ESOP

Understanding the Benefits of Implementing ESOPs for Startups in India

May 10, 20232945 views0

ESOPs or equity compensation is a strategy startups leverage to attract valuable talent and cultivate loyalty amongst existing employees. The business world is rife with stories of successful companies that offered Employee Stock Option Plans, or ESOPs, early on.

For instance, technology giant Infosys’ ESOP scheme, launched in 1994, is considered a benchmark for Indian startups. As Infosys shares appreciated, the company’s ESOP scheme enabled thousands of employees to enjoy monetary benefits.

The battle for valuable talent continues in India, as does the battle to lower attrition. Equity compensation can play an important role in enabling startups to build a competitive edge against established businesses in their field.

In this blog, we understand how startups can leverage equity compensation as a long-term recruitment and retention tool and outline the benefits of implementing ESOPs.

What is Equity Compensation?

Salaries and benefits are not the only way a company can compensate its employees. Equity compensation offers them an ownership stake in the business provided they satisfy certain conditions within the timeframe per the contract terms.

Once the terms have been satisfied employees get access to shares in the business, which become a part of their investment portfolio.

As the business becomes profitable, the employee’s shares also appreciate. The chance to have an ownership stake in the business also translates to deeper psychological ownership in the employees. It nudges employees to remain in the company, motivates them to contribute to its development significantly, and aspires them to be part of the leadership pipeline.

Eligibility for ESOPS

In India, the Companies Act, 2013, under Section 62 (1)(b) states that a company may offer shares to the employees under the employees’ stock option scheme.

However, certain employees are not eligible for ESOPS. This includes employees belonging to the company’s promoter group or directors who directly or indirectly hold over 10% of outstanding equity shares of the company.

Benefits of Implementing ESOPs for Startups

Let’s look at some benefits of ESOPs:

Attractive Perks

A startup may not have the resources to pay a competitive salary compared to established businesses and well-funded startups.

In such a scenario, ESOPs can be an attractive perk to hiring and retaining employees with the right skill sets.

For example, when Google went public, the employees with ESOPs became millionaires. Such stories have set a precedent for startups and resonate with ambitious professionals looking to be stakeholders in a business.

Monetary Benefit

Access to ESOPs comes with the promise of a monetary benefit in the future and a chance to play a larger role in the business. They can also get a tax benefit should they decide to sell shares in the future because the profits are taxed as capital gains and not ordinary income.

Maintain the Workforce

For companies, equity compensation is a competitive tool for hiring and retaining team members. They can do so without compromising the cash flow balance, which is important for operational efficiency and sustainability.

Equity Compensation and ESOPs

Equity compensation can be awarded in three ways.

Under the ESOPs, employees can purchase company shares at discounted prices. If they hold on to the shares for a specific time frame, the employees can enjoy certain tax breaks.
Restricted stock units (RSUs) are awarded by the company on the completion of specific milestones or a timeframe spent at the company. Employees do not need to buy them.
Under the Employee Stock Purchase Plans (ESPPs), employees can purchase discounted shares of the stock through automatic payroll deductions to fund their ESPP account.On each purchase date, the funds go towards purchasing the stock at a price lower than the market value, between 5% and 15%, unlike if they purchased them off the market.

As we can see, a company can structure its equity compensation schemes in several ways. Hence, it is imperative to have a strategic plan based on the startup’s growth stage and its financial and employee growth goals.

How to Build an Equity Compensation Plan

ESOPs need to be designed effectively for them to be successful in achieving the company’s goals. Several factors must be kept in mind when doing so.

1. Early Stage

A startup in the early stages has more equity to offer; equity compensation can be leveraged as a hiring tool.

In the growth stage, the startup must retain valuable employees in key roles, and the role of ESOPs may shift to retention.

2. Mature stage

As the startup matures, say after series B fundraising, equity compensation will need to be rolled out very selectively, as the equity available is limited.

At this point, a company can consider alternatives like phantom shares, which mirror the value of equity shares but do not offer an equity stake.

No matter how they choose to proceed, startups must design equity compensation plans with a long-term growth perspective.

Key Takeaway

Research indicates that companies that provide ESOP tend to grow faster than their counterparts in terms of annual employee growth and sales growth.

It has also been observed that the company’s growth trajectory spirals after the roll-out of ESOPs, a phenomenon that has come to be known as the ‘ESOP effect.’

However, the key to success for an ESOPs scheme is to build a strategic plan that aligns with the company’s finances, plans, and business goals. Employees must be offered the proper equity compensation, with careful attention to the terms and conditions of each agreement.

To build an effective equity compensation plan, startups can partner with a specialist with expertise in designing ESOPs with a long-term perspective.