Demystifying ESOPs for Startups: A Comprehensive Guide to Employee Stock Ownership Plans

ESOPs for Startup

Startup founders frequently face the complex task of strategically implementing an Employee Stock Ownership Plan (ESOP) to effectively attract and retain talent, and can be often seen struggling with its timing and execution. 

To help founders understand and use ESOPs effectively, SanchiConnect hosted an interactive session by CA Sambhav Mehrotra who is Senior Advisor at Startup Movers.

This blog distils insights from the session, providing answers to frequently asked questions that startup founders often have about creating an effective ESOP strategy, offering valuable guidance for those looking to implement this tool in their startups.

What are ESOPS?

ESOP stands for Employee Stock Ownership/ Option Plan.

It’s an employee compensation program that allows employees to become partial owners of the company they work for by acquiring shares or stock options. Company grants an option to its employee to acquire equity shares of the company at a future date and at predetermined price.

What are the benefits of ESOPS for employers ?

Offering ESOPs can be an effective tool for attracting and retaining top talent. It aligns the interests of employees and shareholders, as both have a vested interest in the company’s growth and profitability. It can be structured in a way that links employee compensation to the company’s performance. This helps incentivize employees to work harder, be more productive, and contribute to the company’s success.

What are the benefits of ESOPS for employees ?

Ownership Stake: Employees have a direct financial stake in the success and performance of the company. As the company grows, so does the value of their ESOP holdings.

Motivation and Engagement: Knowing that their efforts directly impact the value of the company’s stock can motivate employees to work harder and more efficiently. This can lead to increased productivity and overall better performance.

Long-Term Financial Security: ESOPs provide employees with an opportunity to accumulate wealth over time, especially if the company’s stock value increases significantly.

Retirement Savings: ESOPs can serve as a valuable retirement savings tool, as employees can sell their ESOP shares back to the company or to other employees when they retire.

What is the impact of ESOP on a company’s financials?

ESOPs granted to the employees are considered as expense in Profit & Loss Statement of the Company under Employee Benefits

The expense is recognized over the period of vesting, depending upon the value of ESOP on the grant date and number of ESOPs expected to be exercised.

ESOPs result in dilution of ownership and EPS, as more equity shares are allocated.

Disclosure- The company must disclose the Method of Valuation of Equity Shares, ESOPs granted, exercised, forfeited and  outstanding in their Annual Financial Statement.

What are some of the Common mistakes while creating an ESOP scheme?

  •  Inadequate Employee Education
  • Vague or Ambiguous Language in the policy or grant letter
  • Lack of Communication and Transparency
  • Unrealistic Vesting Periods
  • No Exit Strategy for Employees
  • Ignoring Tax and Regulatory Requirements
  • Lack of Flexibility
  • Not linking any Performance Metrics
  • Incorrect/ Unrealistic Valuations
  • Failure to do Regulatory Filings & Disclosures

What are SARs?

SARs can be an alternative to ESOPs. 

Stock Appreciation Rights (SARs) and Employee Stock Ownership Plans (ESOPs) are both forms of employee incentives used by companies in India. Whereas SARs can be used to give incentives to anyone (Employees, Advisor, Mentor, Consultant) and ESOPs are only for Full-Time Employees.

The companies by issuing SARs contemplate passing on the appreciation in the value of a certain number of equity shares to their employees. In this way, the company is saved from diluting its rights as a result of which its shareholding remains unaltered. 

The primary benefit to the employee, that comes with SARs, is that the employee can receive proceeds from stock price increases without being required to buy anything outright.

Are there any drawbacks or risks associated with ESOPs?

While ESOPs offer numerous benefits, there are also some potential drawbacks and risks to consider:

Lack of Diversification: Since ESOP participants might get heavily invested in their employer’s stock, they may face a lack of diversification in their investment portfolios, which can increase risk, especially if the company experiences financial difficulties.

Liquidity Issues: ESOP shares may not be easily traded on public markets, making it difficult for employees to sell their shares and access the value of their investment.

Volatility: The value of ESOP shares can be subject to volatility, depending on the performance of the company’s stock in the market.

Regulatory Compliance: ESOPs are subject to complex regulations and compliance requirements, which can be burdensome for employers to navigate.

 Can employees participate in an ESOP from day one of employment?

Participation in an ESOP typically requires some period of eligibility, which may vary depending on the company’s specific plan rules. While some companies may allow employees to participate immediately upon hire, others may require a certain length of service (e.g., one year) before employees become eligible to participate.

What are the tax implications for employees around ESOPs?

There are no tax implications on the grant of ESOP. However, on exercise of the option it is taxable as ‘perquisite’ under the head salary at the time of allotment of shares and the value will be determined on the exercise date.

Moreover, the sales of shares are taxable as long term/ short term capital gain.

What are the tax implications for employers around ESOPs?

Employers are eligible to claim ESOP as expense in their Income Tax Return. They are required to deduct TDS of employees by considering the value of perquisite as their salary.

How do ESOPs impact corporate governance and decision-making within a company?

ESOPs can impact corporate governance and decision-making within a company by giving employees a voice in company affairs through their ownership stake. Depending on the structure of the ESOP and the rights granted to participants, ESOP participants may have voting rights on certain corporate matters, such as the election of directors or major corporate transactions. This can lead to greater employee engagement and alignment of interests between employees and shareholders, but it can also introduce complexities into the decision-making process, particularly in closely-held companies where employee ownership is significant.

What is the right time to issue the ESOPs?

The right time to issue an ESOP for a startup depends on various factors such as the stage of growth, financial stability, employee retention and motivation, valuation, equity allocation, and legal and regulatory considerations. By carefully evaluating these factors and seeking expert advice, startups can implement an ESOP that aligns with their goals and objectives while providing meaningful benefits to employees.

How does the ESOP dilution happen with the subsequent funding rounds for a startup?

ESOP dilution can occur during subsequent funding rounds for a startup when new shares are issued to investors, leading to a decrease in the ownership percentage of existing shareholders, including ESOP participants. Startups must carefully manage dilution to balance the interests of existing shareholders with the need to raise capital and maintain the effectiveness of the ESOP as an employee incentive program.

To learn more about ESOPs, you can also refer to this webinar  : 

Demystifying ESOPS for startups

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