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Exploring the Pros and Cons of Employee Stock Option Plans (ESOPs)

  • Written Written by Team ESOP 03 July 2023 | 4 min read
  • Editor's Note :

    Exploring the Pros and Cons of Employee Stock Option Plans (ESOPs)," the author delves into the intricacies of Employee Stock Option Plans, shedding light on both their advantages and disadvantages.

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This is the era of employees – from the Great Resignation to Quiet Quitting – employees are taking charge of their jobs. One result of this is employers realizing what the employees actually want. Liquidation events offer employees an opportunity to convert their ESOP shares into cash or other assets, providing liquidity. This allows participants to unlock the value of their own and utilize it for retirement, investments, or other financial needs.

In addition to engagement activities and short-term rewards, demonstrating care toward employees has become essential for retention. Long-term rewards, such as ESOPs Employee Stock Ownership Plans, have evolved from being a mere need to becoming a necessity.

What is Employee Stock Option

Employee stock option plan – as the name suggests - is a type of employee benefit plan that grants employees the right or the option to purchase company stock at a predetermined price, usually referred to as the "strike" or "exercise" price. Though usually ESOPs refer to the Employee Stock Ownership plan which is also a type of employee benefit plan that provides ownership (with shares) to the employees, nowadays they are pretty much used interchangeably. For context, in the current article by ESOP we mean Employee Stock Option Plan.

What’s the Need for ESOPs: Moving Beyond the Dopamine of Short-Term Rewards

Though we’ve started with how it is beneficial from a monetary perspective, let’s put it into context.

According to an article by Inc42, Indian employees made $196.5 Mn through the buyback programs in 2022. It may not be as straightforward as this, but most employees view this as an opportunity for wealth creation and to grow with the organization.

Let’s think in a different way: the brain loves short-term rewards triggering the release of dopamine into the body, but it also needs “ self-actualization” and “ Esteem” (remember Maslow’s Hierarchy?) to sustain. In a work environment, this can be only achieved by effective recognition, rewards, ample responsibility, and benefits like ESOPs.

And given that the format of ESOP has gradually vested over the years, it can help see the short and long-term effects.

Psychology guide

Source: Psychology guide of rewards

While the article primarily focuses on the Pros and Cons, it's essential to briefly explore how ESOPs work to avoid any ambiguity before delving into the comparison.

How do ESOPs Work?

Let’s take an example, there is an employee RK at SSK Enterprises. This is what their journey would look like:

The beginning: After RK finishes a year (the usual amount for a cliff period, though it can vary across organizations), ABC Enterprises gives RK a certificate for the issuance of shares.

The vesting: On the certificate, the company mentions that RK needs to stay and work at ABC for a specific period, let's say four years, for the ESOP to become fully his. The vesting can be staggered like giving an increase in ownership across time.

Exercising the ESOP: Once the designated timeframe has elapsed, RK’s ownership is complete. He now has the choice to decide to buy the company's shares at a special price that was set when the ESOP was given in the original certificate.

This is a simplified representation of how ESOPs work For more specific details about ESOP Management, we would need to understand your company-specific policies. Now that you know how they work let’s look at a few benefits.

Pros of ESOPs:

We have touched upon certain aspects, such as wealth creation and motivation. Now, let's delve into the specifics of ESOPs for both employers and employees.

Ownership Culture and Employee Engagement:

Giving employees stocks/shares creates a sense of ownership among employees, fostering a strong company culture where employees feel motivated, engaged, and aligned with the company's goals. This also allows them to grow in tandem with the company, experiencing a direct impact based on their contributions to both the organization and themselves.

Example: Publix Super Markets, an employee-owned grocery store chain in the United States, attributes its success to its employee ownership culture, where employees actively participate in decision-making and share in the company's profits.

Financial Benefits and Wealth Creation:

ESOPs provide employees with the potential to share in the financial success of the company. As the company grows and its stock value increases, employees who hold ESOPs can benefit from the appreciation of the stock price. This wealth-creation opportunity can be significant, especially if the company experiences substantial growth or goes public.

Example: Google's early employees who participated in its ESOP became millionaires when the company went public. The substantial increase in the company's stock value resulted in significant financial gains for those employees. In June 2022, Swiggy, said that they would buyback upto $23mn worth of ESOPs

Recruitment and Retention Tool:

Long-term benefits not only provide advantages to the employees but also to the employers in helping with both recruitment and retention. It can be a powerful tool for attracting and retaining top talent, as it provides an additional incentive beyond salary and traditional benefits. Because it has a clause of timeline or performance, it can also help them retain employees who are looking for benefits in the long run.

Example: Companies like Infosys are expanding their ESOP pool for better retention amid the increasing attrition rates. This shows that ESOPs can be a powerful tool for both startups and enterprises.

Succession Planning and Business Continuity:

Having a stock ownership plan (not just a stock options plan) can facilitate smooth transitions in ownership and management within closely held businesses, ensuring continuity and preserving the company's legacy. Though this won’t be applicable on a larger scale, this can help with the planning of an exit strategy for owners.

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Example: King Arthur Baking Company, an employee-owned baking company, used its ESOP to transition ownership from the original founders to the employees, ensuring the preservation of its mission and values.

Cons of ESOPs:

Nothing is ever too rosy, even though most companies try to paint it that way. Before anyone chooses ESOPs, they need to have a clear understanding of the process and how it works. Let’s talk about a few such things they should be aware of.

Complicated Understanding:

By understanding we mean the exact timelines of the vesting, grant, exercise, and the related taxation that goes with it. Most people care about the wealth being generated based on the approximate valuations but don’t cater to the actual growth or the amount and the frequency of taxation. This can result in a gap between the understanding of stock options and the actual amount presented.

Limited Liquidity:

Given that the amount of money involved in the ESOP process is high – employees might be waiting for instances to encash them, but it doesn’t work that way. They can only be liquidated under conditions like

Valuation Challenges:

ESOPs can present challenges not only for employees but also for employers, with valuation being a key factor to consider. Determining the fair value of privately held company stock, in closely held businesses or startups, can be challenging. Valuation methods and disagreements on the stock's worth may arise, potentially impacting the perceived value of employees' ESOP shares.

Difficult to Manage:

Giving, handling, and issuing stock options takes time and effort, especially from an HR, admin, and legal point of view. Given that the ESOP pool involves a stake in the ownership percentage, cap table management, and ESOP management go hand in hand, making it more complicated. Some key challenges in addition to cap table and ownership management include:

If you find yourself concerned about this, you can rest assured with Vega Equity, an ESOP & Cap table management platform can help you by building a customized ESOP plan, managing multiple scenarios, and managing everything from cap table to issuing stock options under a single window.

Conclusion

Since we have already discussed the pros and cons thus far, we won't go about re-iterating it again. But we want you to leave with a word of caution: the decision to adopt an ESOP should be based on a careful evaluation of the company's unique circumstances, employee needs, and desired outcomes. To effectively implement and manage ESOPs, companies should prioritize clear communication, comprehensive education, and robust administrative systems. Regular review and adjustment of ESOP policies are crucial to address potential challenges and ensure alignment with the company's goals and the best interests of employees.

About Vega Equity

Vega Equity offers companies an effective, intuitive, and paperless platform for managing equity. It provides accurate cap table management, customized user experiences, and precise information. Additionally, it assists in measuring KPIs, analyzing data, and tracking performance towards goals.

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