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ESOPs -A Ready Guide To Employee Ownership, Its Pros, And Cons

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Do you remember Fresh Works recently listed on the NASDAQ? We are sure you remember over 500 employees turned millionaires after the billion-dollar IPO.

How did that happen? Well, Girish Mathrubootham offered his employees company stock options (ESOPs) as a part of their compensation package.

Not sure what that means.

New-age start-ups to large corporate and public listed companies offer employees, both new and existing the opportunity to become stakeholders in the organization to attract the best talent in the industry and retain them for the long term,.

In other words, they are given ESOPs.

Understanding ESOPs

ESOP or Employee Stock Ownership Plan is a type of employee benefit or compensation plan where the employee owns a stake in the company. The firm allocates a specific percentage of equity or shares to the eligible employee. However, the employee does not bear any upfront cost for getting an ESOP.

It can a part of the employee’s remuneration package at the time of joining the organization or it can be earned via promotions over a period of time. That said, ESOPs are given at the sole discretion of the employer.

ESOP shares are held in a trust structure, and it effectively is meant to compound their value over time. Generally, with ESOPs, the employee gets the option to convert them into stocks at a pre-decided rate irrespective of what the market price may be at that time.

Alternatively, some employers even buy back the employee’s shares and return them to the company if the employee chooses to leave the organization or reaches retirement.

It must be noted that ESOPs do not convert into stock ownership instantly. This happens over a period of time as outlined in the agreement between the employee and the company.

The ESOP Lifecycle

Whatever the general perspective may be, the reality is that not every employee who has been given an ESOP will walk out of the company as a millionaire.

In most cases, employees who are granted ESOPs fail to understand how it really works. There are a number of legal intricacies and frameworks involved with these stock options.

Let’s understand with the help of an example.

Company X Private Limited grants the following ESOP to its employees:

  • 150 shares at the rate of Rs. 200
  • The option or vesting period stands at 5 years

What this means for the employees who received this ESOP is that if they are still on the payroll of Company X Private Limited. They can purchase these 150 shares at a cost of Rs 200 apiece as determined in the ESOP agreement between the employee and the company.

Even if the current cost of one stock is Rs. 5000 for Company X Private Limited, the employee will only pay the pre-decided rate.

Many companies offer ESOP vesting for shorter intervals. For instance, the total of 100 shares can vest proportionately over a 5-year term. This means that every year, the employee earns 20 ESOPs.

ESOPs cannot be exercised during their vesting period. At the time of retirement, the employee is eligible to receive the share value in cash.

But how does the company decide on the grant price for an ESOP?

Typically, the company will get an average of the prevailing market price for the stock over a said period, let’s say, 30 days before the issue date of the ESOP. It could also be the average market price on the date the ESOP is issued. Some organizations may even offer a grant value, which is below the market price of the stock during that time. This decision varies from company to company.

Benefits of ESOPs 

ESOPs can be beneficial for both the employer and the employee.

Employer Benefits:

Acquiring Top Talent: Getting the best brains in the industry when the company is low on funds can be difficult. The gap can be easily bridged using ESOPs to compensate employees. If employees accept the ESOP as part of their remuneration package, then they wholly believe in the growth and potential of the company. This ensures that the company can recruit top talent even when the business is at a nascent stage and stock options are available at a much more affordable cost.

Boost Employee Ownership: Giving ESOPs can motivate employees to bring their best to the table. It enhances productivity and performance because they have a stake in the company’s ownership. In the long run, this can boost revenue and overall profitability for the business. Moreover, the valuation of the stock may also increase when the company is on a profitable growth trajectory.

Minimizes Attrition: Whilst hiring the best talent is difficult, so is retaining them. ESOPs can do this job perfectly. Employees holding ESOPs know that they have some skin in the game. Once the vesting period is over, they can cash in their stock options. This automatically increases employee retention for the company.

Employee Benefits:

Option to Profit: With ESOPs employees have access to company stocks at affordable rates. Once the vesting period is over, the employee can purchase them and hold onto them for the long term. If the value increases significantly, the employee has the opportunity to earn high returns from holding on to the stock.

Additional Income Source: Once the employees convert the ESOPs into stocks, they essentially become shareholders in the company. This means they have voting rights. At the end of the year, they can also earn dividends, which can become a secondary source of income.

Job Stability: Just like the employer benefits from talent retention, similarly, the employee has the satisfaction of job stability after receiving an ESOP. The employee understands that the employer will only offer ESOPs to those who can add long-term value to the company.

Things To Keep in Mind Before Employees Opt for ESOPs

While ESOPs sound like a really attractive option there are several things that employees should consider before signing on the dotted line.

ESOPs as a concept is still evolving so, specific legal rules and regulations are yet to be formulated to govern their usage. Companies are using ESOPs as a hook but there are no penalties if they fail to comply with the agreement.

Also, it is important to be aware that ESOPs fall under the purview of taxation when the employee decides to exercise it in the form of a pre-requisite or as an option.

Final Takeaways

ESOPs are great if you have the risk appetite and are willing to hold onto them for a while. On the other hand, if you are looking for short-term gains or are risk-averse, perhaps you should give it another thought.

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