Business, Startups

ESOPs: What, Why and More

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Employee Stock Option Plans have been in practice for a long time, and are being increasingly used as a compensation tool by all companies, be it a startup or an established enterprise. The popular reasons for implementing ESOPs are wealth creation for employees, retention, attracting new talents and inculcating the feeling of employee ownership to motivate employees.

Let’s find out how and when can ESOPs turn the course of any life? And most importantly why should startups consider creating an ESOP pool?

What is an ESOP?

An employee stock ownership plan is an employee program that provides a company’s workforce with an ownership (stock options) interest in the company. In an ESOP program, companies provide their employees with stock ownership, often at no up-front cost to the employees. ESOP shares however, are a part of employees’ remuneration for work performed.

Employee stock ownership plans keep employees focussed on the company performance and share the profit. These plans encourage employees to do what is best for the company.

Employees typically have to wait for a certain duration known as the ‘vesting period’ before they can exercise the right to purchase the shares.

How does it work?

A trust fund is set up by the company in which the company contributes fresh shares of its own or puts in cash to purchase existing shares. These shares could be acquired by employees and thus, they can reap the benefit of stocks as well as saving on their taxes through this contribution.

In normal conditions, any employee over the age of 21 can be a holder of these shares. The preference to the level and limit of shares is given on the basis of seniority of the employees. In case an employee is quitting the company, the latter has to buy those shares from the former at the current market rate.

The allotted stocks take a minimum period to mature, post which the employee can avail money in return. The maturity time period of stocks is known as the “vesting period’ (minimum one year) as mentioned above. If an employee leaves the company or if the company discontinues taking services of the employee, ESOPs lapse.

Once the vesting period ends, ESOPs get matured and can be encashed. This particular period is known as ‘Exercise period’. During the exercise period it is an employee’s choice to sell his stocks (he/she will earn company’s prevailing stock value) or can continue retaining them. In the latter case the stocks value will grow with time. The exercise period also has a time limit (depends on the company) post which it gets dormant.

How does one earn cash from ESOPs?

ESOPs are employee programs with secure long term returns. They are an easy and quick way to make money. An employee can sell his/her stocks back to promoters once they have completed their vesting period and are mature to be encashed.

Another way is by selling the stocks to an investor. Whenever the company raises an investment, employees are given a choice to sell their ESOPs to the incoming investors. In such a case, if they sell it, they get an exit no matter whether its a vesting period or an exercise period running. Investors invest in a company for stocks (as it holds much higher value) and not for salary.

When and why companies offer ESOPs?

It depends on the company policy and the designation of the employee whether the company wants to offer ESOPs or not. There are time limits for availing the ESOP scheme. An employee can acquire the ESOPs after the completion of its vesting period, which generally ranges from one to five years. In case the employee quits the job before the period is complete, then the stock options lapse.

Owning an equity share means owning a share in the company business. Companies offer their employees’ shares because having a stake in the company would increase loyalty, motivation & retention substantially.

Why should startups consider creating ESOPs pool?

ESOPs helps in building the employee-company relationship. It helps to keep the employees motivated and focussed in company’s growth. In return the company get dedicated and generous output from its employees thereby resulting in its growth.

ESOPs over salary?

Every employee has a CTC i.e. fixed salary, but ESOPs are like an additional benefit over what an employee is earning. The only difference between the two is that, ESOPs value can be availed only after a fixed time i.e when its vesting period gets matured. Whereas, salary is an every month income.

ESOPs are a smart move for any employee to earn. Their value depends on the company’s growth trajectory. As the company grows, its stakes value increases. However, there have been cases when startups have failed and ESOPs value has nullified.

There has been news about many companies, famous for giving employee stock options. In most of the cases the employees have become rich overnight. Let’s read about some of such stories in the following section.

Companies in news for giving ESOPs?

A lot of companies have been in the talks for giving stock options (ESOPs) to their employees. Firms like Tastykhana, RedBus, Flipkart, Snapdeal, Shopclues, and Infibeam are among eCommerce notables, that claim they can make their low level workers millionaires.

Shambu Biswas’ inspiring wealth creation story as reported by ET, shows how he joined Bangalore based startup Flipkart as an office boy earning 15k in 2009 and received employee stock options (ESOPs). The value of his ESOPs at that time crossed rs 10 lakh mark.

Likewise, Infibeam’s Founder and CEO Vishal Mehta said that around 15-20 employees – office boys, customer service staff, administration assistants and delivery personnel – have ESOPs. These employees have the freedom to encash some portion of their ESOPs whenever the company raises funds.

“About 400 of the employees who own a stake have now become crorepatis,” said a person who has direct knowledge of the employee stock option scheme at Flipkart. At the senior-most level, nearly 20 employees who are at the grade of senior vice-president or above and joined over two years ago are now dollar millionaires, meaning their stock options are worth at least Rs 6 crore on paper.

It was in 2009, the same year when the company raised its first round of funding of $1 million (over Rs 6 crore) from Accel Partners, that Flipkart started providing ESOPs.

When RedBus was sold to Ibibo in June 2014 for a valuation of Rs. 600 crore, many RedBus employees turned millionaire overnight.

Tastykhana CEO Sachin Bharadwaj posted an interesting tweet when his startup was acquired by Foodpanda. The CEO said that is he happy to add 6 new employee millionaires to the startup ecosystem.

Above mentioned are few among the many success stories of startups employees’ turning rich overnight.

Why should one consider ESOPs? Or not consider?

Real value of a startup is not cash but ESOPs. Startups provide ESOPs which have long time returns and with the work of its employee its value grows. In a small company (startup), an employee puts in the same amount of effort and grows faster. As the company grows, its stock value grows. Startup has less number of employees, therefore, the success return gets distributed among less number of people, i.e. how an employee earns more in less time.

There are cases when startups have also failed, however, it is not always the case. Thus, it totally depends upon an employee whether he/she wants ESOPs or not, for with ESOPs also come in responsibility and dedication, which only an enduring person can go forth with.

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