ESOPs Explained: How Employee Ownership Can Transform Your Company

  • Written Written by Ali Nasir Kidwai 05 May 2023 | 4 min read
  • Editor's Note :

    An ESOP pool is a method used by companies to offer their employees the opportunity to own a stake in the company through the issuance of stock options.

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The key to any startup's success, regardless of size, is a dedicated workforce. An ESOP pool is a reserve of company shares set aside specifically for employees of a private company. This pool serves as a means of attracting talented individuals to join a startup; if these employees contribute to the company's success and it eventually goes public, they will receive compensation in the form of stock options. Typically, those who join a startup early on will receive a larger share of the option pool compared to those who come later.

Early-stage startups benefit greatly from the experience and expertise that their employees bring to the table. These employees take on significant risks by joining a company before it has achieved product-market fit, and they help the company achieve its short-term and long-term goals. While growth-stage companies may be able to offer competitive market compensation, early-stage companies typically cannot. In such cases, they may offer "deferred profit-sharing" in lieu of ESOPs.

Employee Ownership plan

ESOPs are granted either at the time of hiring or during employment, depending on the employee's contribution to the organization's growth. Implementing an ESOP pool is a complex process that requires founders to dilute a specific portion of their ownership in order to establish the pool and distribute shares among employees. Once the ESOP pool is depleted, founders can choose to dilute their ownership further or seek additional funding from investors to replenish it. Without an ESOP pool, it’s impossible to grant ESOPs to initial employees.

Significance of an ESOP Pool

Building the Core Team: Initially, a founder may feel like a lone wolf, but as time passes, even lone wolves form herds. Today's businesses rely on the collective efforts of several teams. To achieve this, a business needs leaders who share the founder's vision and work towards their goal. ESOPs can assist founders in the recruitment and retention of skilled individuals who can contribute to the growth of the business. When employees have a stake in the organization's profits, they curate a greater sense of commitment to its success.

Motivating High Performance: Employee stock option programs can be used to recognize, motivate, and reward high-performing employees. Such incentives enhance employee morale, enable them to accumulate wealth, and inspire them to maintain their loyalty.

Instilling a Sense of Ownership: To achieve their objectives, entrepreneurs need a dedicated and committed team that regards the company as their own. ESOPs can foster a culture of shared prosperity by providing employees with an opportunity to participate in the company's earnings and motivating them to remain committed to its development.

employees profit from esop

Nevertheless, there is no fixed criterion for creating an ESOP pool, as the allocation can differ depending on the company's market position, stage of investment, and other relevant factors. Some entrepreneurs establish a 5% pool from scratch, while others start with a 25% ESOP pool.

Types of Employee stock ownership plans (ESOPs)

Employee Stock Option Schemes (ESOS)

ESOS is a commonly offered ownership plan by most companies. It allows employees to purchase company stocks at a predetermined price after completing the vesting period. The plan is voluntary, and employees are not obligated to invest in or purchase shares of the company.

Employee Stock Purchase Plans (ESPP)

ESPP provides employees with the opportunity to purchase company shares at a value lower than the market price. The plan includes predetermined terms and conditions, such as a vesting period and price. Once employees exercise their ESOPs, they become shareholders in the company.

Restricted Stock Award (RSA)

RSA is a scheme that requires employees to fulfill specific conditions before being awarded a certain number of company stocks. If the requirements are not met, the obligation to award stocks can be relinquished. This plan is unique because the employee becomes a shareholder as soon as the stock is awarded.

Restricted Stock Unit (RSU)

RSU is similar to RSA, but employees do not officially become shareholders until they fulfill the conditions outlined in the ESOP contract. Only after meeting the requirements will they receive the stocks.

Phantom Equity Plan

A Phantom Equity Plan provides employees with notional company shares at a predetermined rate. Although the company's books record the grant or exercise price, the employee is not paid that amount. Instead, on the agreed-upon vesting date, the employee receives the profits earned after exercising their ESOPs. In essence, the employee does not become the owner of the company stock but earns the profit amount of the notional purchase.

What is it that businesses need to be aware of before settling on ESOPs?

While ESOPs can help employers attract top talent, especially in a challenging economy, there are many factors to consider before offering it to employees. Firstly, there are specific legal regulations governing ESOPs that companies must comply with to operate them lawfully.

Additionally, reassessing ESOP management and conducting internal monitoring incur additional costs. Therefore, employers must keep the cost structure in mind while introducing the concept of ESOPs in their organization.

How to structure an Employee stock ownership plan?

ESOP Agreement and Committee

Creating an ESOP Agreement requires careful planning and structuring, where a separate pool is created for the Employee Stock Ownership plan. This pool reserves a certain percentage of company shares exclusively for employees, making them financial shareholders. Additionally, the ESOP Agreement specifies the ESOP committee members who are senior executives responsible for managing the ESOP pool. They also provide recommendations to the Board of Directors on encouraging business moves.

Cliff and Vesting Period

Each ESOP includes a vesting or cliff period. A vesting schedule indicates the portion of shares an employee receives over time and that all shares won't be granted at once. Conversely, a vesting "cliff" period means that there is a no-vesting duration but still allows employees to acquire benefits once the period is complete. The vesting period is the timeframe before the ESOP can be exercised. During this time, employees must work for the company to exercise their ESOP.

esop pool

Employees who resign before the vesting period is over but the cliff period is completed receive pro-rated stocks based on their duration of employment.

Selling Restrictions

Every company outlines selling restrictions in its ESOP rules or specifies a particular time frame during which employees cannot sell shares from their portion.

How do employees profit from ESOPs?

Reduced-cost ownership benefits: ESOPs provide an opportunity for employees to acquire stocks at a discounted price, allowing them to hold onto these stocks for long-term returns or sell them at a higher market value for profits.

An additional source of income: By becoming investors, employees gain voting rights in the company's management and have the potential to earn dividends on their stockholding, serving as an additional source of income.

Job stability: The vesting period provides employees with job stability, leading to increased job satisfaction.

Tax implications of ESOPs: There are no tax implications when offering ESOPs to potential talent. However, any costs incurred on ESOPs can be claimed as a tax-deductible expense from business income. When employees exercise their ESOPs, the shares are subject to the employee's tax bracket. If there is a profit after the employees sell the shares, it is considered a capital gain. If the shares are sold within a year, a 15% capital gains tax must be paid, similar to any other purchase or sale of stock.

Way forward for ESOPs

The most efficient way to motivate your team to work harder and longer is by incorporating ESOP as a component of their employee benefits package. By including your employees in your company's achievements, they will feel a sense of pride and ownership. This also serves as an excellent method of retaining top-performing employees by offering them a larger stake.

To help entrepreneurs and founders establish their ESOP pool, develop their ESOP policy, and more, contact Vega Equity experts. Schedule a demo today!

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