Understanding ESOP Taxation and How it Impacts You as an ESOP Holder

by Sandeep Kumar | November 2, 2021

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Employee Stock Options are a component of nearly every unicorn’s pay plan. Not only they are beneficial for the companies, but also give employees a chance to gain the firm’s equity at an attractive price. The growing valuations of startups across the world have also led to the growth of the ESOP market. Southeast Asia emerging as the hub of the startup ecosystem has witnessed a growth in the ESOP opportunities available for the employees. However, on conducting a survey with employees of the top 100 unicorns in Asia, it has been estimated that about 75% — 80% of vested ESOPs remain unexercised in all large startups. As of today, $30 Bn+ of ESOPs remain unexercised in Asia (excluding China and Japan) in unicorn companies. The major reason behind this is lack of understanding among employees, lack of funding needed to pay the exercise price, high tax obligations, and inability to risk personal capital. Most employees are not even aware of how taxes impact the overall ESOP exercise cost and let their options remain unexercised for long periods of time, letting tax obligations rise steeply. We have seen situations with early-stage employees where the tax obligation was 3–4X exercise price because of a sharp rise in startup valuations.

Source: Pitchbook, CB Insights, Primary interviews

As ESOPs grow increasingly common, it’s critical for startup employees to understand all aspects of owning and exercising this key component of their compensation. Done well, ESOPs can be a significant wealth generator for startup employees. In this article, we cover the taxation aspects related to Employee stock options, exercise, and advice on how to manage your tax obligations. We also give you a perspective on how Torre Capital’s ESOP financing program helps your startup make ESOP funding and exercise a painless process and reduces your tax obligations manifold. We have covered a few countries in this article as ESOP taxation is different in every country.

Understanding ESOP taxation in India

A large number of startups in India opting for the ESOP route are on the rise. Several companies including PhonePe, Licious, Wakefit, etc. have rolled out fresh ESOP plans for their employees. A survey by KPMG estimates that over 72% of the private companies in the country have an ESOP plan or are contemplating having one. The growth trend is attributable to easy liquidity opportunities that have created value for ESOPs. But before one exercises the option, it is important to be aware of the tax implications.

In India, you may be liable to pay ESOPs tax on two occasions as an employee.

  • First, when the shares are allotted as a result of exercising vested options (taxed as salary income);
  • Second, when the shares are sold as a result of exercising the vested options (taxed as salary income) (taxed as capital gains).

As a condition of allocation, the difference between the Fair Market Value of the shares (as of the exercise date) and the exercise price is taxed (considered part of salary income). TDS is deducted from the value of the perk as calculated by the employer. This has a negative impact on your cash flow because a greater tax rate is withdrawn from your paycheck without any additional inflow. It is important to highlight that tax is only imposed on the allotment of shares, not on the allotment of options (known as a grant of options in common parlance). When an employee chooses to exercise his or her vested options, shares are allocated, and taxation begins.

As an example, as part of the company’s stock option plan, Mr. X is given 10,000 shares by company A (employer). Mr. X’s taxable prerequisite would be (200–10)*10,000 = 19,00,000 if the Fair Market Value of the shares on the day of exercise is 200 per share and the exercise price is 10.

Assuming Mr. X is in the highest tax rate with a 10% surcharge, the tax on $19,000 would be deducted at 34.32 percent (with a 4% cess). An additional TDS deduction of 6,52,080 is resulting as a result of this.

The employee must either sell a few shares or make other arrangements to fulfill this obligation due at vesting.

Moving on to the second type of taxes, capital gains tax is imposed on sales, which can be long or short term depending on the holding period. If you’re asking what the cost of acquisition is for capital gains purposes, the answer is the Fair Market Value on the exercise date (used to calculate the perquisite value).

Changes in Budget 2020

Startups (who rely heavily on ESOPs to retain people) ran into practical challenges when it came to taxing ESOPs as perquisites. As previously stated, an employee must either sell a portion of his stock or arrange for funds from other sources to pay his TDS liability. Finding buyers for startup shares can be difficult because they are typically not listed and may not have an active market. The Income Tax Act was revised to grant relief to ‘qualifying startups’ after examining numerous representations and acknowledging the true hardship encountered by entrepreneurs.

What are eligible startups?

In simple words, an eligible startup is a corporation or limited liability partnership formed after April 1, 2016, but before April 1, 2022. In addition, it must meet the turnover requirement (no more than 100 crores) and engage in suitable business as defined.

What is the relief provided?

An eligible startup can deduct TDS within 14 days:

  • After expiry of 48 months from the end of the relevant assessment year or
  • From the date of sale of such shares or
  • From the date, the employee resigns.

So, if you receive shares in FY 2020–21, the earliest date on which your employer (as an eligible startup) is required to deduct TDS is April 14, 2026 (assuming you continue to hold the shares and are in employment with the company till that date).

It’s a smart decision because the employee now has at least 5 years to pay tax on the perquisite income unless he resigns or sells the stock before then. It allows the employee to keep his or her shares rather than being obliged to sell a portion of them to fulfill tax requirements. What’s not fair is that the relief is only available to employees of startups who qualify. The number of qualifying start-ups in relation to the overall number of ESOPs issued is insignificant. As a result, the majority of startup employees will be unable to make use of this choice.

Perquisite Tax and Capital Losses

Taxing ESOPs in the year of allotment might result in another potential loss from a tax perspective if the value of the share drops significantly after paying tax on fair value.

In the example discussed above, if Mr. X decides to hold on to the shares by paying tax of ₹ 6,52,080 (assuming Company A is not an eligible start-up) from his personal savings and within a few years’ time the value of the share drops to say ₹ 20 (possible sometimes) he will have a capital loss of ₹ 18,00,000 (10,000*(200–20)).

Salary income cannot be used to cover capital losses. If Mr. X does not have enough capital gains to offset the loss, he may be forced to carry the loss forward for the allowed term and then write it off. Allowing capital losses to be offset against salary income, to the extent that these losses are related to ESOPs, is a big help.

Salary income cannot be used to cover capital losses. If Mr. X does not have enough capital gains to offset the loss, he may be forced to carry the loss forward for the allowed term and then write it off. Allowing capital losses to be offset against salary income, to the extent that these losses are related to ESOPs, is a big help.

EXAMPLE: Mr. X, an employee of ABC Pvt Ltd, was given an ESOP option to purchase 10,000 shares of ABC Ltd on July 1, 2014. According to the policy, the option can be exercised at the end of three years, on July 1, 2017, for INR 60.

Mr. X chose to execute his option on July 1, 2017. At the time, the fair market value of ABC Ltd’s shares was INR 100. He also decides to sell the shares at a price of 120 per share on January 31, 2018.

Now let’s look at how ESOP taxation will work:

The first level of taxation (when the option is exercised):

ESOPs would be taxed as a requirement, with the value equal to (FMV per share — Exercise price per share) × number of shares allotted (on the date of allotment).

The sum computed above as the perquisite value of an ESOP, i.e. Rs. 4,00,000, will be included in X’s salary and will be taxable in the year in which the shares are allotted. On such an amount, the employer is required to deduct TDS.

The second level of taxation (when ESOPs are sold):

When Mr. X sells the stock on January 1, 2018, he will be subject to capital gain tax, which will be calculated as follows:

Because X has held the shares for less than a year (counting from the date of allotment), the gains will be categorized as short-term capital gains and will be taxed at the standard slab rates applicable to X.

For listed shares, a holding period of over a year is considered long term. While for unlisted shares, holding period of over 2 years is considered long term.

Currently, 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%. However, in accordance with section 112A of Finance Act 2018, any amount more than Rs 100,000 is taxed tax at 10% without indexation (plus health and education cess and surcharge). This is subject to some criteria, including the condition that transfer has taken place on or after 1st April 2018. Short term capital gains shall be taxed at a flat rate of 15% as per 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 combined with other kinds of income, being taxed at the appropriate slab rate.

ESOPs Issued by Foreign Companies

Employees of Indian enterprises are frequently given ESOPs from the parent company, which is based in another country. The tax treatment of the allotment remains unchanged. It is still subject to taxation as a condition of employment, and the employer (an Indian corporation) is required to deduct TDS. It increases the compliance cost because these shares must be declared as foreign assets in the ITR, and you can’t submit ITR 1.

The question of whether capital gains are taxable in India or the foreign country where you hold these shares arises when you sell these shares. The answer is that it depends on your residency status; a resident pays tax on all of his income, regardless of where he lives. As a result, if you are a resident, you may have to pay taxes in both nations. However, you can qualify for relief under the Double Taxation Avoidance Agreement (if India has such an agreement with a foreign country). This must be determined on a case-by-case basis.

To summarise, ESOPs play an important role in the remuneration structure of employees. The benefit of tax deferment should not be limited to only “qualified startups.” Even if the relief provided to “qualified startups” is not as appealing, a scaled-down version of the same may be required.

Inter Country ESOPs

ESOPs are often provided by the parent business to the group’s employees. However, tax issues arise when a delegated employee moves from a parent company in one nation to a subsidiary in another. Typically, the nation of service at the time of ESOP issuance may differ from the country where vesting and exercise occurs, resulting in a taxation rights apportionment issue between the countries.

How are ESOPs Taxed in this Case?

The first stage is to determine an employee’s residential status for a given year. In the event that an employee becomes a resident of more than one nation in a given year, the ultimate residential status must be determined using a tie-breaker test in accordance with the tax treaty. ESOP benefits are taxable in a country based on the number of days the employee worked there.

Example of how ESOPs are taxed between two countries:

On 1st May 2013, A Ltd (Indian Parent) issues 150 ESOP options to the employee for Rs.100, with the proviso that the options vest over three years, i.e. 1st May 2014, 1st May 2015, 1st May 2016 (per year 50 options), as long as the employee is employed by any business in the group.

On January 1, 2015, an employee is assigned to a foreign subsidiary. The taxability of ESOP perquisites for the second vesting, which occurred on May 1, 2015 (assume the date of exercise: 1st May 2015). On May 1, 2015, the FMV of the shares was Rs.1100. The perquisite is Rs.1000 (i.e. FMV Rs.1100 minus Option price Rs.100).

Tax in India will be calculated from the date of grant (1 May 13) to the date of departure (1 January ‘15), a period of 610 days, and tax in a foreign country will be calculated from the date of arrival (1 January ‘15) to the date of vesting/exercise, a period of 120 days.

Key Points Covered in Inter-Country ESOPs Transactions

a. Divergence in tax treatment

Perquisites are apportioned based on the number of days of service provided in respective nations throughout the grant and vesting periods for ESOPs issued in country A and exercised in country B. However, if enough time has passed between the date of departure from country A and the date of exercise in country B, country B does not tax its portion on the basis that the ESOP was not granted in anticipation of duties in country B.

b. Double Taxation

When an employee of an Indian parent exercises shares while in India, the difference between Fair Market value and option price is subject to perquisites tax in India. After then, the employee is sent to a subsidiary abroad, where he or she sells the shares while serving in the company. In the year of the sale of the shares, the employee would have become a tax resident in the foreign company and would be responsible to pay tax on all of his or her earnings, including the capital gain on the sale of the shares. The FMV should preferably be used as the cost of shares when computing such capital gains. Due to the fact that perquisite tax is remitted in India, foreign jurisdictions usually treat option prices paid as a cost rather than FMV. The FMV must persuade foreign tax authorities that it is a fair cost for calculating capital gain. Employees would otherwise be taxed twice on the portion of the difference between the FMV and the option price they paid.

c. Cash Flow

Employees from the parent firm are occasionally delegated to the foreign subsidiary. Following the assignment of shares, the employee is required to pay perquisite tax in India and overseas, based on the number of days of work given in each country. However, culpability arises in this instance when the employee is abroad. He will have a difficult time remitting his Indian tax liability in INR to the parent firm because he will no longer be paid in INR and will have closed his Indian bank account.

You need to become aware of ESOP taxation and its implications on your future wealth. ESOPs have a lot of laws and requirements to follow. Companies that provide it to their employees must have an appropriate administration system in place to ensure that they have stock ownership. If a corporation lacks the personnel or resources to oversee the administration of ESOPs, it may expose itself to certain risks. The corporation must have proper administration, staff, including third-party administration, legal costs, and trustees when establishing ESOPs. It needs to be aware of the costs associated with providing this service.

ESOP Taxation in Singapore

Singapore is the startup hub for Asia. In such a thriving ecosystem, ESOPs have emerged as an ideal tool for private companies. When it comes to determining the tax on ESOPs, there are a number of variables to consider. In Singapore, ESOP taxes are only levied once — at the time of exercise or when the ESOP’s selling restriction is repealed. Any gains or profits resulting from the execution of a share option will be taxed to the employee who received them from their employer. When options are exercised, tax is payable on earnings emerging from an ESOP with no selling restriction. Furthermore, ESOPs with selling restrictions are only taxed in the year the restriction is eliminated.

If the stock option’s open market value exceeds the exercise price, the difference is considered a profit for the employee. This profit is taxable since it exceeds the employee’s basic salary.

Note — The intrinsic worth of an asset is known as open market value. It is largely reliant on supply and demand market variables. This value changes over time and is quite dynamic.

In terms of a mathematical formula,

The taxable amount is then subjected to the applicable tax rate for the employee

Singapore personal tax rates start at 0% and are capped at 22% (above S$320,000) for residents and a flat rate of 15% to 22% for non-residents.

Example:

At a $1 exercise price, Lee holds 1000 stock options in a firm called ‘Herbilitie.’ Lee now has two choices. If the open market value of each share is $5 at the time of exercise, and the tax rate on Lee’s stock options is 20%, then:

ESOP Taxation for Foreign Employees

If an employee is given ESOPs while working abroad, the profits are not considered income in Singapore and are therefore not taxable there. In such circumstances, the ESOP tax computation is based on the double taxation avoidance agreement between Singapore and the nation where the employee was given ESOPs. However, if ESOPs are granted to the employee in Singapore, two rules are applicable:

a. Deemed Exercise Rule: The presumed exercise rule applies to ESOPs given to foreign citizens working in Singapore on or after January 1, 2003. Employees may have ESOPs that have not been used when their employment ends. The final profits from unexercised ESOPs are considered income obtained by the employee one month before the date of termination of work or the date on which the monetary benefit is granted, whichever comes first. When a foreign employee’s employment ends, they are regarded to have received a final gain if they have one of the following:

  • Unexercised ESOPs;
  • Restricted ESOPs where the moratorium has not been lifted

b. Tracking Option Rule: The tracking options rule, which is an alternative to the deemed exercise rule, permits the employer to trace the period when the foreign employee realizes ESOP gains. The gain is subsequently reported to the government by the employer. The following events are monitored:

  • Exercise of unexercised ESOPs
  • Restricted ESOPs where the moratorium is lifted

Note:

 If the employer has been permitted to use the tracking option rule, the considered exercise rule does not apply.

• When an employee leaves Singapore for more than three months, regardless of the reason, ESOPs are taxed.

Employee Remuneration Incentive Scheme (ERIS) for startups

The Equity Remuneration Incentive Scheme, or ERIS, only applies to stock options given between February 16, 2008, and February 15, 2013, inclusive (both dates inclusive), as long as the award date is within the first three years of the company’s establishment.

Employees who profit from their employers’ ESOP schemes are eligible for ERIS tax benefits. Employees who participate in ERIS might get a tax break of up to 75% on their ESOP plan gains. Tax can be waived for a period of ten years provided certain criteria are met. The tax exemption is restricted to $10 million in accumulated gains over a ten-year period, and the gains must be realized on or before December 31, 2023.

ESOP Tax Deferment Option

Employees can choose to defer the payment of tax (subject to an interest charge) on the gains from ESOP for any period of time up to a maximum of 5 years. Conditions for ESOP tax deferment:

  • For ESOPs with a staggered vesting period, only the proportion of shares that have not vested
  • At the time the ESOP is granted, the employee must still be working in Singapore
  • The employee (who receives the share option) must be someone who:

a. is not bankrupt

b. does not have a poor tax-paying record

c. possesses a tax of more than $200 on ESOP gains

d. has not been granted area representative status, and

e. is eligible to settle tax by installments under current tax rules

Understanding ESOPs in Indonesia

The ESOP market in Indonesia is still gaining popularity. Founders are educating themselves to provide the best ESOP options to retain their talented employees.

In Indonesia, employee stock option schemes are not subject to any specific regulations. Offering stock in a firm is considered a personal matter. As a result, a business can impose any standards it sees fit.

Normally, income tax is required only when a profit is realized after the shares are sold. According to Regulation of the Directorate General of the Tax Office No. PER-16/PJ/2016 dated 29 September 2016 (PER-16), income tax is owed on revenue derived from a party’s work, services, and activities in or outside Indonesia, including:

· Salary.

· Wage.

· Remuneration.

· Allowance.

· Other payments in any form related to a person’s work or office, services, or activities.

A dividend or a capital gain might be received by a shareholder via the selling of shares obtained under a share option scheme. Profits from the selling of stock are considered capital gains and are taxed accordingly. Income tax is determined at the following progressive rates based on the taxpayer’s annual income:

· Up to IDR50 million: 5%.

· From IDR50 million to IDR250 million: 15%.

· From IDR250 million to IDR500 million: 25%.

· Above IDR500 million: 30%.

The rates listed above are for taxpayers who have a Tax Identification Number (NPWP). Those who do not have an NPWP may face higher fees.

Any dividend paid, available to be paid to, or payment due from a government institution, national taxpayer, event organizer, permanent establishment, or representative of a foreign company to a national taxpayer or permanent establishment is subject to 15 percent tax under Article 23 of Law №7 of 1983, as amended by Law №36 of 2008 on Income Tax (Income Tax Law).

Share system tax effects must be examined on a case-by-case basis, based on the exact scheme used by the company. As a result, the corporation must engage with its tax consultant about its intended scheme.

Understand, Exercise, Benefit

Many employees choose not to exercise options because they find the taxation and the entire process to be overwhelming. As a result of lack of understanding, huge costs, and lack of easy liquidity options, employees miss out on great investment opportunities. It is estimated that those who had successfully exercised their ESOP were able to more than double up their investment returns as the company became public. Torre Capital is committed to providing you complete guidance and the best platform throughout your ESOP journey. Our non-recourse financing options minimise the risks for employees. We aim to maximise employee returns by minimising the costs involved.

So, if you are an employee looking forward to exercise your ESOP options, Torre Capital can provide you with the best and the most convenient exercise and financing journey. You can reach out to us at [email protected] in case you wish to know more and seek further assistance.

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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.

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

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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.

 Cryptocurrency

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.

 Hiring:

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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