Traditionally, ESOPs were given to remunerate senior employees and to acknowledge their proven contribution to the company. However, in modern times, ESOPs are used as a consideration as Startups can't afford to spend high salaries in the beginning. Employee Stock Options in India has gained immense popularity in the recent times with the emergence of a vibrant startup ecosystem in the country.
Stories of how Infosys, one of the earliest companies to offer ESOPs, created millionaires of employees such as drivers, are very well known. Thus ESOPs are beneficial for high growth companies.
Google recently employed a Indian with a Package of 1.2 crore per annum, with a catch that half of it was in 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.
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).
The option provided under this scheme confers a right but not an obligation on the employee. Stock options are subject to vesting that requires continued service over a specified period of time. Upon vesting of options, employees can exercise the options to get shares by paying the pre-determined exercise price.
ESOPs are generally awarded for performance or tenure of the employee with the company. Thus, it serves a two-fold purpose for both the company and the employees.
1. It acts as a tool of motivation for the employees that once they own a stock they feel responsible for performance of the company, as it determines the value of the stocks of the company.
2. It helps the employer to retain the company and assure a good level of performance in the work.
ADVANTAGES OF ESOPs:
1. ESOPs can be treated as a retainership instrument for small businesses as there is a lock in period for exercising the right to purchase the shares. Thus, a business can retain its employees. If an employee opts for this option then he has to serve the lock in period to become eligible to exercise it.
2. Getting shares of the company in which they are working gives employees an ownership feeling. They start feeling that they are not employees of the organization but owners. Also, they get to share the profits of the company in the form of dividends and are motivated to work for the best of the company.
3. Businesses that needs funds and are not in a position to spend hefty amounts can offer this option to their employees in lieu of salary and motivate them to work for the betterment of the company.
4. It is a non-cash compensation tool to compete for the best human resources.
5. It gives an opportunity to corporate to pay without a reduction in book profits.
6. Boosted Morale of Employees.
DISADVANTAGES OF ESOPs:
1. When the ESOPs are exercised the founders share holding gets diluted.
2. Since, Company is unlisted Company, there are no marketability or liquidity of shares of private company. Hence, there are chances of disputes between employers and employees when employee leaves the organization.
3. There are also chances of disputes while transfer of shares and the value at which shares should be transferred.
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.
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.
IT industry like Infosys was the first to use this ESOP feature in India. Now, almost all the sectors are using this to attract and retain best talents of the industry. Nowadays, Startup companies are actively using ESOP for attracting best human resources and to stop brain drain. Many startups fail just because of non-availability of qualified and experienced employees because startup companies can't afford to pay higher packages to them like MNCs offer. The only option for startups to retain and attract them is to use ESOP so that employees can feel ownership rights and help startup to grow and foster.
Stocks are never vested immediately - founders want you to stick around for a reasonable amount of time (say, 4 years) for you to be entitled to the benefits. Hence, immediate value of the stocks is just an indicative number. The startup needs to be massively successful before those numbers become meaningful and of any real (cash) value. More than the stocks themselves, you need to do a lot of hard work to find more about the company, founders and their vision. Very few startups go on to become big names. it may sound, but ESOP's of only such companies makes sense. Rest, as I said earlier, is just as good as a piece of paper.