What is ESOPs? Meaning, How They Work, Benefits & Drawbacks

Ever wonder how CEOs like Sundar Pichai, Jeff Bezos amass millions and are some of the richest people on the planet? Salaries are a part of it, yes, but the real game-changer? Stock options.

Take Mark Zuckerberg for example, his base salary at Meta is just a measly $1. But in 2023, the value of his stock options in the Meta was a staggering $125 billion, which contributed to his gigantic net worth! That’s right, billions with a “B.”

Similarly, Jeff Bezos, founder of Amazon, received a fixed salary of $81,840 for decades. But his significant stake in Amazon (8.8%) has propelled him to billionaire status, with his current net worth exceeding $214 billion.

The good news is that you don’t need to be a CEO to get an opportunity to participate in a company’s equity plans. There is a clear global trend for both large corporations and early-stage startups to take equity compensation seriously at all levels of the organization – not just when it comes to executive compensation. 

If you have an opportunity to receive ESOPs at your current company or from a prospective employer, or you already have ESOPs and have no idea what this all means for you, you’ve come to the right place. ESOP full form is employee stock option plans.

In this article we will dive deep into the world of employee equity, explaining how it works, its benefits and drawbacks, and how to navigate this exciting yet complex form of compensation. This way, you can make the best possible decision given your individual circumstances as you weigh your options (no pun intended).

What is ESOPs: Ownership and Opportunity

In the United States, ESOP refers to an employee stock ownership plan, which is a type of retirement plan where employees contribute a portion of their salary towards company stock. In India, however, ESOP meaning changes a bit and it typically refers to employee stock option plans (ESOPs).

An ESOP grants employees the right, but not the obligation, to purchase a predetermined number of shares in their company’s stock at a pre-set price (exercise price) after a specific period (vesting period). This essentially allows employees to become part-owners of the company they work for.

How do ESOPs work?

The lifecycle of an ESOP typically involves these steps:

1. Company Design and Approval: The company drafts an ESOP plan and gets shareholder approval.
2. Granting Stock Options: Employees receive a “letter of grant” outlining details like the number of shares they can buy, the exercise price, and the vesting schedule.
3. Vesting Period: This is the timeframe employees must remain with the company to gain ownership of their stock options. Vesting schedules can be structured in various ways, such as a cliff vesting period where employees don’t acquire any ownership rights until a specific date, or a gradual vesting schedule where they gain ownership rights in increments over time.
4. Exercising Stock Options: After the vesting period ends, employees have the right to “exercise” their stock options, meaning they can purchase the allotted shares at the pre-determined exercise price.
5. Selling or Holding Shares: Employees can then choose to sell their shares on the open market (if the company is public) to generate a profit, or hold onto them with the expectation that the company’s value will continue to grow.

A Simple Example:

Let’s understand how ESOPs work with a simple example. Let’s say Raj works at ABC company and has received ESOPs as a part of compensation.

However, there’s an initial waiting period, typically one year (can vary), known as the cliff period. Raj needs to complete this period to be eligible for any stock options.

After the cliff period, ABC issues Raj a certificate. This document formalizes the initial grant, specifying the number of shares he has been awarded. It’s important to remember that Raj doesn’t become the immediate owner of these shares.

The Vesting:

The certificate also outlines the vesting schedule. This schedule defines the timeframe during which Raj needs to remain with the company to gain full ownership of the ESOPs. Let’s say the vesting period is four years, with ownership gradually increasing each year.

Year 1: Upon completing the first year, Raj becomes 25% vested. This means he now owns 25% of the total shares granted under the ESOP plan.

Year 2: Completing year two grants Raj an additional 25% vested ownership, bringing his total ownership to 50%.

Year 3: With year three complete, he becomes 75% vested, owning 75% of the total shares.

Year 4: Finally, upon finishing year four, Raj reaches 100% vesting, granting him full ownership of all the shares included in her ESOP offer.

Exercising the ESOP:

Once fully vested, Raj enters the exercise period. This allows him to exercise his options, meaning he has the right to purchase the shares at a pre-determined price (mentioned in the initial grant certificate).

 

The Allure of ESOPs: Potential Benefits for Employees

• Wealth Creation Potential: If the company experiences significant growth and its stock price climbs, employees can achieve substantial wealth creation by exercising their stock options and selling the shares at a much higher market value. This can be a life-changing benefit, particularly for employees who have been with the company during its early high-growth phase.
• Increased Ownership and Engagement: ESOPs foster a sense of ownership among employees. They are no longer just working for a paycheck; they are working for a stake in the company’s success. This increased sense of ownership can lead to greater engagement, motivation, and a more entrepreneurial spirit within the workforce.
• Long-Term Focus: Vesting periods encourage employees to adopt a long-term perspective. Knowing that their financial rewards are tied to the company’s long-term success incentivizes them to make decisions and take actions that contribute to the company’s sustainability and growth.

Understanding the Rationale Behind ESOPs: Benefits for Companies

Companies leverage ESOPs for a multitude of strategic reasons:

• Motivation and Alignment of Interests: When employees own a stake in the company, their personal success becomes intricately linked to the company’s performance. They have a vested interest in driving growth and profitability, as their efforts directly translate to increased stock value and potential wealth creation for themselves. This fosters a win-win situation, where employee motivation and company success are mutually reinforcing.
• Retention Strategy: In today’s dynamic job market with high employee turnover, ESOPs with multi-year vesting periods incentivize employees to stay with the company for the long haul. This not only reduces recruitment and training costs but also fosters a more experienced and stable workforce, contributing to overall organizational effectiveness.
• Attracting Top Talent: ESOPs can be a powerful tool for attracting skilled professionals, especially in competitive industries. Offering equity alongside a competitive salary package makes the company a more attractive proposition for top performers.Cash-strapped companies can use ESOPs to attract skilled employees by offering future wealth potential. This not only enhances the company’s talent pool but also fosters a culture of excellence.
• Building a Shared Vision: When employees have a stake in the company’s ownership, it creates a stronger sense of collective ownership and a shared vision for the future. They become more invested in the company’s success and are more likely to go the extra mile to contribute to its long-term goals. This collaborative spirit can lead to a more engaged and productive workforce.

The Other Side of the Coin: Potential Drawbacks of ESOPs

• Lackluster Company Performance: If the company’s value stagnates or declines, employees holding ESOPs might see little to no return on their investment, or even experience a loss if they exercise their options and the stock price falls below the exercise price.
• Concentration risk: Employee Stock OPlans (ESOPs) can be a great way to share in your company’s success. However, they can also lead to a concentration risk in your portfolio. As your ESOPs vest and their value increases, a significant portion of your wealth becomes tied to the fortunes of just one company. This can be dangerous if the company’s stock price falls. To create a more balanced portfolio, it’s wise to spread your investments across various companies.This way, a downturn in one company won’t devastate your overall wealth.

For those holding ESOPs or Restricted Stock Units (RSUs) in a public foreign company, Vested offers a unique solution. Now you can sell your ESOP/RSU proceeds and re-invest the proceeds abroad without repatriating the funds back to India.

• Liquidity Challenges: Even with a successful company, employees may face limitations in selling their shares when they desire. Liquidity typically comes through an IPO (Initial Public Offering) where the company goes public, employee stock buyback programs offered by the company, acquisitions or mergers, or rarely, grey market sales to specific investors. These options can be limited or unpredictable, potentially impacting employees’ ability to access their gains quickly. 
• Tax Implications: Understanding ESOP taxation is crucial. In some cases, employees might end up paying taxes twice on their stock options. Once when they exercise their options (on the difference between the exercise price and the fair market value at that time), and again when they sell the shares (on the capital gains). This can add complexity and potentially reduce the overall gains.

Do Your Research Before You Dive In:

Before getting swept up in the excitement of ESOPs, it’s essential to carefully consider these factors:

• Company Performance: Research the company’s track record, future prospects, and industry outlook. Is it in a high-growth industry with strong potential for success? Can the company’s valuation grow from here?
• Financial Stability: A financially sound company with a proven track record is more likely to offer valuable ESOPs with a higher chance of generating returns.
• Vesting Schedule: Understand the vesting schedule and how long you need to stay with the company to gain full ownership of your stock options. A longer vesting period can lock you in for a considerable time.
• Tax Implications: Seek professional advice to understand the tax implications of ESOPs in your specific situation. Tax laws can be complex, and proper planning can help you maximize your gains.

A Strategic Approach to ESOPs

Employee stock options can be a powerful tool for wealth creation and employee motivation. However, a strategic approach is necessary to maximize the benefits and mitigate potential risks. Carefully weigh the pros and cons, understand the company’s performance and financial health. By understanding the benefits and drawbacks of ESOPs, you can make informed decisions about whether they are the right fit for you and your career goals.