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Building a Strong Foundation: Understanding ESOP Trusts for Businesses

  • Written Written by Ali Nasir Kidwai 18 March 2024 | 4 min read
  • Editor's Note :

    As businesses increasingly recognize the potential of ESOPs as a mechanism for fostering employee ownership, productivity, and long-term sustainability, it is crucial to grasp the intricacies of ESOP trusts fully. This blog enlightens exploration as we unravel the complexities of ESOP Trust and empower businesses to build a strong foundation for future growth and success.

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Retaining quality talent is only possible if you compensate them well for their efforts. However one of the biggest problems most startups face is funding and cash flow, which hampers their capability to retain their good employees. Nevertheless, a simple solution to this problem involves offering stocks via an ESOP trust (Employee Stock Option Plan Trust).

employee stock option plan trust

The ESOP survey found that 30% of Indian firms have already implemented an ESOP plan, and 8% plan to do so soon. This indicates that the ESOP concept has gained significant traction in India. With 30% of companies currently implementing an ESOP system, it can be confidently asserted that this arrangement is proving to be a lucrative and successful model.

Through this blog, let's explore the possibilities.

Defining ESOP Trust

ESOP trusts, created by companies, differ from charitable trusts. They allow employees to purchase company stocks at a discounted price compared to the present market price, often serving as compensation representing a percentage of the employee's salary.

Participation in the ESOP trust is voluntary, and employees can choose to decline. Nonetheless, its mutually advantageous impact on the Company and employees has fostered widespread acceptance, particularly within the startup community.

Operational Framework of ESOP Trust

framework of esop trust

The ESOP Trust mechanism involves issuing shares through adopting an Employee Stock Ownership Plan scheme. A dedicated ESOP Trust is created and officially registered to implement this plan. The Company formulates a scheme that requires approval from its members.

Simultaneously, by the Indian Trust Act of 1882, an ESOP Trust is formed to serve as an intermediary between the Company and its employees. As option holders exercise their options, the ESOP Trust is responsible for issuing shares to the employees.

One notable benefit of the ESOP Trust route is that it allows the organization to issue shares without diluting its existing capital base. This makes the ESOP Trust mechanism preferred by listed companies for the secondary market acquisition of shares.

Additionally, the ESOP Trust mechanism offers employees a more streamlined exit route than the ESOP Direct route structures. This results in increased liquidity for employees upon the exercise of their options.

Assessing Various Approaches to Set Up an ESOP

Before establishing an ESOP trust, it is crucial to be well-informed about the available options for its setup. Two distinct routes for implementing an ESOP are the Direct Route and the Trust Route. A comparative explanation of each is provided below to enhance your understanding of the disparities between these two approaches.

ESOP - Direct Route
ESOP - Trust Route
In the direct route, the organization issuing fresh equity grants the stocks.
A special trust is formed for the ESOP scheme in the trust route. The organization then funds the trust to buy shares from the secondary market and transfer them to eligible employees.
The employees can apply for shares once the vesting period is over. The vesting period usually lasts for a year. Since the Company issues new shares here, they must opt for equity dilution.
Depending on the Company's scheme, the trust can hold the shares for safety and growth. It will be handed over to the employee upon retirement or termination. ESOP under the trust route works with pre-existing shares. Hence, there's no need for equity dilution.
Especially for private limited companies, when the employee decides to leave, the Company might need to buy back those shares. Otherwise, the employee needs to wait for the Company to go for a public offering to quit as a shareholder of the Company.
The exit route is pretty simple here. The employee can sell the shares to the trust or in the secondary market.

Critical Factors to Keep in Mind When Establishing an ESOP Trust

Several considerations must be taken into account before opting for an ESOP Trust structure. These include:

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Highlighting ESOP Trust Benefits

There could be several reasons companies could utilize the ESOP Trust structure to manage their ESOPs, some of which are listed below.

Final Thoughts

Henceforth, companies need to foster understanding through active communications and education; they also must have a supporting strategy that is strongly connected with the overall direction of management. An ESOP has the potential for an advantageous outcome if these complexities can be successfully addressed.

If you need assistance creating or rolling out ESOPs or want to streamline your ESOP management, contact our team at Vega Equity to learn more.

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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