In recent times, employee stock ownership plans (ESOPs) have gained a lot of traction as a medium for aligning the interests of employees with a company’s success. ESOPs are established by employers to share ownership and financial rewards with their workforce. ESOPs help create a shared sense of ownership, accountability, and responsibility among employers, as they also have a stake in the company’s future and its tangible success. Thus, ESOPs can culminate in a workforce that is more motivated, productive, and strongly committed to the organization’s larger shared goal.
ESOPs are among the best startup business plans, especially for startups. However, young entrepreneurs often face the complex task of strategically implementing their ESOP to effectively attract and retain talent and usually struggle with timing and execution. However, by adhering to certain guidelines and dictums, the implementation of ESOPs becomes easier and more fruitful. Sounds interesting? Read ahead!
What are ESOPs?
ESOPs or Employee Stock Ownership Plans are a type of program that enables employees to become partial owners of the company they work for by acquiring shares of the company’s stock. ESOPs are usually used as an employee benefit plan and a corporate finance strategy. The company provides an option for its employees to acquire equity shares at a future date and a predetermined price. ESOPs are usually viewed by employees as an additional form of compensation, which can be a robust incentive and motivator to excel in their respective roles.
How do ESOPs Work?
Before understanding the strategies that can help with ESOP implementation in a startup, let us check out how ESOPs actually work.
To begin with, an ESOP is a qualified retirement mechanism that invests mainly in the employer’s stock. An ESOP is designed to offer employees an ownership stake in the company and align their interests with the shareholders. ESOPs can be a mechanism for employee compensation, motivation, and retirement planning. The working of ESOPs has the following steps –
- Establishment – The startup establishes an ESOP trust that holds shares on behalf of employees.
- Contribution – The company contributes shares of its stock to the ESOP trust. These contributions are usually tax-deductible for the company.
- Employee Participation – Eligible employees become participants in the ESOP. The selection of employees is based on certain criteria, such as length of service, hours worked, tangible contribution to the company, and more.
- Allocation – The ESOP trust distributes shares to employee accounts depending on salary and years of service.
- Vesting – The penultimate step of ESOP functioning is vesting. Employees typically become fully vested in their ESOP accounts over a stipulated period. This means that employees gain full ownership rights to the allocated shares.
- Distribution – Employees may get ESOP dividends when they retire, leave, or meet specific requirements. The distributions are usually in the form of company stock or cash.
Best Practices for ESOP Implementation in Startups – A Crisp Guide for Beginners
Engage in Discussions and Deliberations with Experts
Employee Stock Option Plans are simple in principle, but there are several considerations in the setup mechanism, such as leverage v/s no leverage financing, share sale timetable, C company v/s S corporation election, etc. Obtaining expert advice can save you effort and money and ensure that you have a proper plan structure in handy.
Meet the Requirements to Allocate ESOP
ESOPs work with a variety of shareholder liquidity situations, but they must fulfil certain basic characteristics. Some criteria that ensure your company’s eligibility for ESOP allocation include –
- One or more stakeholders are interested in selling all or a portion of their preferred equity right now or in the coming five years
- Your company has more than 10 people
- Your average pretax earnings are more than USD 200000
- Your business is an S or C Corporation
- Your company is not in one of the following services – doctors, dentists, lawyers, etc
- Your business is profitable
- Your overall earnings are more than USD 1 million
Understand and Prepare the ESOP Structure
An ESOP structure is a tax-efficient way to dispose of all or a section of your ownership holdings on a desired timetable. It also enables businesses to distribute additional shares to employees to encourage higher productivity and accountability.
Get 409A Valuation from Experts
If the price of the business is too low, you might not be able to sell share options. The 409A valuation could help your business decide on how to allocate company shares to your employees and what percentage of the company shares could be issued through ESOPs.
Get the Documentation Ready
An Employee Stock Option Plan is simple and sorted in terms of taxes. However, the required documentation to ensure the tax benefits can be sophisticated and rather complicated. Owing to this, it is essential to employ a consultant.
Start Granting ESOP
Every time you provide options, ask the company’s relevant person to create new board resolutions allowing the issuance to a particular beneficiary or group of beneficiaries.
Issue Option Certificates
The penultimate step that can streamline your ESOP implementation strategy is by providing the option certifications once you have obtained back the signed and dated letter. Thereafter, you can update the cap table to register and record all options issues, vesting schedules, expiration dates, etc.
Common Mistakes to Avoid While Implementing ESOP Schemes
Now that we have touched upon the seven strategies for easier ESOP implementation, let us wrap up the article by checking out some common mistakes that you should avoid while creating an ESOP scheme.
- Do not use vague or ambiguous language in your policy or grant letter
- Lack of communication and transparency
- Absence of exit strategy for employees
- Ignoring tax and regulatory requirements
- Unrealistic vesting periods
- Lack of flexibility
- Failure to do regulatory filing and disclosures
- Not linking any performance metrics
Wrapping It Up
So, there we have it, a crisp overview of the seven steps that can help in the implementation of ESOPs for startups.
