ESOPs - Good tool for startups, but a bet for employees


Indian start-ups 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? Lets analyze.

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 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.

Lets take an example of Alpha Private Limited.
esop-india
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 who’s 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

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 to Employees

  • 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.