A 5-minute guide to ESOP and why they matter
What is an Employee Stock Option Plan (ESOP)
An Employee Stock Option Plan (ESOP) is an employment benefit that gives workers the opportunity to own a part of the company they work for. This is normally presented as an option to buy shares of the company.
Companies with ESOP typically reserve a pool of their shares for employees. They can either issue these stock options freely or charge an “exercise price” for these shares. This exercise price tends to be priced lower than the market value of the company’s shares.
Example:
Here’s a simple illustration. Imagine a startup founder – Adam, who uses ESOP to reward early employees and align their interests with the company’s long-term goals.
Adam distributes stock options to employees from the ESOP pool
For simplicity, imagine that Adam sets aside 100 of his company’s shares for employees. He hires 10 workers and gives them 10 shares each, in the form of stock options. Adam initially decides to set the exercise price of the stock options at $0.10 each. This means that when his employees choose, they can purchase company shares at $0.10 each (Total of $1 for 10 shares).
As the company grows, so too does the value of the shares
When the value of the company grows, the value of the shares of Adam’s company grows as well. Thus, when the workers choose to exercise their stock option, they will earn money based on how much the company has grown.
After 5 years of growing the company, Adam’s business grows in value and the price of each share rises with the growth of the company. Now the selling price of a share is $1.10.
During an exercise period, employees can buy shares at the exercise price and sell them at market value if they choose
When a worker decides to exercise his stock option, he will be buying a share of the company at $0.10. If he decides to, he can sell it at a value of $1.10. Thus, the worker will receive $1 per share in profits. With 10 shares each, the worker will receive $10.
Of course, this example is an oversimplification of how an ESOP typically works. In reality, the amount, form, and rules of each ESOP varies across companies. Also, the number of shares involved would typically be much higher.
Vesting
Vesting is the process where employees earn their stock options over time. This is meant to provide employees with an incentive to perform well and remain with the company during this period.
Typically, when employees are offered stock options, the shares offered are earned over four years. All the options begin “unvested”- which means they are invalid, and the employee will not be able to exercise their stock options yet. They will only receive their full stock options after the vesting period is over.
Often, there is a “cliff” or “lock-in” period (typically 1 year) before employees start to accumulate their stock options over time. If an employee resigns before the full vesting period is over, they might not receive all their shares. If they resign before the cliff period is over, they will not receive any shares at all.
Why ESOP
For startups and small businesses, ESOP can serve as an effective strategy to attract talented employees in the early stages of starting a company. ESOP presents an alternative way to reward early employees by supplementing their salaries with additional compensation. Stock options can be highly attractive to talented employees given the recent rise and upcoming exits of “unicorns” in Southeast Asia. With companies like Grab and GoTo going public by the end of 2021, early employees will be able to cash out their ESOP.
Employee stock ownership creates a direct incentive for workers to contribute to the growth of the company in a meaningful way. When the company grows, so does the value of their shares. This directly aligns the interests of employees and the company in the long term.
In many companies today, the people who own the company do not work for it while the employees do not own any stake in their work beyond a monthly salary. When employees are stakeholders themselves, the people who own the company, work for the company.
The sense of ownership created by ESOP drives worker performance. A study by Rutgers university showed that ESOP companies grew about 2% faster after setting up ESOP. Having “skin in the game” motivates employees and fosters a positive team environment. When everyone has a common long-term goal of growing the company, work becomes more collaborative and efficient.
Overall, ESOP can serve as powerful tools to grow your business, incentivize your team at work, and foster an environment of trust and collaboration. Setting up an ESOP can be complicated and time-consuming, but we want to make ESOP easy for you!
If you would like to know more about how ESOP can benefit your business, do contact us! Reach out to us at admin@svested.com.
ARTICLE WRITTEN BY: Svested
Svested is a part of our Portfolio startups in Plug and Play APAC. As an in-house venture capital, our goal is to fund the teams that are building the defensible businesses of the future. By leveraging our capital, our network of VCs, and our corporate partners, we give our portfolio companies an added advantage. Find out more here!
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