Does My Startup Need An ESOP?

ESOPs

A deep dive into employee stock options.

A company is only as good as its people, and ESOPs can be a great way to keep those people happy.

ESOPs, or employee stock ownership plans, allow employees of companies the right to purchase company stock based at a fixed price, and on terms set by the company. These stock options do not usually exceed 15% of a company’s total shares, unless the company chooses to be strikingly optimistic.

The terms on which employees can exercise their stock options vary from company to company, and come with an expiry date. They generally require the completion of a fixed period of service by the employee (anywhere between 1-3 years is the trend).

In addition to this–the vesting period–ESOPs are also doled out based on the concerned employee’s pay grade.

Not all ESOPs have a blanket application. While some companies do choose to open them up for employees across the board, some others can either be selective in nature, focusing on strategic employees instead.

What’s in it for Employees

Apart from acting as a reward mechanism, ESOPs can help companies retain key employees who may be pondering a shift. They also are a smart way for young companies to attract talent they want but cannot pay on par with expectations.

Such candidates may be willing to settle for a lower package than they might get elsewhere. It is the opportunity cost of placing their bets on good returns from the shares they will come to hold when exercising their ESOP option.

As future shareholders, with ownership over a bit of the company, growth and profitability are likely to take precedence in their minds when they come to work. More bang for the buck is always welcome, especially when the buck is hard earned.

It is not only about deep pockets, though. Different motivational factors come into play at the workplace, and one of them is sheer commitment and belief in the company’s vision.

A token of gratitude that goes a long way, such as an ESOP, can boost morale for such employees and makes a strong statement for company culture.

The Catch Is…

… there are no such things as free shares. Implementing ESOPs requires strategic thought–it is an admin-laden process, and companies will have to shoulder these costs in addition to legal fees.

The bigger challenge is managing cash flows. ESOPs block the amount of money available to a business for business-specific investments. While this is especially true for companies with a bigger workforce, younger startups have enough cause to be wary (especially capital-intensive ones).

Few startups become profitable early on, and having an employee exercise their stock option under the ESOP when the company is going through a cash crunch, or is without additional funding on the horizon, can turn into ugly business.

On the other side, employees need to think about what happens when the company runs into a loss. They may have to shoulder some of this loss as shareholders of the company, and this could potentially affect their savings.

The same goes for the tax implications of exercising stock options or selling shares that they have already received. As with any shareholder, holding stock requires acute financial planning and attention.

Additionally, ESOPs are generally taken out of the founders’ shares, rather than diluting any investor’s stake. Founders need to be careful when setting aside the ESOP pool, as it could lead to more dilution of their ownership than they may like.

It’s not all pitfalls, however. ESOPs can be tricky for startups and employees alike, but can nonetheless work out well for both if planned correctly.

Header image by Cytonn Photography on Unsplash

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