Employee stock ownership plans (ESOPs) are one of the most popular methods of stock-based compensation around the world. Similar to stock options in private companies, ESOPs enable employers to offer their employees a portion of the company's stock. With the increasing interest in ESOPs, you may be wondering, are ESOPs really that beneficial for employers and employees alike? After all, ESOPs come with many costs and complications, from legal requirements to taxes. In this article, we will walk you through ESOPs and the primary benefits for businesses and employees.
Well, why would a business not want to retain and reward its employees? And why would employees not want to hold a stake in the company for which they work? Employee stock ownership plans or ESOPs are financial tools designed to help achieve both of these objectives. ESOPs are financial arrangements that give employees an "ownership stake" in the company by granting them stocks. The purpose of ESOPs is to tap into the competitiveness of employees and bridge the gap between employers and employees. ESOPs are considered a great way to retain and reward employees while simultaneously drawing business value from their ownership stake.
An employee stock ownership plan (ESOP) is an equity-based incentive plan that allows employees to purchase stock in their company. Since employee stock ownership plans are similar to stock options in terms of their structure, privately held companies often use ESOPs as employee benefits. From a business perspective, ESOPs are seen as a way of retaining and rewarding key employees while employees, in turn, can take an active ownership interest in the company. Overall, the goal of an ESOP is better to align the interests of the company and its employees.
Employee stock ownership plans (ESOPs) are based on a simple concept. By giving employees the option to hold stock in the company for which they work, employees are more likely to work harder and remain loyal to the company. In an ESOP, the employer sets aside a predetermined number of shares of company stock under the option pool. The employees are granted the right to purchase these shares, given a predetermined price (strike price) after a certain period of time (vesting period).
As such, the employee can exercise the option to acquire the stock from the company after the vesting period is completed at the predetermined price. Probably you might be confused about the terms used in regard to an ESOP. Let us take a look at some of the key terms related to ESOPs.
There are a number of key terms that relate to ESOPs. Typically, there are four key terms used when discussing employee stock ownership:
1. Grant date - This is the date when the employee stock option (ESOP) is granted and assigned to the employee. It is the date when the ESOP agreement is signed and when the employer sets aside the shares for the employee.
2. Strike price - It is also known as the exercise price or purchase price. This is the price at which the employee can purchase the company stock. The strike price is usually equal to the fair market value (FMV) of the stock at the time of the grant.
3. Vesting period - Before the employee can exercise or purchase the company stock, they have to complete a predetermined period of time. As such, the employee must hold the shares of stock until the vesting period is complete.
4. Expiry date - This is the date when the employee stock option (ESOP) expires. Employees must exercise the share on or before the expiry date, otherwise, the option is forfeited and the company can repurchase the shares.
Now that you have a basic understanding of how ESOPs work and their terms, let us take a quick look at how an ESOP works in practice. For instance, ABC Company is a privately held company that has its own share capital. The company decides to use ESOPs to motivate and reward employees for their hard work. Andrew, an employee, is granted an ESOP in the amount of 500 shares which have been set aside for the option pool.
The option's strike price is $10 per share with a vesting period of 10 years. In order to exercise the option to acquire the 500 shares from ABC Company, Andrew must hold these shares until the 10-year vesting period is complete. Upon completing this period, Andrew decides to exercise the option by purchasing the 500 shares at the strike price of $10 per share. As a result, Andrew now holds 500 shares in the company.
The main benefits of using ESOPs lie in the direct alignment of the company and employee interests. In this dynamic environment, employees want to be rewarded and encouraged to perform to the best of their abilities. Likewise, employers want to retain their key employees since they are the backbone of the business and are crucial to long-term success. A successful ESOP can provide a win-win opportunity that helps achieve both of these objectives. In the following section, we will discuss the key benefits of using ESOPs from both the employer's and employee's perspectives.
For privately held businesses, the use of ESOPs can effectively serve as a retention and rewards tool. The following are the top benefits of using ESOP for business:
1. Change and adapt to current market trends - For businesses, it is crucial that they stay abreast with new changes and trends in the market. Traditional rewards and benefits schemes for employees, such as cash bonuses, may need help to keep up with the changing market dynamics. In recent years, ESOPs have emerged as a popular way to reward and retain key employees. The use of ESOPs has proven to be a great way for the company to achieve the benefits of employee retention and innovation.
2. Develop a strong foundation for the future - When using ESOPs, businesses get the added benefit of strengthening their employee base. By providing employees with a financial stake in the company and an opportunity to acquire part ownership in its growth, businesses can better retain key talent crucial for long-term success. This increased commitment to work is likely to be felt among the entire company and its employees since it is a win-win situation for all parties.
3. The equity capital is increased - By using ESOPs, employers gain access to the equity capital needed to finance future growth and expansion. In the case of ESOPs, when employees acquire shares in the company by paying the option's strike price, this, in turn, increases the equity capital available for business activities. In other words, the amount of funds received by employees for each option grant increases the overall equity capital.
4. Enhanced motivation and productivity - Employees that find a sense of ownership in the company for which they work are typically more engaged and motivated about their work. As a result, they tend to put in greater effort in order to promote the interests of the company. ESOPs, in this regard, can prove to be an effective and cost-efficient way of motivating employees, thereby enabling businesses to achieve a greater level of productivity.
5. Exit strategy for retiring employers - Another advantage of using ESOPs is that they can provide a viable and effective exit strategy for ageing founders and owners of the company. When using ESOPs, founders can gradually transfer ownership of the company to key employees. In doing so, they can protect their financial interests without having to sell their business to a third party. As a result, the company can continue to operate smoothly and efficiently while the founder can take a well-deserved retirement.
Now that we have looked at the top benefits of using ESOPs for businesses, it is time to take a look at the primary benefits for employees. In this context, there are several key ways in which ESOPs can benefit employees. The following are some of the top benefits of ESOP for employees:
1. Employment stability - The first benefits employees get from using ESOPs is the sense of job security that it brings. In an era where the job market is competitive, ESOPs can help employees retain their jobs and work with a sense of stability. This is because ESOPs provide employees with an ownership stake in the company, and thus, this deliberate effort can help create a more stable working environment.
2. Wealth creation - ESOPs allow employees to build wealth and amass substantial financial rewards in the future. This is because of the fact that by exercising their options, employees are able to gain a partial ownership stake in their company. Therefore, with long-term planning and effort, employees can potentially benefit and build a personal financial portfolio through their ESOPs.
3. The sense of ownership - The third benefit of using ESOPs is the sense of ownership that it provides to employees. Once the option has been exercised, and the employee has acquired a partial ownership stake in the company, they will naturally develop a greater sense of responsibility towards the company. Here, employees will likely work with greater motivation, dedication and commitment to the company for which they work.
Although ESOPs are among the most popular and effective employee rewards and benefits schemes, they do have their drawbacks. However, their benefits are worth the effort and can prove to be an effective long-term solution. But, it would be wise to identify and understand the potential drawbacks of using ESOPs before you implement them in your company.
From the perspective of the employer, ESOPs can result in a significant dilution of the company's equity. On the other hand, the funds required to exercise the options can be substantial for employees. Consequently, they will require considerable time to accumulate the necessary funds and make the option viable. As a matter of fact, the benefits of ESOPs outweigh their drawbacks for both employers and employees.
After taking a comprehensive look at the pros and cons of using ESOPs, it is clear that they prove to be an effective way to reward and retain key employees while enabling a company to retain its innovative potential. But, a successful ESOP is all about management and execution. Why not hire a third-party professional or use a cloud-based HR software to help you manage an ESOP? Eqvista offers a wide range of financial services, including equity management, 409A valuation for pricing ESOPs, and other related services. The services at Eqvista are carried out by a team of qualified and experienced professionals, and we can help you design and implement a highly efficient ESOP. Get in touch with us today for more information.
