A 5-minute guide to ESOP and why they matter.
- Employee Stock Option Plan (ESOP) grants employees partial ownership of the company.
- ESOP has a vesting period (typically a few years). Employees will receive and accumulate their stock options over that time.
- ESOP helps startups in attracting talent, incentivising good performance, and creating a more equal and trusting work environment.
Whether you’re starting a business, being offered stock options, or simply curious about employee stock ownership, you might have heard of ESOP or Employee Stock Option Plan. Well, what is an ESOP and why do they exist? Here is a simple, intuitive guide to ESOP for the complete beginner.
What is an Employee Stock Option Plan (ESOP)
An Employee Stock Option Plan (ESOP) is an employment benefit that gives workers the opportunity to own a part of the company they work for. This is normally presented as an option to buy shares of the company.
Companies with ESOP typically reserve a pool of their shares for employees. They can either issue these stock options freely or charge an “exercise price” for these shares. This exercise price tends to be priced lower than the market value of the company’s shares.
Here’s a simple illustration. Imagine a startup founder – Adam, who uses ESOP to reward early employees and align their interests with the company’s long-term goals.
For simplicity, imagine that Adam sets aside 100 of his company’s shares for employees. He hires 10 workers and gives them 10 shares each, in the form of stock options. Adam initially decides to set the exercise price of the stock options at $0.10 each. This means that when his employees choose, they can purchase company shares at $0.10 each (Total of $1 for 10 shares).
When the value of the company grows, the value of the shares of Adam’s company grows as well. Thus, when the workers choose to exercise their stock option, they will earn money based on how much the company has grown.
After 5 years of growing the company, Adam’s business grows in value and the price of each share rises with the growth of the company. Now the selling price of a share is $1.10.
When a worker decides to exercise his stock option, he will be buying a share of the company at $0.10. If he decides to, he can sell it at a value of $1.10. Thus, the worker will receive $1 per share in profits. With 10 shares each, the worker will receive $10.
Of course, this example is an oversimplification of how an ESOP typically works. In reality, the amount, form, and rules of each ESOP varies across companies. Also, the number of shares involved would typically be much higher.
Vesting is the process where employees earn their stock options over time. This is meant to provide employees with an incentive to perform well and remain with the company during this period.
Typically, when employees are offered stock options, the shares offered are earned over four years. All the options begin “unvested”- which means they are invalid, and the employee will not be able to exercise their stock options yet. They will only receive their full stock options after the vesting period is over.
Often, there is a “cliff” or “lock-in” period (typically 1 year) before employees start to accumulate their stock options over time. If an employee resigns before the full vesting period is over, they might not receive all their shares. If they resign before the cliff period is over, they will not receive any shares at all.
For startups and small businesses, ESOP can serve as an effective strategy to attract talented employees in the early stages of starting a company. ESOP presents an alternative way to reward early employees by supplementing their salaries with additional compensation. Stock options can be highly attractive to talented employees given the recent rise and upcoming exits of “unicorns” in Southeast Asia. With companies like Grab and GoTo going public by the end of 2021, early employees will be able to cash out their ESOP.
Employee stock ownership creates a direct incentive for workers to contribute to the growth of the company in a meaningful way. When the company grows, so does the value of their shares. This directly aligns the interests of employees and the company in the long term.
In many companies today, the people who own the company do not work for it while the employees do not own any stake in their work beyond a monthly salary. When employees are stakeholders themselves, the people who own the company, work for the company.
The sense of ownership created by ESOP drives worker performance. A study by Rutgers university showed that ESOP companies grew about 2% faster after setting up ESOP. Having “skin in the game” motivates employees and fosters a positive team environment. When everyone has a common long-term goal of growing the company, work becomes more collaborative and efficient.
Want to know more about the multiple benefits that ESOP can bring to your business? Check out 5 Reasons Why Your Company Should Adopt ESOP or 4 ways ESOP helps founders build and retain a high-performing team.
Overall, ESOP can serve as powerful tools to grow your business, incentivize your team at work, and foster an environment of trust and collaboration. Setting up an ESOP can be complicated and time-consuming, but we want to make ESOP easy for you!
If you would like to know more about how ESOP can benefit your business, do contact us! Reach out to us at firstname.lastname@example.org.
Disclaimer: All contents in the article are based on our own opinions and interpretations, and the reader agrees to discharge us of any liabilities for any error or omissions. Article is not meant to be legal or tax advice, but for informational purpose only.