Best Guide 2023: What is ESOP and How it Works?

What is ESOP?

Attracting and retaining competent professionals is an uphill task, where company’s try their best to provide all kinds of incentives, bonus, compensation and rights to their human capital. Employee Stock Option Plan or Employee Stock Ownership Plan (ESOP), is one of them, where an employee provides employees the ownership of stocks in the company. It is one of the profit sharing plans.

Startups do ESOP buybacks to give their employees a piece of their achievements. In 2022, Indian employees earned $196.5Mn through these buybacks. Notable startups like Razorpay, Pine Labs, CoinSwitch Kuber, and Cars24 were some of the companies that bought back ESOPs in 2022.

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Eligibility Criteria to get ESOP for Employees

• An employee is eligible for the ESOPs only after he/she has completed 1000 hours within a year of service. 
  
• After completing 10 years of service in an organization or reaching the age of 55, an employee should be given the opportunity to diversify his/her share up to 25% of the total value of ESOPs.

In July 2023, Flipkart began paying cash compensation worth $700 Mn to its employees as part of PhonePe’s demerger from the company. 

Myntra: The online fashion retailer has also been known for its ESOP culture. It has given out ESOPs worth over Rs. 300 crore to its employees over the years.

How an Employee Stock Option Plan (ESOP) Works?

Employee ownership can be accomplished in a variety of ways. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit sharing plan.

ESOPs are a way of giving employees a stake in the company they work for. They are usually offered by startups or companies that want to incentivize their employees to stay with them for a long time and contribute to their growth and success.

ESOPs work in different ways depending on the type and structure of the plan. However, the basic idea is that the company sets up a trust fund that holds the shares of the company. The company then allocates the shares to the eligible employees based on certain criteria, such as tenure, salary, position, etc. The employees do not have to pay anything to receive the shares, but they also do not have any voting or dividend rights until they vest.

Let’s understand the same with an example: 

​The company sets up an ESOP trust. Into that trust, the company can either contribute cash to buy shares of stock from the existing owner(s) at no more than the fair market value, or if the owner does not want to sell shares, the company can issue new shares.

​If the company doesn’t have the cash to do this at the outset, the ESOP can take out a loan to buy new or existing shares while the company contributes money so that the trust can pay its loan.   Employees get shares in the trust, usually distributed according to relative pay. As they work longer for the company, they get an increased right to the shares, also known as vesting. Generally, all full-time employees over 21 must be able to participate in the plan.

Suppose you join a startup as an employee and you are offered 1000 ESOPs as part of your compensation package. The ESOPs have a vesting period of 4 years, with a one-year cliff and monthly vesting thereafter. - The current valuation of the company is Rs. 100 crore, and the current share price is Rs.100. 

The vesting period is the period between the date the options or shares are issued, and the date the participant is able to exercise all of the rights that attach to them. Vesting usually happens over a period of time or based on certain milestones or goals. For example, an employee may vest 20% of their shares every year for five years, or they may vest 100% of their shares when they retire or leave the company. The one year cliff period is a widely prevalent industry practice that requires employees to wait for 1 year for their ESOPs to start vesting.

Year	Shares Vested	Valuation (Rs. Crore)	Share Price(Rs.)	Value of Vested Shares
1	0	100	100	0
2	250	100	100	25,000
3	20.83*12	500	500	1,04,150
4	750	1000	1000	7,50,000

This means that you will not receive any shares until you complete one year in the company. After that, you will vest 25% of your shares (250 shares) and then vest 1/36th of the remaining shares (20.83 shares) every month for the next three years. By the end of four years, you will have vested all your 1000 shares.

Now, suppose after three years, the company’s valuation increases to Rs. 500 crore, and the share price increases to Rs. 500. At this point, you have vested 750 shares (250 + 20.83 x 24). If you decide to sell your shares back to the company, you will receive Rs. 3.75 lakh (750 x 500). However, if you decide to keep your shares and wait for another year, you will vest the remaining 250 shares and have a total of 1000 shares.

If the company’s valuation increases further to Rs. 1000 crore, and the share price increases to Rs. 1000, you can sell your shares for Rs. 10 lakh (1000 x 1000). Alternatively, if the company gets acquired by another company at a higher valuation, you can sell your shares at a premium price and make even more money.

However, if the company’s valuation decreases or remains stagnant, or if the company goes bankrupt or gets acquired at a lower valuation, you may not be able to sell your shares at a profit or even at all. In that case, you may lose your investment or get nothing in return.

Therefore, ESOPs are a risky but rewarding form of employee benefit that depend on various factors such as the company’s performance, growth potential, market conditions, exit opportunities, etc. You should carefully evaluate these factors before accepting or selling your ESOPs.

When an employee vests their shares, they can either sell them back to the company at a predetermined price, or they can keep them and enjoy the benefits of ownership, such as voting and dividend rights. However, if an employee leaves the company before vesting their shares, they usually forfeit them and lose their ownership rights.

Conclusion

ESOPs represent a dynamic way for companies to reward and engage their workforce. By offering employees a stake in the company's success, ESOPs create a mutually beneficial relationship that fosters commitment, motivation, and financial security. As you explore employment opportunities, keep an eye out for companies that offer ESOPs – they might just pave the way to a brighter financial future while you contribute to the growth of a company you believe in. However, ESOPs are not without their drawbacks and risks, and they need to be carefully designed and implemented to suit the needs and goals of both the employees and the company.