ESOP Scheme for Startups

Overview

Startups are created for new business ideas and may have some constraints in initial stages like liquidity problems and hence they come up with innovative ways to compensate employees. Share based payments are one such innovative way to compensate the employees. ESOP schemes for startups are a share-based compensation given to the employees which is greatly valued in the startups as it provides the founding employees with a sense of ownership and belongingness towards the company. Although startups are not listed on stock exchanges however, they can allocate a proportion of the share equity to the employees to attract top talents to join and work for them just like publicly listed companies. ESOP for startups helps to retain the employees for a longer period and acts as value generation aligned with the organisation growth.

How startups can set up ESOP Scheme

Most startups are private limited companies and hence are governed by the Companies Act, 2013. This act allows the allotment of shares to employees, under an approved Employee Stock Ownership Plans (ESOP), at a future date at a pre-decided price. ESOP schemes for startups can be issued only if at least 75% of majority shareholders approve it. A startup can allocate a certain percentage of its equity, ranging from 10% to 15%, to create an ESOP pool. The pool size needs to be a strategic decision as it should be large enough to provide meaningful incentives to the employees while making sure that the dilution of existing shareholders' equity is within acceptable limits.

Another critical aspect is the grant size of the ESOP scheme for startups, the number of ESOP shares granted to an individual employee should take several factors into consideration such as their role within the company, their seniority, and their contribution to the organisation’s success. The exercise price is also a crucial element as it directly impacts the potential financial benefit for the employees and the attractiveness of the ESOP as an incentive. The most important thing that needs to be looked after is the dilution. Startups need to carefully manage that the dilution is within acceptable limits and does not harm the interest of the existing shareholders. Overall, a startup needs to take an expert’s advice before issuing ESOP shares as it requires careful planning, ongoing management, and should follow all the regulatory compliance.

Different types of ESOP for startups can issue

Startups can issue below-mentioned types of ESOPs:

1. Incentive Stock Options (ISUs) - These are stock options provided by employers that permits employees to purchase stock at a fixed price within the specified time. The employees must adhere to specific requirements when opting for these options. ESOP taxation for startups differs from ISO taxation, in which employees pay capital gains tax only when they sell their shares.

1. Non-qualified stock options (NSOs) - This type of stock option can be provided to employees as well as board members. It allows an employer to sell stocks for a specified price at any time during a specified period. When NSOs are exercised, the difference between the exercise price and the fair market value of the stock is considered as prerequisite as ordinary income and is subject to payroll taxes. Any future increase is taxed as capital gains upon the sale of shares. These may be more flexible than ISO.
2. Restricted Stock Units (RSUs) - These are the company shares given to employees that are subject to restrictions such as employee performance and the company’s financial targets. Hence, RSUs cannot be unlocked or liquidated unless the pre-decided conditions are met.
3. Restricted Stock Awards (RSAs) - Although these sound similar to RSUs but they are quite different as under this option the stocks are immediately issued to the employees, allowing them to own the shares along with the benefits associated with it. The only restriction is the vesting period during which the employee cannot sell the shares. Employers may set some conditions, which if not met or if the employee leaves the company before the vesting period is over, employees may have to forfeit the RSAs.
4. Stock Appreciation Rights (SARs) - These options allow employees to receive appreciation in the value of a specified number of shares over a set period, usually in cash. These do not lead to equity liquidation as employees only get the amount of increased value on the allotted shares. Employees are taxed on the value received at the time of exercise as ordinary income. Also, employees don’t need to pay the exercise price as they do for regular ESOP.
5. Phantom Equity Plan (PEP) - PEP and SARs are used interchangeably but there’s a slight difference between them. PEP doesn't include actual stock and only provides the employee with the increased share value benefit. It operates like a bonus rather than a stock option, with the company granting it to employees on a set future date, subject to certain conditions. Employees cannot exercise it at their discretion within a specific time frame.
6. Employee Stock Purchase Plan (ESPP) - This ESOP gives employees the ability to purchase shares of the company stock at a discounted or lower than the fair market price. The ESPP allows the employees to make periodic investments into the company’s stock, increasing their ownership interest in the business. With every investment, the employees receive dividends. The company can offer the employees to participate in ESPP every year by investing annually or through payroll deductions.

Pros of ESOP for Startups

ESOP schemes for startups offer numerous benefits to startups as well as to employees. For Startups ESOPs offer the following benefits:

1. Attract and retain top talent - By offering ESOP for startups, companies can attract high-calibre entrepreneurial individuals who look for long-term rewards and by aligning the vesting period with this long-term need, they can retain employees for a longer period in the organisation. Also, employees who own equity in any company are most likely to stay committed to the company’s success over a long time. 
2. Employee motivation and productivity - ESOP plans for startups are granted to the employees, they adopt an ownership mentality, ready to take greater responsibility for the company’s success. Also, ESOP schemes help to align the interests of employees with those of the company, leading to a higher level of motivation and productivity. 
3. Cash Flow Conservation- Offering ESOP shares to employees helps startups conserve cash which is important during their growth stages. Startups can offer lower base salaries along with stock options, helping manage operating expenses.
4. Potential for Wealth Creation- If the startup grows and becomes successful, the ESOP valuation of the shares can increase significantly, providing substantial financial rewards to employees. The potential for financial gain incentivizes employees to work harder and contribute to the company’s growth and profitability.
5. Market Perception- Companies that offer ESOP share are viewed favourably by the public as it shows how well-managed they are and how much they value their employees and foster a positive work environment.

For employees ESOP shares offer the following benefits:

• Financial Benefits - ESOP shares provide a potential for wealth creation to employees which increases the income of the employees. Employees may receive dividends on a few ESOP, providing them with additional income.

• ESOP tax- Employees don’t need to pay taxes on ESOP shares until they cash the stocks out so it is a tax-deductible contribution.

• Retirement Benefits - ESOP for startups can be a valuable component of an employee's retirement savings plan, providing an additional source of retirement income and financial security.

• Equity and Fairness - ESOP for startups help distribute wealth among employees and allow them to share in the company's success, which makes them feel recognized and rewarded for their contributions to the company's growth and profitability.

Cons of ESOP for Startups

Just as ESOP shares provide certain advantages, they have certain disadvantages too. For Startups ESOP shares have the following shortcomings:

1. Ownership Dilution - ESOP for startupsOffering to employees dilutes the ownership percentage of existing shareholders, whose main concern can be wanting more control.
2. Complexity and Costs - Setting up an ESOP scheme for startups can be costly as it involves legal, accounting, and administrative fees and complex as it requires continuous administration.
3. Regulatory Compliance - ESOP schemes for startups must comply with a complex set of federal and state regulations, which can be burdensome for startups to navigate.
4. Impact on Cash Flow - If the employees leave or retire, the company may be obligated to repurchase their shares. Also, if the company pays dividends, then it will have to distribute the additional cash to the ESOP participants, impacting the availability of funds to reinvest.

For employees ESOP for startups may have the following shortcomings:

1. Financial Risk - Employee’s financial well-being may be overly dependent on the company’s performance. If the company performs poorly, then it might have a severe impact on retirement savings and investment of the employees.
2. Liquidity Issues - Startups are mostly private companies that have no readily available market for employees to sell their shares. In a few cases, employees need to wait for specific occasions (such as retirement, termination and company buyouts) to get access to the funds.
3. Impact on Compensation- Companies offer low base salaries in exchange for ESOPs which might not be favourable for employees needing immediate income.
4. Limited exit opportunities- Employees may be restricted from selling their shares for a certain period, limiting their ability to realise gains or move on to new opportunities.

Conclusion

ESOP schemes for startups can benefit startups by driving growth, fostering loyalty, and enhancing performance. However, they require careful planning, administrative effort, and ongoing management for regulatory compliance and alignment with strategic goals. Startups should thoroughly analyse their specific needs, goals, and resources before implementing an ESOP. Consulting with legal, financial, and HR experts can help optimise the implementation. When executed thoughtfully, an ESOP plan for startups can be a win-win strategy, promoting long-term success and shared prosperity.