.

Depending upon the company, the plan may specify the same or a different exercise price for each year. The exercise price, or the price at which an employee can purchase a share from the company, is usually set at beginning of employment and is significantly lower than the current market price of the shares.

The employee has no obligation to exercise the option and can let it lapse. If the current price of the shares is lower than the exercise price, the employee can choose to exercise the option or let it lapse. The employee is granted a certain amount of time to exercise his option, after which his vesting rights may lapse. Typically, you can hold on to your options indefinitely till you are inactive employment. If you leave the company, all unexercised shares expire at the end of 90 days or any other deadline specified by the company. The ‘exercise date’ is the day on which an employee exercises his option to purchase shares.

When options are granted, as well as when they are vested in the employee, there are no financial outflows or tax ramifications. It is only when you wish to exercise during employment or exercise post-resignation that you need to worry about exercise and tax obligations.

Exercising options: why, how much, and when?

You pay to exercise options today so that you can participate in the future growth of the company by acquiring shares at historical valuations. You stand to benefit significantly if the company does well, however you can lose your entire investment if the company fails.

After an employee’s options are vested, he does need to exercise them immediately. The employee has a set amount of time in which he can exercise his options. From a financial and taxation standpoint, knowing when an employee should exercise his options is critical.

When the employee exercises the option, he must pay the agreed-upon price for the shares as per his ESOP agreement, resulting in a financial outflow. Because the shares cannot be sold unless they are listed on a stock exchange, the money is locked up until the shares are listed or the promoters offer you a way out through buyback. Furthermore, because tax obligations keep on increasing as your company’s valuation increases, the later you exercise, the higher taxes you have to pay.

Surprisingly, taxes can make up to 50% — 80% of stock option exercise cost. Exercising options have two fees associated with them:

· The cost of obtaining vested shares (the strike price multiplied by the number of shares)

· The costs of the accompanying taxes. Taxes are frequently the determining factor in the cost of options. In some circumstances, there is no tax liability. Taxes, on the other hand, drive up exercise costs up to 6.6x the starting price for the average late-stage unicorn employee. This is because the difference between striking price and fair market value (also known as 409A valuation) is taxed, which can be significant for high-growth firms. We call this the surprise element since most people are unaware of their tax liability.

When it comes to exercising, you have complete control. As long as you work for the company, you can buy shares whenever you want, and you don’t have to buy them all at once. When you leave a company, you usually have 90 days to decide what you want to do next (a few companies extend this to 5, 7, or 10 years).

The exercise of stock options becomes more expensive as a company grows. This is because the tax bill from exercising climbs in tandem with the company’s 409A valuation.

Case in point, Nykaa (Indian E-Commerce Platform) — As the valuation increases, so does the share price. Had an employee exercised the share price at an earlier date, the lesser his tax liability, and vice versa.

Nykaa’s Valuation History

Your company exits — finally!

When a business goes for an IPO or a strategic sale, one of two things can happen:

· It is acquired, which means that another firm buys it. Microsoft purchased GitHub, Amazon purchased Twitch, and Facebook purchased WhatsApp. In case a company gets acquired, the acquiring entity can opt to continue with the ESOP program, or create a new program for existing employees of the acquiree company. The acquiring company can also opt to buy all ESOP shares and provide an exit to employees.

· It goes public, which means it sells its stock in an initial public offering on the open market (IPO). Slack, Uber, and Lyft have all done just that. When an IPO happens, your shares convert to public shares and you can sell them through your broker whenever you desire. Employees usually have a 90- or 180-day ‘lock-up’ period after the IPO during which they are unable to sell their shares.

You can sell your shares for a profit if the company’s exit value is greater than your exercise price. Unfortunately, the exit value is an unpredictable variable. You’ll never know how much money you’ll make as a result of your efforts. The only certainty is that when the exit value rises, your profitability will increase.

When should you sell the shares?

Selling an ESOP stock is equivalent to selling any other type of investment. When making a decision, you must consider the capital gains implications as well as the necessity for liquidity. The decision will also be influenced by the company’s long-term prospects.

It’s also possible that the ESOP shares you bought aren’t listed, in which case you won’t be able to sell them until they are, or until the promoters offer you an exit, which might or might not be in very favorable circumstances. In this case, it would be prudent to wait until the shares are listed on a stock exchange or any other liquidation event.

Tax implications when exercising your options or at the time of exit

ESOPs are generally subjected to two levels of taxation. The employee’s option to exercise shares at the exercise price is the first stage. The eventual sale of shares is the second stage.

First stage,

When an employee’s ESOP options are exercised, the difference between the exercise price and the security’s value is treated as a prerequisite in the employee’s hands. The employer must deduct tax from the employee who exercises the option at source, recognizing it as a prerequisite. If the shares are listed on any stock exchange in India, the value of the shares given to the employee will be the average of the market price (average of highest and lowest price) on the date the option is exercised. In that instance, the fair market value will be determined by the merchant banker’s valuation certificate. The certificate of share valuation must be no more than 180 days old from the date of option exercise. Even if the shares are listed outside of India, the Company must get a certificate from a Merchant Banker because such shares are considered unlisted for ESOP purposes.

Second stage,

When the employee sells his stock. Capital gains tax will be imposed if a sale occurs. Depending on how long the employee has owned the shares, the gains can be either long or short term. The holding time requirements for both listed and unlisted shares are different.

Starting from F.Y. 2016–17, If the holding period is more than 12 months, the listed shares will become long-term. However, if the holding period is more than 24 months, unlisted shares will be considered long-term. The period of holding begins from the start of the exercise date and ends at the date of sale.

At present the long-term capital gains on listed equity shares (on a recognized stock exchange) are tax-free up to Rs 1,00,000, however, short-term capital gains are taxed at 15% as of FY 21–22.

Let us explain!

When shares are traded through a broker the long-term capital gains are fully exempt under Section 10(38) of the Income Tax Act. However, as per the newly inserted section 112A via Finance Act 2018, if the amount of long-term capital gain exceeds Rs. 100,000 then the amount in excess of Rs 100,000 shall be chargeable to tax at 10% without indexation (plus health and education cess and surcharge). However, the application of sec 112A is subjected to certain conditions, one of it being the transfer should have taken place on or after 1st April 2018. Moreover, such short-term capital gains shall be taxed at a flat rate of 15% under Section 111A.

If the shares are not sold through the stock exchange’s platform, long-term capital gains are calculated by indexing the original purchase price. Indexed gains will be taxed at a 20% flat rate, plus any applicable surcharges and cess. Short-term capital gains are treated like any other form of income, and they are combined with other kinds of income and taxed at the appropriate slab rate.

For computing capital gains, the cost of acquisition is treated as FMV (fair market value) on the date of exercise, which is taken into account for perquisites of the options, rather than the amount paid by the employee.

Taxation of Foreign ESOPs

If a foreign company grants an ESOP to an Indian resident, the ESOP will be taxable in India. Furthermore, the tax regulations of the company’s home country, as well as the double taxation avoidance agreement, must be investigated to determine the actual tax implications. Furthermore, because these shares would not be offered on Indian stock exchanges and are unlikely to be listed in India, the long-term capital gains exemption under Section 10(38) or the concessional rate of 15% tax on short-term capital gains in respect of such shares would not be available. ‍

When you have incurred a loss

In case you have incurred a loss you are allowed to carry forward short-term capital losses in your tax return and you are eligible to set them off against short-term capital gains in the coming years. Long-term loss on equity shares is a dead loss and has no treatment, simply because gains are not taxable as well.

Torre ESOP Financing: How does it help startup employees exercise their ESOPs with a risk-free, non-recourse solution

Torre Capital is the world’s first commission-free tokenized shares platform that gives investors access to exclusive opportunities in pre-IPO companies. We also offer ESOP Funding solutions to startup employees. Exercise your startup stock options without paying out of pocket. You can earn up to 80% more due to potential tax savings at the time of exit. Exercising your stock options early can reduce your tax burden and also exercise price in certain cases.

Employees seeking ESOP funding can register on our platform to secure funding for their ESOP exercise obligations. The product has the following features as listed below:

· Get 100% of ESOP funding + tax obligations required to exercise your shares

· No personal guarantees, no credit checks

· 30%-70% of equity participation in profits in the case of early or late-stage growth startups

The advantages of our ESOP funding program are as follows:

· You continue to benefit if the value of your company stock rises.

· You take zero risk on personal capital when exercising your ESOPs

· Reduced tax obligations from exercising early than late

· Make room in your budget to invest in other opportunities

· Maintain the advantages of owning Qualified Small Business Stock

For example, if the loan is non-recourse, Torre Capital accepts the risk and the shareholder (employee) is not required to put up personal assets as collateral, such as your automobile. Before we get into the technicalities, let’s take a look at why ESOP funding is useful in the first place.

It’s usually better to exercise your stock options as soon as possible rather than later. If your company grows, exercising sooner means paying less tax both during the exercise and after the IPO — which means more profit for you.

However, exercising options can be financially out of reach for many employees of high-growth businesses on the verge of an IPO or exit. Consider this: exercising options costs nearly twice as much as a household’s annual income.

Furthermore, as the value of start-ups rises, exercising options becomes more expensive and prohibitive. That’s because the higher your options’ 409a valuation, the more tax you could owe.

Non-recourse finance can aid in this situation. It works like a cash advance, allowing you to exercise your start-up stock options without having to pay for them out of pocket.

How does it work?

Torre Capital delivers you the funds you need to exercise your stock options and pay your taxes. There are no recurring monthly interest payments, unlike a traditional loan.

You wait for your company to have a liquidation event. If your firm has a successful exit (such as an IPO), you repay the money you borrowed plus any fees. The employee gets nothing if your company has an exit lower than the exercise price or shuts down completely. Your other personal assets are never at risk because it is a non-recourse finance.

This is how it all works:

· Submit your financing request in minutes to find out how much you qualify for.

· Once your ESOP funding request is approved, you sign an Option Funding Agreement (OFA) with the investors. The Options Funding agreement covers key elements of the funding solution including profit share in future cash flows, exercise events, exit events, etc.

· You exercise your ESOPs and provide proof to Torre Capital.

· Sit back and watch your shares grow in value

· As and when your company goes for a liquidity event (IPO or company sale), you liquidate your shares and pay the principal along with a certain percentage of upside (ranging between 30% to 70%, depending upon the stage of the growth startup) back to your investors.

· On the flip side, we bear all risks related to performance issues with the investee company, delays in IPO/other liquidation events, or closure/bankruptcy scenarios.

· We do not conduct credit checks, and our funding has no effect on your credit score.

How does the funding work in different scenarios?

As described earlier, our non-recourse ESOP funding does not put your assets at risk, and the investors bear all of the adverse risk. These are the different exit scenarios

Case 1: The company exits successfully at a multiple of option funding agreement exercise price

The investor participates in the success of your startup. The more effective the exit, the better for everyone. In the end, the amount you get is determined by your equity participation percentage. For example, if you have $100,000 worth of ESOPs on the date of funding, the equity participation with the investors is 50%, and the ultimate exit price is 3X of exercise price. Post exit, the investor receives ($ 300,000 — $ 100,000 principal and $ 200,000 in 50% profit share), and the employee receives $ 200,000 in profits. The amount you owe to the investor will be determined by your equity value at the exit event and the profit participation.

Case 2: The company exits but at a lower price than the initial options funding agreement exercise price.

Torre Capital investors will receive all cash flows till the time their principal is paid back, and bear the loss if entire principal is not returned. Carrying forward the previous example of $100,000 worth of ESOPs. Suppose, the exit value of the ESOP shares position is $90,000. The entire $ 90,000 will go to investors who take a loss of $ 10,000 on their initial investment, and the employee takes no loss whatsoever.

Case 3: The company doesn’t exit at all and shuts down.

In case of a total loss, Torre Capital investors bear the risk. Our ESOP funding arrangements provide value to both employees as well as investors to make sure both parties have an equitable share in future growth of promising companies.

The same cases have been presented in the table provided below:

In conclusion

We at Torre Capital are on a mission to assist start-up employees and shareholders to understand, maximize, and unlock their stock’s value. Torre Capital offers non-recourse stock option exercise financing to help you reap the benefits of exercising your options early. We also offer financing alternatives that allow you to access the cash of your hard-earned equity before departure without selling your stock. Reach out to us at [email protected] if you wish to know more about Pre-IPO investing or other related services.

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This article has been co-authored by Sargam Palod and , who is in the Research and Insights team of Torre Capital.

Related Posts

Crypto Scare: Is the Hype Settling Down?

by Sandeep Kumar

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Crypto Volatility Index (CVI) hit a near one-year high of 127.03 on May 12th. The value of Coinbase, a big bitcoin exchange, has plummeted. A cryptocurrency that advertised itself as a reliable medium of exchange has gone bankrupt. A drop in cryptocurrency values has wiped away more than $300 Bn. The decline in cryptocurrencies is part of a broader shift away from riskier assets, which has been fueled by rising interest rates, inflation, and economic uncertainty resulting from Russia’s invasion of Ukraine. These reasons have exacerbated a “pandemic hangover” that began when life in the United States began to return to normal, damaging the stock values of companies like Zoom and Netflix, which profited during the lockdowns. However, crypto’s collapse is more severe than the stock market’s overall decline. While the S&P 500 has lost 18% this year, the price of Bitcoin has plunged 40% in the same time. Bitcoin has dropped 20% in the last five days alone, compared to a 5% drop in the S&P 500. Let us have a look at the kind of impact the crypto slump is creating on various stakeholders.

How the fall of TerraUSD and Luna has created panic?

The crypto shock occurred primarily after the sudden crash of the stable coin TerraUSD and Luna token. For the past six months, investors bought UST in order to profit from Anchor, a borrowing and lending platform which offered a 20% yield to anyone who bought UST and lent it to the protocol. The idea was criticized as it was likened to a Ponzi scheme which would not be successful. Karma hit the founder, Do Kwon, hard enough who is known for calling out critics as “poor”. Former Terra employees and retail investors in the crypto are holding the Kwon responsible for the losses. While he is still optimistic about his plans to revive Terra, Kwon is facing some major backlash in the form of lawsuits, fines and penalties.

Since May 10th, when TerraUSD and Luna began to show indications of difficulty, cryptocurrencies used by South Korean gaming firms for in-game purchases and trading have experienced erratic trading. As of then, C2X, which formerly used TerraUSD as its main platform thanks to a collaboration with Terraform Labs, the firm behind TerraUSD, which is now depegged from the US dollar, was trading at roughly 1,000 won. According to industry officials, game firms with products that include virtual coins and other blockchain functionality are still on high alert due to the recent collapse of the TerraUSD and Luna cryptocurrencies.

Wemix, a cryptocurrency run by Wemade Co., the maker of the play-to-earn game “MIR4 Global,” dropped by 28 percent during the TerraUSD fiasco before recovering back to the 2,700 won level on May 16th. MBX, Netmarble Corp’s virtual currency, has also plummeted by more than 80% to roughly 11,000 won, compared to around 64,000 won on May 6. Klaytn, a blockchain platform established by internet behemoth Kakao Corp., was also down to roughly 500 won, down from over 650 won on May 10th. Companies are keeping a close eye on the newest developments and concerns in the Bitcoin market in general since a loss of user and investor confidence might jeopardize the gaming industry’s Blockchain ecosystem, which many companies have already extensively invested in. Several crypto exchanges including Coinbase, Binance, Coinswitch Kuber, CoinDCX, even temporarily delisted Luna coin.

Sector euphoria that fueled the NFT boom has given way to more pessimistic conditions, forcing the mostly speculative NFT market to face reality. NonFungible, an NFT data business, stated that transaction volume was down 47 percent in Q1 2022 compared to the previous quarter. The figures are even more dramatic when looking at daily average sales, which fell by 92 percent between September 2021 and April 2022. Such challenges are far from insurmountable. For an NFT market that has been weak on value proposition but strong on hype, a washout was always going to happen. This data will be seen by critics of NFTs as the beginning of the end for projects that have been marked by over-promises, rug pull scams, and flash over substance. A reduction in speculation is more likely to refocus entrepreneurs on adding clear value to digital assets. A more clearly defined use case with a highly motivated and well-capitalized stakeholder to assist drive forward development is required to propel innovation forward.

What to expect in the longer run?

The fall of USDT has reflected poorly over the entire stable coin industry. Developers created functional and safe algorithmic in order to make it less susceptible to government oversight and more resistant to inflation than fiat-backed stable coins. However, they have lost their peg and failed. Some crypto analyst even suggest that the idea of algorithmic stable coins will now be put to rest. On the other hand, despite the volatility in the crypto industry since the beginning of 2022, private equity and venture capital investment into the crypto and Web3 space have been optimistic. The recent shocker has led Terra’s major investors to decide whether to help bail the project out or pull back and escape. While Lightspeed Venture Partners, one of the investors of Luna token, is planning to double down specifically in infrastructure, DeFi and emerging use cases, there is a possibility that the DeFi hype may now calm down. Until economic growth and corporate earnings forecasts are altered, there will be a sluggish flow of fresh money into equities, commodities, bonds or cryptocurrency markets in the coming months.

The arising concerns due to the crashing crypto market have been drawing attention to the regulation of cryptocurrencies. From USA to India, public officials are calling out the need for a regulatory framework to guard against the volatility risks of crypto. The US Treasury Secretary Janet Yellen has called for stable coin regulations to mitigate the risks, ensuring there are no gaps in the regulation. In India, experts are in a process to lay out tax policies for cryptocurrencies. However, naysayers believe that it could disturb the huge potential that the crypto industry brings in terms of intersection of blockchain, machine learning and job creation. Lack of clarity on policies is discouraging innovation in the sector and forcing job seekers to look for opportunities outside India where there are more crypto friendly policies.

A wake-up call for investors

There is no doubt that crypto is a volatile space. The crypto market has survived all this due to the underlying premise that the blockchain is a powerful tool that can change the way the next generation of digital products is built. However, some investors try to make quick money out of these volatile markets. Several people lost their entire life savings through crypto investments. It is advised that investors should research the projects, the technology and promoters before investing in tokens and not just follow returns blindly. Shocks like the recent one will act as a wake-up call and likely make investors mature. As per Sidharth Sogani, founder and CEO of Crebaco Global, a rating, research and intelligence firm focused on blockchain and crypto, more trouble is yet to come. He mentions that as for the crypto market is concerned, we might see a further down or a sideways movement for the next three to six months before it enters the bull market again.

So next time you make any investment decision, especially in a volatile market like crypto, be sure to be patient and do extensive research instead of running after quick returns.

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This article has been co-authored by Sayan Mitra and Tamanna Kapur, who is in the Research and Insights team of Torre Capital.

Valuation Reset: Who are the gainers and losers?

by Sandeep Kumar

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From a year of record funding to valuation check, how have things changed?

For any startup, raising funds is an inevitable part of the journey, and it highly depends on how the company is valued. VC funding sky-rocketed in 2021 with over $643 Bn going into global venture investment. This marked a 92% growth compared to the previous year. Consequently, we witnessed more than 10 new unicorns being minted each week on an average, adding around $1.8 Tn in value.

The amount of funds that went to higher-risk, early-stage startups was notable in 2021 as it witnessed almost 100% YoY growth in early-stage funding, with $201 Bn in about 8,000 startups. However, the good times do not seem to continue in 2022. Often, startups overvalue themselves in order to raise funds without giving up much of their equity. This may be detrimental in the long run — in case the company struggles to meet the expectations of the investors, it will have to raise funds at a lower valuation in the future rounds. Moreover, external factors like geopolitical tensions, inflation, underperforming IPOs and public markets have also affected the startup valuations. Through this article, we try to understand the different reasons for the decline in valuations and the kind of impact it could have on investors and startups.

Source: Crunchbase

Valuation reset for overvalued tech unicorns

After the hyped market in 2021, venture capitalists are now renegotiating their deals. As reported by WSJ, Tiger Global Management which has been one of the most prolific startup investors is renegotiating the investments for several companies, reducing the valuations by more than 20%. Manhattan Venture Partners also noted a nearly 10% plunge in the stock purchases of certain private companies in the first month of 2022. Some high-growth startups are even scaling back the funding rounds or delaying their IPOs that could value them lower than expected.

Let’s have a look at some recent examples where startups have been revalued by the investors or have themselves reset their valuations.

  • Philadelphia-based growth startup, Dbt Labs Inc, scaled back its funding round that valued it at around $4 Bn instead of the initially negotiated $6 Bn.
  • Fidelity, which has an investment in fintech giant Stripe, recently marked down the value of the company by over 9%.
  • The delivery giant, Instacart slashed its valuation by about 40%, valuing the company at $24 Bn down from its earlier valuation of $39 Bn.
  • Startups like OYO and Pharmeasy, who were preparing to go public are now considering downsizing their IPO valuations considering the market conditions.

The effect of tech sell-offs in public market is also visible in the private secondary market as there is a heightened interest in selling shares at a discounted price, typically 10% — 30% lower than the last quarter of 2021. With fewer IPOs, shareholders are looking for liquidity solutions in the secondary market, ready to sell their shares at a discount.

VC pull-back and a shift in focus

As market correction started happening in the public markets, its effects have been trickled down to the private market as well. As a result of huge tech sell-offs and dropping valuations in the public market, many VC firms have tightened their grip on startup funding as well. Investors are rechecking the startups’ valuation at a lower level to account for the pressure on the public peers. Firms like Tiger Global Management and D1 Capital have pulled back from investing in late-stage startups. The growth stage and later-stage funding seem to be stagnated. At times like these, some startups may be in desperate need of raising funds, so they will have to lower down their valuation expectations to be able to raise some cash. Meanwhile, startups that had raised huge rounds last year are being advised to use their funds wisely and prepare for even worse times.

The plunging tech stocks facilitated by inflationary concerns and rising interest expectations added to the pessimistic lending behaviour. The stocks of public companies, which typically guide the valuation of startups, saw a decline in valuation. By the end of January, companies that went public last year were down an average of 32.6% since their listings. Less proven companies performed even worse. Not only did the drop hold back investors, but also delayed the startups from going ahead with the IPO. The reset in startup valuations was well predicted, but what is surprising is that historically there has always been a long lag in the private market’s reaction to a public market slowdown, now it’s much faster.

However, things are not the same for all the sectors. While consumer businesses have taken more brunt of the pullback, companies dealing with blockchain, cryptocurrency, and cybersecurity have continued to attract VC interest. Despite the tight funding hand, investors’ focus has been shifted to seed and early-stage startups. The risk may be high with early startups and they are far away from taking a meaningful exit, but they allow investors to write smaller checks that could still give them some returns.

How is the valuation reset going to impact the stakeholders?

A drop in valuations is a double-edged sword. Investors may welcome the dip in valuation as it would mean that they would get new deals at a meaningfully lower value. VCs would love to offer lower prices on new deals, but also want their existing portfolio companies to be marked up in subsequent rounds. There is also a significant chance that the public companies, that guide startup valuations, will normalize back to the mean of the last couple of years. Consequently, VCs have tightened their lending capacity and shifted their focus to early-stage startups. Many startups had raised huge amounts for the early rounds, which raised the expectations and hence the valuation of the company. Now, slashing their valuation in order to raise funds would mean that startups will have to dilute a greater chunk of their equity.

The kind of valuation reset that we have started to witness was much needed after all the craziness in 2021. However, whether this is just a minor correction or has a long-term impact is difficult to determine now and we will have to wait and see at least till Q2 or Q3 of this year to understand where this goes. Till then, startups need to utilize their available cash prudently.

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This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.

How will the Cybersecurity Sector Rise in a Digitized World?

by Sandeep Kumar

Keep up to date with the latest research

Every now and then we keep hearing about instances of cyber threats and attacks wiping out millions of dollars from various organizations. The cases have risen as several companies went completely digital, especially post-pandemic. 2021 saw a record rise in cybercrime with ransomware attacks rising by 151%. As businesses realize the importance of digital security, they are taking steps to keep their digital stack secured, making cyber resilience a top business priority. As per a survey by WEF, nearly two-thirds of businesses find it difficult to deal with cybersecurity incidents due to a lack of skills. Hence, they need to rely on partnerships with security firms to secure their business from such threats. Cybersecurity is a massive market with over $150 Bn in annual spending. It has led to a positive outlook toward cybersecurity startups. As a result, VCs are betting their money on security startups. 2021 is considered a record-breaking year for the sector as cybersecurity startups raised over $29 Bn in venture capital, outpacing the previous two years combined.

Source: 2022 Cybersecurity Almanac | Momentum Cyber

VC activity and trends

VC investments in cybersecurity have grown gradually over the years. In 2021, VC firms had a really big appetite for cybersecurity as the deal volume crossed $29 Bn, seeing a YoY growth of over 136%. With this, the size of the funding rounds has also increased for security startups, as 82 financing rounds grabbed a deal of more than $100 Mn.

As the startups in the sector are attracting VC money, there has been significant growth in the number of unicorns. About 30 cybersecurity startups achieved the unicorn status last year, with a few of them achieving the mark in just a few years of their inception. For instance, Orca Security, which was founded in 2019, raised $550 Mn in October at a valuation of $1.8 Bn. Wiz, a cloud security provider which was founded in 2020, is now valued at $6 Bn!

According to Momentum Cyber, cloud security has been the favourite segment to receive financing with a total of $4.3 Bn, followed by identity and access management receiving $3.4 Bn in funding, and endpoint security with $2.8 Bn. Geographically, the majority of the cybersecurity startups that received funding, securing over $17.4 Bn, belong to the U.S. followed by Israel (as per Crunchbase data).

Source: 2022 Cybersecurity Almanac | Momentum Cyber

Cybersecurity investment trend forecast

Based on the current momentum and growing threat landscape, the cybersecurity sector could see an even bigger year in 2022. This year, cybersecurity startups could see a market opportunity in the following areas, thereby drawing investors’ interest.


The crypto market is booming across the world. However, the area is also prone to growing amounts of cyberattacks. Most recently, Axie Infinity was a victim of one of the biggest crypto heists worth over $600 Mn. There are multiple cases like these, hence crypto security platforms (like Fireblocks) are expected to see investors’ focus. According to the Managing Director at Insight Partners, areas within crypto security, such as coin monitoring will see a critical focus. It is expected that large payment companies and even traditional market exchanges will carefully look at the space around security.

 Compliance and Auditing

2022 is likely to see a move towards “shifting left of compliance”, which intends to find errors early in software delivery for compliance and third-party audits. This also includes smart contract security audits. Some startups already working in this space include CertiK, Certora, and OpenZeppelin.

 Web3 and Metaverse

A large number of startups are exploring the web3 and metaverse space. This means startups involved in securing user identity and ownership could attract VC money. Identity management and authentication have already been popular in 2021, however, startups looking beyond and into the future of the internet could win big.

How to spot promising early-stage cybersecurity startups?

The number of cybersecurity unicorns and new startups in the sector is multiplying. As many startups are attracting VCs and raising funds at higher valuations, it is important to spot promising startups early-on to get higher returns.

YL Ventures, an America-Israeli VC firm specializing in early-stage cybersecurity investments, suggests some benchmarks that you can look out for. Some of the early-stage startups backed by YL Ventures include Orca Security, Enso Security, Grip Security, Piiano, Valence, and Eureka.

 Initial Revenue:

Series A companies with $500k in ARR attract strong investors. Best startups in the sector manage to reach the $500k benchmark in less than 18 months of operation. From this level, top-performing startups can reach $1 Mn in 18–24 months, which largely depends on the company’s ability to get relevant customers.

 Average Contract Value:

Contrary to founders’ concern, Average Contract Value (ACV) is rather a misleading point of comparison as cybersecurity goods and services, along with their business models, sales motions, and customer profiles, are far too divergent when compared across the industry. However, despite the divergence, it is expected that growth-oriented companies can improve their ACV over time as the company develops additional features and improves their ability to secure large enterprise customers.

 Initial Paying Customers:

On average, successful US-based cybersecurity startups will have closed their first payment within 12 months of their seed round. A company should aim to secure at least one paying customer one full year from initial funding. As per YL Ventures, at around the 18-month mark, a startup should aim for at least 10 paying customers. However, security startups in traditional and heavily regulated sectors may have a smaller number of contracts. They should instead focus on the size of the contract.


On average, successful startups will have a go-to-market (GTM) executive within the first year of securing seed funding. Apart from this, successful startups tend to have about 25 full-time employees by the 18-month mark, and the number doubles at around two years.

Cybersecurity’s demand on rise

The number of cyber threats is growing in current times, and they are not expected to decline in the near future. It is expected that over the next five years, global cybercrime costs will be rising by 15% per annum, and is estimated to reach $10.5 Tn by 2025. As businesses have made a shift towards a digitized economy, they need to protect themselves from such malicious attacks. Security companies are building themselves continuously with the necessity to deal with the present and possible threats. Contrary to the horizontal approach which focuses on enterprise applications, cybersecurity has now been focusing on the vertical approach so that specific pain points of each industry can be addressed.

The global spending on cybersecurity products and services is estimated to reach $1.75 Tn between 2021 and 2025. This number suggests the huge TAM potential that the industry holds in ensuring cyber safety. As the security concern comes to the forefront in business discussions, the cybersecurity bubble is going to rise and is not expected to burst any time soon.

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This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.

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