How does employee stock option plan in startups work?
The purpose behind ESOP in Startup is to provide a monetary incentive to the employees, that is directly linked to the growth and performance of the business. The basic idea is that the employee makes a financial gain, when the stock price of the startup increases over time.
Many Startups usually have tight liquidity and limited funds available to provide employee salaries/compensation. This might be especially true in the early years of the company. The Employee Stock Ownership Plans (ESOPs) allow the Startup to offer additional and unique monetary incentives to the employees.
Depending on how the Startup ESOP has been structured, the employee might even get ownership of actual shares of the company. While in other cases, the employee just makes a monetary gain when the stock price increases, and does not get an equity stake in the business.
How ESOP works in startup?
Usually, there is a time gap between the beginning of the Startup ESOP scheme and the actual benefit being received by the employee. This is also known as the Vesting Period of the scheme. If the employee leaves in this duration, then he/she will not be eligible for the monetary benefits.
As explained below on this page, the ESOP policy in startups might focus on direct issuance of shares to the employees. Or the focus might be on providing monetary compensation, that is in proportion to the rise in valuation of the company/shares.
When the startup has to give equity shares to the employee in any scheme, the company usually issues new equity shares. This leads to a dilution of the existing shareholders. That is why, the ESOP in startup has to be approved by the current shareholders. Besides this, the regulatory bodies in the region also provide guidelines related to the working of ESOPs in startup.
The dates related to the granting of ESOPs, Vesting Period, and the exercise/maturity of the ESOP is notified in advance. Other details like minimum and maximum equity dilution, eligible employees, assumptions, accounting policies, duration etc. are also published before-hand.
Valuation of Startups
An important aspect to be considered for all ESOP in startups is the valuation of the company at different stages in the scheme. So, the startups try to clearly define the valuation mechanisms that will be used in the equity ownership plan.
A common example of ESOPs in startup is the Employee Stock Option (ESO), which has an Issue Price and an Exercise Price. So, it becomes important to accurately estimate the stock price at different time instances, in order to determine the prices, costs, and benefits of the scheme.
For listed entities, the Market Capitalization can be easily calculated by using the market price of the shares on the Stock Exchange. But for Startups, there is no standard market price or valuation mechanism readily available. So, the valuation of the company during the latest funding round is usually taken as a reference. (Refer: How is valuation of startups done?)
Types of ESOP in Startup
There are different ways of structuring the ESOP plan for startups. The company usually considers the following factors when setting up the employee benefit plan: Seniority of employees, contribution of employees, growth plans of company, fund requirements in the business, approval from investors, plans for IPO (Initial Public Offer), funding stage of the startup (Refer: What are the different Startup funding rounds?) etc.
Some of the most common ESOP agreement in startups have been detailed below. The company might opt for one (or more) of the below schemes, for selected employees.
1. Direct Stock Issuance / Direct Stock sale
This is perhaps the simplest and the most straight-forward method for issuing shares of the company to the employees. There are two ways in which this type of ESOP in startup can work:
Part of compensation: The shares of the company might be offered as a direct compensation tool. This is usually more relevant at the initial stages of the business, like the Pre-Seed Funding round. For example, 5% ownership might be given to a startup founder, who is responsible for the initial marketing of the business.
Injecting funds at the same valuation as last round: This type of equity issuance is offered by some startups that have recently raised external funding from investors. As part of this Stock Ownership scheme, the employees get an option to purchase equivalent shares of the company, at the latest valuation round.
For example, suppose that a company recently raised funds at INR 50,00,00,000 (INR 50 crore) valuation. An employee might have the option to match this valuation, and inject INR 10 Lakh of his/her own money in the business. In return, the employee would receive proportional shares of the company, at INR 50 crore valuation.
2. Phantom shares
The companies which take a conservative attitude towards issuing new equity shares to the employees, usually opt for the Phantom Shares approach. Through this stock ownership plan, the companies issue dummy shares to the employees. So, this is more like a mutual agreement, because no stocks/securities are actually given.
These dummy shares try to shadow the movement in price of the stock of the company. So, the change in price of the Phantom Shares is governed by the increase/decrease in price of the underlying stock. These shares do not have any voting rights, and the settlement happens in cash mode only (because no shares are traded).
Example: Suppose that the Phantom stock has been issued at INR 100 per share to the employees today, and they have a Vesting Period of 3 years. Suppose that after 5 years, the stock price of the company is INR 350, and the employee is leaving the company.
The employee will then receive a monetary amount, that will value his/her Phantom Stock holding at INR 350 per share. This is just a type of financial agreement, and there will be no transfer of actual shares in this example.
3. Share Appreciation Right (SAR)
Just like Phantom Shares mentioned above, the Stock Appreciation Right (SAR) can be used for providing a monetary incentive to the employees. If the stock price of the startup moves up in a pre-defined time period, then the employee will get a payout that is in proportion to the increase in price.
But if the stock price decreases in this defined duration, then no incentive is given to the employee. On maturity, the payout can happen in cash, or in terms of Bonus Shares. But the SARs are not actual shares of the company, and they do not have any voting rights, Dividends, ownership interest etc.
So, the employee will get a benefit of an increase in the stock price of their employer, without the need for actually owning the stock. In case of cash settlement, there will be no Equity dilution for the existing shareholders.
4. Employee Stock Options (ESOs)
The Employee Stock Option is perhaps the most commonly used ESOP plan in Startups. In this scheme, the employees are issued Call Option contracts, which can be used to purchase the shares of the employer, at a defined time and price in the future.
Instead of directly issuing new shares, the employer gives Stock Options, which mature on a future date. The employees get a right to purchase the shares, but it is not mandatory for them to exercise this option. This type of ESOP in Startups can be heavily customized in different ways by the Startup.
Basic example: Let us assume that the current market price of the stock is INR 300, and the Startup issues Stock Options with an Exercise Price of INR 450, and a Vesting Period of 3 years. The Stock Options are given to the employee as a salary component, and the cost of issuance is absorbed by the employer.
After 3 years, the employee gets an option to purchase the shares at INR 450. If the employee chooses to exercise the Options, then he/she would need to pay INR 450 (per share) to the employer, and he/she will receive equivalent shares of the company. The company could issue normal Equity shares that can be freely traded, or it could issue Restricted Stock to the employees.
5. Employee Stock Purchase Plan (ESPP)
The Employee Share Purchase Plan or a Direct Stock Purchase Plan is mostly used by Startups that are big in size, or that have already listed on the Stock Exchange. As part of this incentive scheme, the employees can buy the shares of their employer at a discounted rate.
This discount on the stock purchase can be offered as a direct cash deduction from the purchase price. Or it could be in the form of additional/bonus shares, which are issued in proportion to the quantity that was purchased by the employee.
The scheme is usually voluntary in nature, where the employees can choose to regularly contribute a portion of their monthly salary towards the stock purchase. The acquired shares can only be sold after a minimum holding period has completed.
Trading of Startup equity
After the Vesting Period is over and the employee gets ownership of shares through the Startup ESOPs, he/she is free to trade the stock in open market. For unlisted startups, the shares are traded Over the Counter (OTC), while for companies that list in the future, the shares could simply be sold on the Stock Exchange.
Since the shares of unlisted startups might not be traded easily, some startups also propose to Buyback the shares from their employees at regular intervals. Few startups even offer to buy-back the Stock Options, Phantom Shares and SARs from their employees, based on the latest valuation of the company.
On the other hand, if the employee leaves the company in between the scheme, then he/she usually forfeits the benefits that he/she could have received in the future. So, another major reason of using ESOP in startups is that it can help in improving the employee retention in the company.
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