ESOPs : Good Tool For Startups, But A Bet For Employees

Indian startups such as Flipkart, Snapdeal and Housing.com, are increasingly offering ESOPs as part of their packages, to attract talent. How beneficial is it for startups? What should employees take care of? Here is a quick primer on ESOPs and what it means to different entities.

So what are ESOPs?

Employee Stock Option Plans are the plans in which employees get the right to purchase a number of shares (decided by the employer) in lieu of Salary in the company at a discounted price (less than the market price). Like for example, Google recently employed an Indian with a Package of 1.2 crore per annum, with a catch that half of it was in the form of ESOP.
In this case, employees have to wait for a certain time period – known as vesting period – before they can exercise the right to purchase those specified number of shares.
Let’s take an example of Alpha Private Limited.
ESOP 1
In this case, the founder Roy and Joy incorporate a company with 1 lakh share capital i.e. 10,000 shares with 50% holding each.
To scale up, they need talented employees whose current CTC is around 15 lakhs. As a startup Alpha cannot afford these high salaries, it proposes 10 lakh per annum plus 500 shares each with vest in period of 4 years.

Benefits to Employer

  • Hire good talent

Start-up companies use Esops to hire good talent, as they cannot afford to pay very high salaries

  • Ownership feeling

The employees have the feeling that they are partner in Company and are motivated to work harder as companies growth is linked to their growth

Disadvantages to Employer

  • Dilution

When the ESOPs are exercised the founders share holding gets diluted.
In above example the shareholding will look like this:
ESOP II

Benefits to employees

  • Chances of becoming a millionaire

Stories of how Infosys, one of the earliest companies to offer Esops, created millionaires of employees such as drivers, are known. Thus, ESOPs are beneficial only for high growth companies.

Disadvantages

  • ESOPs are a bet

Only one among 10 startups are really successful. Stories of drivers becoming millionaires might happen only in some cases. In fact, in the case of start-ups, it is safer for candidates to consider only the salary component and look at Esops as an added bonus.

Things to take care by employees when having ESOPS in lieu of salary

  • Proper Documentation

Employees should ensure that all the documentation is in place. They should also consider the present value and future value of shares

  • Proper Exit Mechanism

Ensure there is a proper exit mechanism, like promoter buyback, in case listing of the start-up is delayed

  • Taxation

When the shares get allotted, they are taxed as salary or perquisite. Suppose in the above case when shares are allotted to employee A, he will have to pay flat 30% on difference between the fair value and exercise price.

Summary

Thus ESOPs are a really good tool for startups to attract and retain talent, but at the same time it’s a bet for the employees. Employees should be convinced about the growth of company and should see if proper documentation is in place.
[About the author: Rohit Lohade is the cofounder of Business Setup.]

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