It’s now widely acknowledged that companies can use ESOPs as a powerful tool to increase their employees’ emotional as well as financial involvement in the company. But companies are diverse entities and therefore ESOPs must be too. That’s why there’s no single ESOP template that can be applied to all businesses.
An Important Definition
Let’s clearly outline what ESOPs are to clear lingering doubts. ESOPs give employees an ownership interest in the company they’re working for. They’re created to let employees acquire stock in a closely held company. These motivate employees to work in the best interest of the shareholders since they become shareholders too. Companies also acquire tax benefits, and that works as an incentive for owners to offer ESOPs. They mostly tie distributions from the ESOP to vesting periods and the exercise usually happens when some significant milestone, most often some kind of liquidity event, occurs in the lifespan of the company.
Types of ESOP
In the interest of clarity, let’s get it out of the way that technically speaking there are 4 main types of ESOPS:
1. Employee Stock Purchase Plan (ESPP)
Here, the company gives shares to their employees at lower rates than the market value. These often require a minimum service period from the employee.
2. Employee Stock Option Scheme (ESOS)
The employee is given options on a pre-defined valuation. That’s normally constrained by a vesting period and certain performance metrics the company and sometimes the individual must achieve. Once the stipulated vesting period is over, they can exercise their options to own shares. They can purchase those shares at the pre-defined exercise price. That will protect them from fluctuating valuations or market rates.
3. Restricted Stock Units (RSU)
Here, the employee is given shares of a company after an event occurs. Usually, there’s no or nominal exercise price in this plan.
4. Stock Appreciation Rights (SARs)
Several companies use SARs as an ESOP model, despite this being a little different. Here, the company offers equity or cash equivalent to the appreciation over a predefined base price if certain conditions are met. SAR saves equity dilution vis-à-vis ESOPs and also come at no or nominal exercise price.
Who Uses ESOPs?
Many companies offer ESOPs to their employees to be able to hire top talent in the face of competition from bigger employer brands as well as to incentivize their employees to strive for company growth. The ESOP plans of start-ups and private companies need to be designed differently because their objectives are different. Of course, both require flexibility in design and handholding in every small step they take when implementing ESOPs. Even for individual companies, there are many specific circumstances that apply to each of them that would make their ESOP plans vary from each other. Each company has different answers to questions like:
When to launch ESOP plans?
Who, what category, and how many people to include in the plan?
How much equity to dilute from the share of the owners?
And most importantly, what business goal are they shooting for, in the pursuit of which they feel ESOPs can play a key role?
Answers to such questions will determine the specific nuances of the plan they adopt.
Uses of ESOPs
Employees in start-ups usually leverage early-stage access to ESOP and align their gains to the company’s growth. When the vesting and exercise are over, they’re allotted shares of the company – which can be monetised. That will happen when the company announces a liquidity event, where shares are bought back/ arranged for sale, or options are settled in cash, or during an IPO. Start-ups registered as private limited companies will have to follow guidelines under the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014.
This set of rules outline the scope of ESOPs as far as private companies are concerned. It’s important to follow these rules or they are liable to face penalties. According to these rules, only a certain category of employees and directors can be included under an ESOP. Start-ups registered with the Department of Industrial Policy and Promotion (DIPP) have certain other advantages in terms of coverage of founders/ promoters and tax deferral for employees.
One Size Does Not Fit All
We can see that along with there being different types of ESOPs, and a variety of uses for them – there are also separate rules and regulations for different types of companies. Therefore, every individual start-up must adopt the plans that are right for their employee – and right for them as well. There are many things to consider as well, such as the cost of implementation, taxation of the ESOPs at different levels both on the employer and the employees side, and more. In fact, every start-up looks to offer these plans based on different lifecycle considerations. They ponder conditions like:
- Does the company have the scope to stay in the market for at least a few years?
- Is the business idea validated and does it solve genuine problems?
- Will the options be considered as a part of your employee’s perks and accordingly taxed. What are the other taxation and compliance obligations?
- Are employees aware of the circumstances under which they can cash out and what happens after that?
- Can the startup ensure employees have faith in the ESOP plan and how can they provide transparent visibility to employees and stakeholders at all times?
Choosing an appropriate plan would help companies save on taxes while instilling loyalty and meaning in the lives of their employees. But using the wrong plan will mean missed opportunities and extra hassle.
That’s where ESOP ezee comes in. This is our tailor-made solution to address your unique needs. ESOP ezee is a one-stop solution aimed at early stage and unlisted private companies. We believe that equity compensation solutions for businesses in this stage of the lifecycle need to be tailormade because they are unique in many ways as compared to steady-state, large, and matured businesses. Using our expertise, we can guide you on your journey into creating the best plans for your company. Contact us to know how.