The most pivotal asset a company has is its workforce. Therefore, it is not only vital to hire outstanding talent, but it is also critical to retain them. It’s only then that a business grows.
The reason is simple. A high attrition rate is expensive. The repetitive cycle of finding, onboarding, and training talent leads to a bleeding cash outflow. Besides, the business sorely lacks engaged, vested employees.
Cash incentives are one route to attracting top talent, as attested by the economic principle of efficiency wages. Paying the workforce wages higher than the market equilibrium lures better candidates. It is also an effective path to making employees more committed and amplifying productivity.
But cash inducements work only in the short term. Employees need more than that to remain with a firm. It necessitates a more robust strategy to retain talent. ESOPs are one of the best tools to do so.
What are ESOPs?
Employee Stock Ownership Plan (ESOP) is an employee benefit scheme. It gives the workforce equity ownership in the organization through stock shares.
Here’s how they work: After an employee is hired, they are offered a grant letter that gives them the option to buy a certain number of company stocks within a set period. After the cliff period is over (12 months in India), the options are vested, i.e., the employee gets a percentage of the total committed ESOPs.
The employee now can exercise the options, meaning purchase the stock at an exercise price. The price is either a predetermined nominal amount or a discounted current share price. The actual benefit to the professional is at the ESOP liquidity stage. The employee can sell the stocks during a secondary sale, through ESOP buyback, or when the company lists on an exchange.
Types of ESOPs
- The most prevalent way for employee’s to get some ownership in the startup they work in is via employee stock option schemes. Under ESOS, the employee simply gains the right to the shares. If the vested options are exercised at a pre-agreed price then the employee comes to own the shares.
- Employee Stock Purchase Plans (ESPP) give employees the option to buy shares of their company at a price lower than the Fair Market Value (FMV).
- Restricted Stock Units (RSU) entitles an employee to receive stocks at a given date if they fulfil set conditions. The stocks are withdrawn if the underlying terms are not met.
Stock Appreciation Rights don’t fall under ESOPs, but they are often treated as such. SARs are cash-based incentives. They grant an employee the right to a cash equivalent of a stock’s price gains over a pre-decided interval. The employee doesn’t pay an exercise price with SAR; rather, they receive either cash or stock. This form of compensation is beneficial to the employee when the company stock price rises.
Why Are ESOPs Excellent for Employee Acquisition and Retention?
ESOPs have become the accepted tool for hiring the most qualified talent for startups and businesses alike because they bring in a strong potential pool without the necessity of a fat salary.
They also help in retention because once granted ESOP, the employee has a vested interest in the company’s performance. If the business succeeds, they get a part of the profit earned. On the other hand, if the company doesn’t fare well, the employee suffers losses too.
This aligns an employee’s personal goals with that of the business. They are motivated to work harder, are engaged, and become more productive because they know the better they work, the bigger their profit share.
Essentially, ESOPs become the impetus for employees to work harder and take the startup to the next level. Rutgers University found that compared to a business with no ESOPs, companies with ESOPs increase sales and employment by about 2.3% to 2.4% per year. Furthermore, organizations that offer ESOP have a higher probability of staying in business for more years.
Overall, ESOPs are mutually beneficial. They boost morale and keep good talent within the business, generating more value for the organization. For employees, they create wealth while rewarding hard work.
One last reason ESOPs work so well with retaining good employees is that they are rare. In India, only 43% of IT firms have given ESOP to employees. For non-IT firms, the percentage is as tiny as 17%.
In the US, NCEO estimates the number of unique companies with an ESOP is approximately 6,272. Compared to the total number of companies in the country, the percentage is minuscule.
This makes the wealth-creating tool valuable, giving the push that workers need to stay with a business. Since it is unlikely that their new employer will provide the same.
A solid retirement plan for US-based companies
Another reason ESOPs make an effective employee retention strategy is no additional cost for the workforce. Standard retirement plans require both the employee and the employer to contribute. However, in most ESOPs, the contribution is entirely from the businesses.
Add into the bargain that the contribution is far more substantial. For instance, 401(k) plans contribute 4% of pay per year. ESOP contributes to 6 to 8% of pay per year. Also, the rate of return is much higher with ESOPs. In a gist, they make great retirement plans urging employees to stay with the firm.
The key to building an effective ESOP strategy
Any founder hoping to retain an engaged employee who wishes to generate wealth needs a solid compensation plan. ESOPs are a crucial part of it since they benefit both employer and employee.
- The rule of thumb to building an effective ESOP strategy is to create equity pools for founders, co-founding teams, and employees right at the start. The pool should be double-digit because a larger pool is more advantageous. But this can vary based on the founder’s needs.
For example, a single founder has more equity to share, whereas a team of 5 co-founders has very little. So a single or two-person founding team is better placed to use ESOPs as a hiring tool.
- As the startup moves from foundation to valuation to growth, the stock option plan should change. This is important because, right at the beginning (early stage), founders need fewer employees. Plus, these employees are taking as much of a risk as the founder. Hence, their return on ESOP should be higher than that of an employee who joins during the growth stage.
Moreover, taking a one-size-fits-all approach grants all employees an equal number of options. It doesn’t factor in their experience or skill. Consequently, you could be giving away a precious asset without gaining a return. If there are employees who would rather take the cash, it isn’t necessary to grant them an equal number of options as an employee happier with lower cash compensation.
- Make sure that your equity plan remains the same for all three stages (foundation, validation and growth). That consistency is necessary throughout the grand term (10 years as per industry best practices).
- Do not copy another founder’s equity plan. The reason being your business is likely different from theirs, so is the market and the profit margins. Build a plan tailored to your revenue and business.
An effective ESOP strategy can be the magnet that pulls and retains top talent. But for that to happen, a solid equity plan is essential for any startup.
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