India has a vibrant start-up ecosystem. Start-ups are big drivers of growth in India. It has seen consistent growth for a good while now and Indian Startups collectively raised a record $24.5 billion last year. A gargantuan sum. Little credit of all of this goes to ESOPs too. Investment influence consumer spending, boost employment at all levels and provide innovative solutions for unaddressed problems.
For them to succeed in what they do, they need to attract and retain highly skilled employees. The problem is they might not necessarily have the resources to afford this talent.
It is next to very difficult for any company or for a start-up to acknowledge and remunerate senior employees to remain in the company. So they came up with ESOPs because the employers cannot afford lakhs of money for remuneration. So ESOPs became very much crucial for the Startups.
In another way, the business ensures that their employees are on board and same time very happy at the workplace. Employees feel very happy when they have a sense of belonging and can find themselves where they stand in their company and able to identify with the company. Bonuses, Incentives, and the like are what keeps the employees motivated.
What is Employees Stock Ownership Plan(ESOP)?
ESOP (Employees Stock Ownership Plan) is one such scheme where the employees have the right to invest in the shares of the company at a discounted price or with some other benefits at any given future date. Schemes like ESOPs encourage employees to work harder and do better in their job. To attract the best talent at the early stages of the startups offers ESOPs to the prospective hires.
Some terminology kept in mind for the better understanding of ESOPs:
- Grant of Options: It’s the issue of the right given by the company to its employees to buy shares of the company.
- Vesting Period: This refers to the amount of time an employee must work before acquiring the right to exercise the options.
- Vesting: Vesting is earning the rights of the employee to exercise the options.
- Exercise Period: A period after the vesting period within which the employee has to exercise his options.
- Strike price or exercise price: A strike price or exercise price is what you need to pay to convert the stock option to a share.
For Example: If a company employed Ashutosh with a yearly package of Rs 10 Lakhs. The Company has decided that half of the salary will be in the form of ESOP. In such a case, Ashutosh will wait for a certain time period (Vesting Period) before he can exercise his right to purchase those specific number of shares.
How Does ESOP Work?
Many small organizations opt to have the Board approving the grant of stock options but in the large MNCs, either they prefer to have a compensation committee or set up a trust for the ESOP Management. Many Indian companies including Reliance, Wipro, Infosys limited already used the trust route to implement the ESOP scheme.
It is recommended that Startups opt for the administration of ESOP by its Board of Directors rather than the creation of the trust. Because an ESOP Trust sometimes results to disorganized kind of things that later leads to a mess in their ESOP grants.
What’s the flow of the ESOP issue?
First, an ESOP Scheme should be drafted. Then the shareholders have their approval of the scheme. Thereafter a letter of the grant must be issued to the employee informing them about their options to know them what is the vesting period would be and how the exercise price will be determined. The amount of stock issued to the employee varies according to the pre-decided terms and conditions.
The employees may cash out after the vesting period is over. That means he has to continue to work for the company for a minimum number of years before any options can be exercised. Unfortunately, if the employee dies then the beneficiaries will receive the vested portion of the decrease in one’s ESOP account right away.
How ESOPs are different from Sweat Equity?
ESOPs, give you the right to buy company shares for a modest sum(at a price lower than what the shares are actually worth)and a start-up can offer employees ESOPs instead of cash. It’s good compensation.
And they work quite well. Usually, the employee is offered the ESOP and asked to wait for a while. Then, at a specified date in the future, she can exercise the “option” to buy the shares for a modest sum. If she chooses her right, the shares will be allotted, And if the company does well in the future, these shares could potentially be worth a whole lot more.
But then there’s another alternative –Sweat Equity. If an employee puts in the efforts, management could just choose to compensate her with part ownership in the company. Remember, she is not the founder here. She is not an investor. She is not parking money. Yet, she’s being offered equity. Not options to own stock, but direct ownership.
Are ESOPs taxable?
Yes, ESOPs are Taxable. But, the tax you have to pay might vary from country to country based on their own laws. In India, however, if you own ESOPs, you will have to pay tax twice. Once, when you exercise your right to ESOPs and actually buy the ESOPs and secondly when you sell the ESOPs.The amount of tax you have to pay depends on two things, how much you have gained from the share you sold and how long was your vesting period.
Advantages of ESOPs to company
ESOPs are a great incentive to paying the employees when a start-up does not have a lot of funds to offer competitive salaries but want to hire top talents. This not only ensures that the employee receives compensation for his work but his compensation is also linked with the growth of the company now that they are a part-owner through ESOPs.
This means that the employees who own ESOPs will shares the responsibilities along with the founders of the startup in order to help them grow the startup as the value of their shares is directly linked with the growth of the startup.
This ensures that you only get employees that are actually serious about growing the business just like you. This is particularly handy for a bootstrapped startup that does not have enough funds to offer handsome salaries to its employees.
Disadvantages of ESOPs to the company
When the ESOPs get converted into shares the shareholdings of the founders of the company get diluted in the proportion of ESOPs.
Advantages of ESOPs to the Employee
There are chances for employees to earn a huge amount of money and create wealth. If the company turns out to be a huge success in the future.
Disadvantages of ESOPs to employees:
Accepting ESOP is like gambling or buying lottery tickets .There are chances of both winning and losing.
Thus ESOPs are a really good instrument for startups to attract skillful talents, but it’s too risky for the employees. Employees should be convinced about the growth of the company and should see if proper documents are there in place.
Do you continue to hold the same number of shares till the time you are at the company? Well, not really. A startup might start out by giving you 500 shares but as the start-up grows and needs to raise more funds, it might end up splitting the shares. If the share splitting is done 1:10, then your 500 shares will be multiplied 10 times and you will now have 5000 shares.
This only means that if you had 500 shares worth 1lakhs rupees, now have 5000 shares worth 1lakh. Your monetary value remains the same but the value of individual shares decreases with respect to the share splitting ratio.
Now when the start-up is raising funds, it ends up selling the shares to new investors to raise more capital. In this case, a start-up might happen that you could end up selling your shares as well.
What all should be kept in mind before accepting ESOPs?
Employees should keep certain things in mind before accepting ESOPs from the Startups:
- You should go through the agreements thoroughly before signing and agreeing to the terms and conditions.
- You need to make a smart move between good CTC or CTC plus ESOPs. Both are having their advantages and disadvantages of having them.
- The most important thing is to evaluate whether the startup has the strengths to survive in the market in long run. It is very important to know the growth potential of the startups before accepting the ESOPs.
- ESOPs are different from shares. If an employee buys ESOPs and this tenure gets ended before the vesting period the ESOPs are lost.
- ESOPs are considered as employee perks and taxed twice by the income tax slabs.
This is it for the ESOP. but there are many fascinating things happening in the start-up environment like Ola is in the final stage of launching its electric vehicles in India and in Europe soon. you can read more about it here.
Keep reading, keep growing.
I am a girl who’s passionate about charts and numbers in economics and enjoy converting them to simple lines so that any layman can understand them easily.