Everything You Need To Know About Employee Stock Ownership Plan (ESOPs)

Foss Miller, the owner of Sawbones Worldwide, was about to retire. He wanted to give his company in good hands but couldn’t find anyone. Around Christmas, Miller announced to his 135 employees that he was distributing the shares of the company among them and that they were the new owners of the company. He did so under the government’s ESOP (Employee Stock Ownership Plan).

Let’s talk about the noteworthy example of Google. When the company went public, its founders Larry Page and Sergey Brin’s wealth grew but so did their employee’s wealth because they offered them stock ownership in the company.

What is Employee Stock Ownership Plan (ESOP)?

Employee Stock Ownership Plan is a program that provides shares or ownership interest to a company’s staff in the company. Under the program, the employees of a company are allowed some rights to purchase shares of the company for free or at concessional rates.

As defined under the provisions of section 2(37) of the Companies Act, 2013, “employees’ stock option” means the option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price.


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Benefits of ESOPs for startups

But why would companies do so and what are the benefits of ESOPs (employee stock ownership plan) for a company? You might wonder. There could be several reasons for this.

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1) ESOP programs are most common in startups that cannot afford to pay huge salaries to employees. Such startups may be willing to share future profits with employees.

2) ESOP also creates a sense of ownership and belonging among employees, which helps in retaining talented employees in the long run. Some companies use ESOP to attract talent.

3) Startups are highly dependent on the efficiency of its employees and how driven they are. ESOPs can be a strategic plan for startups to ensure growth.

4) At times companies could require funds. Startups require funds. Offering ESOPs could be a good way to increase the capital of the company.

5) ESOP programs also aid in improving the company performance and in increasing the value of the shared.

6) By providing ESOP, companies can avoid giving cash incentives to the employees, which mean that the company’s cash flow is not affected.

Benefits of ESOP for employees

1) It is a motivation factor for employees. If the company does well, the stock prices would rise and it will benefit the employees. This could keep employees motivated and engaged in performing better.

2) Employees can increase their wealth much faster than when they are earning just a normal salary.

3) Employees can purchase the shares at a nominal rate and sell them at a higher price when they want.


The math behind Employee Stock Ownership Plan

However, startups have to decide key aspects such as: how much equity to keep aside for the employees, how many shares to offer to each employee and the terms that would govern those shares. Here are some key aspects to think about.

1) Percentage of shares: Startups usually keep a certain percentage of the shares of the company aside for ESOPs. The percentage usually depends on the stage of the startup and is roughly between 5 and 20 per cent.

2) The more a startup receives funding, the more valuable its ESOPs become. And the more scarce, too. Hence, ESOPs are more valuable to employees if they are purchased once the startup has received funding.

3) Usually, employers and owners add up the salary of the employee and the number of stocks owned by him, which becomes the employee’s CTC.


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Some Important Details

1) Documentation: There should not be any discrepancies in the fine print. Both, the employer and the employees should ensure that all the paperwork is in place.

2) Exit mechanism: There should be a proper exit strategy, for example, a promoter buyback. The agreement terms should be understood clearly.

3) Taxation: Employees have faced a number of issues related to the tax due to ESOP. Both employees and employer should consult a tax expert to work out the numbers. Moreover, taxation laws keep changing, which is a big factor that should be considered.

4) Vesting period: Vesting period is the time set for when an employee can purchase shares. Generally, the vesting period is four years. If an employee leaves the company or gets fired before the vesting period then the ESOP is lost.

In most of the cases, 25% of the shares allocated get vested at the end of year 1. Subsequently, an equal amount of share gets vested every quarter.

5) Assess the business: It is important to assess the business and understand its market, scope for growth and whether or not it will scale in the next three or four years. Startups are tricky. 90% of the startups in India fail within the first year of starting.

If implemented well, ESOPs can be beneficial to both startups and employees. Although not the easiest in the Indian startup sector, ESOPs could be a win-win for both parties if assessed, planned and implemented efficiently. Are you going to explore this further?

Want to read more about startups, funding and other aspects? Read more from the HQ Digest:

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