Employee Stock Option Plans (ESOPs) are part of policies to attract, motivate and retain employees by organizations. Thanks to the startup ecosystem, ESOPs have become a famed instrument amongst new emerging organizations. Earlier, they were usually offered to senior employees for their long-term association with the organization but in this new age, it has become a tool to attract the best talent by startups. An ESOP is a plan that offers an option to the employees to purchase the equity shares in an organization at a discounted price.
Startups need to design the ESOPs scheme before granting options to the employees. For startups, it is imperative to fix the number of shares to be granted in an option rather than fixing the percentage stake because the equity stake will be subjected to dilution with further fundraising or another option plan. The option has to be exercised during a specific period and must have a termination clause followed by the exit of an employee from the organization.
ESOP is an instrument that helps save cash for a startup in its initial phase. There is no denying the fact that every startup wants the best talent for its venture. However, the best talent comes at a price. One may be required to design a very competitive compensation structure to attract them. But ironically, startups are usually not in a position to shell out a huge amount of cash on salary cost. At an early stage, ESOPs come into play for cash conservation. The potential employees are attracted by giving them the option of purchasing an equity stake in the company. On the contrary, they are made to sacrifice on their cash component of salary structure to an extent where it does not affect their lifestyle. The instrument has proved to be beneficial as it aligns the organizational goals with the employees’ personal goals. The employees holding the ESOPs are motivated to work towards the success of the organization. They take the onus of fulfilling the business’s vision and mission along with the founder(s). They become the part owner of the company and thus, would be liable to the share of company’s profits. Due to this, the employees’ give their best shot to grow and nurture the startup and take it to the next level. As an entrepreneur, when you are hiring talent from the industry – you would typically ask the individual to take a 20-30% haircut in their existing salary and make up for that gap through ESOPs.
For the early hires, the cash component in their salary remains low as the startups try to balance it out by offering ESOPs. There is a risk associated with such plans. There can be a decline in the value of equity that an employee holds if the startup is unable to show up the requisite results. On the other hand, for founders – ESOPs lead to equity dilution of their holding.
Although it might involve dilution for existing owners and future uncertainty for the employees, the benefits from such plans outshine its downside. They have even been successful in compelling the talented employees working with big and stable organizations to leave their existing jobs and join a startup. Such can be the power of ESOPs if designed diligently.