IBS Consultants corporate legal - What are ESOPs?

The concept of start-up business has gained an increased attention since the development of technology. Business and technologies go hand in hand, but while in the process to start a startup business, an entrepreneur must be equipped with all the necessary factors and elements of the business, that will result in sustaining the business in market for a longer period of time. Factors of business revolve around several technical and legal elements. To have a clear understanding of these factors, an entrepreneur must always take an expert by his/her side in order to effectively develop a strategy that will increase the business potential in the market. While we talk about experts, IBS Singapore makes the best choice for entrepreneurs to walk to, wherein business is provided with wide range of services like Incorporation services in Singapore, Compliance advisory services in Singapore and several other services related to financial reporting in Singapore and information security management services in Singapore. Start-ups also have to consider certain important areas of business, one of which ESOP is elaborated as below.

ESOPs – This became the catchphrase when IT companies like Infosys turned employees into millionaires overnight post IPO and a with a series of annual ESOP offerings. An acronym for Employee Stock Option scheme, ESOPs refer to plans that give employees the right to purchase a certain number of company’s shares in lieu of salary.

The startup ecosystem has witnessed various companies like Flipkart, Skype, Facebook, and Amazon offering ESOPs to its employees and has seen an increasing number of Indian startups following suit.

In this edition, we will look at the ESOPs and discuss the pros and cons of the gamble for a Startup.

ESOP trend in Start ups

2016 saw some successful startup acquisitions where the employees made huge gains and become crorepatis with ESOPs – most notable being the buyout of Citrus Pay by online service provider PayU. The $130 million acquisition made 15 employees crorepatis, that included even an office boy who took home Rs.50 lakhs. The Citrus Pay crorepatis encashed their ESOPs and hit the jackpot. The second half of 2016 especially saw an increase in the mergers & acquisitions of startups.

The startup ecosystem is currently marked by mergers & acquisitions and buyouts. The trend is likely to continue as funding gets increasingly difficult. Startups have two ways to encash their ESOPs – through listing or when it is bought. The latter is a more realistic option, since listing looks a bleak possibility for any Indian start up. ESOPs are more of a lottery and as startups move towards consolidation, the chances of winning this lottery brighten considerably.

ESOPs were made popular by IT legends couple of decades ago but the trend got revived by the startups with a vengeance. The ESOP case helps founders to attract talent, instill a feeling of ownership in their employees and also ease the monthly cash flow in the name of compensation in the initial bootstrap days.

The Flip side…

For every great story of exit of ESOP holders, there are a dozen others where companies have folded. In US too, there have been cases when a lot of paper millionaires ended up with nothing in their wallet when their stock options turned out to be worthless. Many a times, ESOPs don’t materialize.  Startup employees will have to assess and understand the risks while opting for ESOPs. While it is ok to take risks, it is necessary for an employee to ensure that he/she is not trading one’s basic necessities for ESOPs.

Part of the problem lies in the misleading or unclear communication about potential value by the prospective employer who wants to pitch it as pot of gold. Unless the investor or public actually pays for the value that the startup is commanding, all gains are notional.

Also, employees have inadequate understanding of the risks with ESOPs, payouts, and other issues like exercise price and fair value. Misleading information of this nature tends to give ESOPs a bad name, but one can’t really blame the vehicle for these ambiguities.

How Startups can use ESOPs?

For a Startup, ESOPs are a useful tool to not just attract but also retain high talent individuals who can participate in its journey. We are currently witnessing new shifts in the Indian job market, where enterprising individuals are opting to work for a passionate idea and are ready to take salary cuts in lieu of high rewards later. The onus is therefore on the founders to be able to communicate their vision and retain the right candidates through appropriate ESOPs. Besides enlisting employees as stakeholders, Startups can also aim for better working capital management in the initial years. 

The ESOP agreement should clearly lay down all the governing terms & conditions. Startups may either create trusts or create an ESOP pool to manage the functioning.  All the details of an employee’s grant should be correctly captured, right from the vesting period to even shut down – to avoid any discrepancies. While the ESOPs should take care of employee rights, Startups should safeguard their objectives and accordingly devise appropriate vesting periods and other terms for its employees. ESOPs provide a great opportunity to create wealth and the excitement and scope that it offers in a startup makes it worth the effort.