When are ESOPs the right option for you?

With an ever-rising startup ecosystem in India, Employee Stock Option Plans (ESOPs) have become one of the best strategies to attract talented employees.

But, what are ESOPs?

ESOPs are a way for employees to obtain company shares as part of their compensation plan, usually at a lower price. It’s a way for employees to gain an ownership stake in the company and is typically offered by early-stage startups. For companies just starting business and having little cash flow, this is a great option to offer new employees.

How does an ESOP work?

A lot of early-stage startups and companies will set aside an ESOP pool - typically 10% of their total shares. In the first two to four years of their business, they’ll offer these stock options to attract and retain talent who might not be as inclined otherwise. There’s typically a tenure set by the company, and until it ends, you can’t sell these stocks.

It’s also often a requirement put forward by venture capitalists. You see, when startups go to raise capital, VCs set this as a requirement because it could otherwise dilute share ownership for investors.

Are ESOPs Actually Good for Employees?

After a certain point, working with a company is not about your salary. Sure, money is great but that feeling of fulfilment can feel lacking.

Getting ESOPs is a great way to feel invested in your company’s growth, since they’re a direct ownership stake in the company. Your performance affects company growth which in turn affects your ESOPs.

Hence, employees with stock options will find a greater sense of loyalty and commitment to their company’s success leading to overall better performance.

In what situations do ESOPs work?

ESOPs come with a ‘High Risk - High Reward’ kind of situation. Because when your startup does work out, it reaps a lot of benefits for the founders, stakeholders and its employees.

But coming down to it, when it comes to employees, there are three ways for them to make money off of ESOPs.

1. Listing on Stock Exchange

The first is when your company gets listed on the stock exchange and launches an IPO. Like what happened with Nykaa in 2022 and Aether in 2023 - which works out for its employees with ESOPs.

2. Buyouts by bigger companies

The second is when your startup gets acquired by a bigger company. The best case scenario is when a startup becomes a Unicorn, increasing the value of its shares and thus making their employees rich through ESOPs.

3. ESOP Buybacks

The third is in the case of ‘buying back’ of shares. This happens when investors buy back Employee ESOPs in exchange for cash, typically initiated ahead of time. In fact,  if you look back at the last year, Indian startup employees made over 196.5 million dollars through ESOP buybacks .

So, what this essentially means is that:

Company Success = More Profit = Better results for ESOPs

=

Happier and hard-working Employee

When Should You Opt-in for ESOPs?

You shouldn’t join a startup simply because it’s offering ESOPs. But if you believe in its product and growth strategy, make sure you get what you’re worth. The first few employees can get a greater share in the ESOP pool, as high as 1%. This, of course, depends on their job role and total value to the company. If it works out, these shares offered to a new core employee could be well worth crores down the line.

Analyse the startup's growth potential and see if you find yourself on its future growth track.

Are there any problems associated with ESOPs?

It’s quite obvious  - ESOPs have little value if the share price tanks.

That’s the element of risk every startup faces and the same goes for ESOPs. As the company grows bigger, the administration costs to manage these ESOPs get higher and trickier. Another problem is taxation at the time of realisation - your gains could be very easily offset when filing for income tax.

But if you’re an employee at a startup whose product you value and you see yourself growing with the business, ESOPs could very well be worth it.

Frequently Asked Questions

Can I buy into ESOPs?

You can buy into an ESOP if your employer offers it as a benefit to eligible employees. However, the specific details of how to participate and the rules surrounding the purchase of ESOP shares will depend on your employer's ESOP plan and any applicable laws and regulations. It's best to consult with your employer's HR department or a financial advisor for more information on how to buy into your company's ESOP.

Who cannot participate in ESOP?

Not all individuals can participate in an ESOP. Non-employee individuals and non-eligible employees are generally restricted. Eligible employees may still face restrictions on immediate share purchases due to vesting schedules or plan restrictions. It's best to consult with HR or a financial advisor for more information.

Is an ESOP good for employees?

ESOPs can be a good retirement benefit for employees, providing an additional source of income in the form of company stock. It also aligns their interests with those of the company. However, investing too heavily in one stock is risky. Diversification is necessary. Reviewing the plan's terms is important before participating.