One of the most complex challenges for start-up founders in India is hiring and maintaining competent employees. Competition for top talent is high in a thriving start-up ecosystem. To solve this, many entrepreneurs adopt Employee Stock Ownership Plans (“ESOPs”) as a tool for attracting and retaining key personnel. In this post, we will look at what ESOPs are, how they work, and why they are an attractive incentive tool for Indian start-up founders.
What are ESOPs?
ESOPs as defined under section 2(37) of the Companies Act, 2013 is a type of employee benefit plan that allows employees to own a share of the company they work for. This means that employees have a financial stake in the company and can benefit from its success. ESOPs are commonly used in start-ups as a way to attract and retain talent, as well as to align employees’ interests with those of the company.
Before offering ESOPs, it is typically preferable that the company conducts a feasibility assessment to determine the financial viability of ESOPs. In case, the assessment turns out to be successful, the company drafts an ESOP scheme and present it before the shareholders in a board meeting to get it approved. Once it gets approved, the company issues “Letter of Grant” to the employees entailing the number of granted ESOPs, the vesting schedule, exercise price, exercise period, etc.
How do ESOPs work?
ESOPs work by granting stock options to employees, which allow them to buy a certain number of shares at a predetermined price. The price at which the options can be exercised is typically lower than the current market price, which means that employees can buy shares at a discount. This creates an incentive for employees to feel motivated to work hard and help the company succeed, as the value of their shares will increase as the company grows.
ESOPs typically have a vesting schedule, which means that employees have to work for a certain period of time, (minimum a year in most cases) before they can exercise their options. This helps to ensure that employees are committed to the company’s long-term success and are not just looking for quick returns. Once the options are vested, employees can choose to exercise them or hold onto them. If they choose to exercise the options, they can buy the shares at the predetermined price and either hold onto them or sell them for a profit to a third party or to the company exercising company buy-back option.
How big the ESOP pool size should be?
Typically, the ESOP pool size depends upon the stage of the start-up. During the seed stage, a company focuses on building the brand and therefore puts high stakes in hiring the resources and to attract and retain them. A 10% -15% of the ESOP pool is considered as standard pool in the normal parlance. However, this differs from company to company and business to business, so a company must carry its assessment before creating an ESOP pool, as the future investors might ask for an increase in the pool size to avoid dilution of their shareholding in the company or an already big sized pool can act as a barrier in the future transactions. As the company grows, depending upon various factors such as employees’ lookout on the salary cut for ESOPs i.e. conservative or progressive view; company’s strategic decisions pertaining to whom to issue the ESOPs as well as company’s revenue parameters, and such other similar factors, ESOP pool should be determined.
ESOPs an attractive incentive tool for start-up founders in India
ESOPs are definitely a popular incentive tool for start-up founders in India for several reasons. Firstly, they allow founders to attract and retain top talent, which is critical for the success of any start-up. With so many start-ups competing for talent, offering an enticing ESOP plan attracts potential hires.
Secondly, ESOPs helps to align employees’ interests with those of the company. Having a financial stake in the company can lead to a more engaged and committed workforce, which is essential for the growth and success of a start-up. The classic example of this is Infosys, which reinstated ESOPs in 2016 to combat attrition after a 13-year gap.
Thirdly, ESOPs are beneficial as they help in conserving cash of companies. Start-ups often have limited financial resources, and offering a competitive salary or bonus package to all the potential employees may not be feasible. ESOPs provide a way for start-ups by offering a valuable benefit to employees without having to spend a lot of money upfront.
Lastly, issuance of ESOPs is considered likely to give an edge to the start-ups in the future investment rounds as investors are often more likely to invest in a company that has a strong incentive program in place for its employees as it suggests and ensures that employees are committed to the company’s long-term success and are aligned with the interests of investors.
However, as said not everything that glitter is gold, it is to be noted that issuance of ESOPs comes with red flags, such as issuance of ESOPs is also suggestive of the dilution of shares and thus the start-ups should be cautious of excessive granting of ESOPs to avoid over-dilution of shareholders’ equity (particularly founders) in the business, as it takes away the investors’ confidence to invest in a company with the promoters/ founders holding minority shareholding. Further, the experts often recommend to issue ESOPs only to the key employees who can bring innovative ideas beneficial for the company’s growth. Moreover, ESOPs might not be lucrative option for all the employees as not each and every employee gets excited with the grant of ESOPs for various reasons including the waiting period that is attached with the ESOPs for exercising the options, risk associated with the performance of the company and, some employees look for cash bonuses over ESOPs to meet their immediate needs such as buying of a property or to meet family expenses.
In conclusion, while ESOPs can be a valuable mode of employee compensation, they are not without their own set of challenges. Companies should carefully consider the pros and cons of ESOPs before implementing them, and employees should fully understand the terms and conditions associated with their options before making any decisions.