The private sector and start-up culture in India is coming of age since the last 30 years of the economic reforms in 1991 which promoted globalization and increased FDI. Increased investments in business lead to increased employability and helps generate new jobs. Most of these employees working for a company, especially startups look for lucrative benefits over and above the monthly salaries drawn by them. The younger generation looks beyond the linear career progression and fixed promotions having an obsession over control of their future and growth. Employee Stock Ownership Plan (ESOP) are generally designed to reward the employees who help the company grow and contribute most to the employer’s success.
Under ESOP the employees have the right to acquire shares of the company in future at a pre-determined price. The right to acquisition of shares (option) is provided under a scheme (grant of option) and the option may be exercised after a certain number of years (vesting period) at a pre-determined price (exercise price).
The first employee ownership plan was developed back in 1956 by a San Francisco lawyer Louis O Kelso who believed that the company’s own employees should be the logical buyers and ultimate owners; as they were the ones who knew in and out of the business and made it successful in the first place. And as the company grows, the value derived by these individuals should also multiply considerably with the potential to earn a handsome return.
Even in India, ESOP are mostly offered to senior management and in limited cases to select people in middle management. However, ESOP have gained currency in recent times due to an increase in the number of sale and opportunities to monetize.
As the Indian economy is aggressively striving to reach USD 5 trillion mark by 2025 the government is providing major thrust to initiatives like ‘Make in India’ and ‘Start-up India’ by providing them with easy funding and tax benefits. In this quest of becoming ‘Job Creators’ various initiatives helped build a pool of nearly 0.6 million direct and .18 million indirect jobs in 2019 alone as per the NASCOMM report. But a major issue for these start-ups is to hire superior talent, as these employees may doubt their job security because these start-ups are not well recognized.
For example, companies that have a reputation for effective leadership, for nurturing a culture of growth and innovation, for being employee-centric by rewarding and recognizing staff contributions, and for building a sustainable legacy, are most often the best fit for an ESOP. This may not always prove to be accurate. Unlike large corporations, startup community and culture are ‘highrisk/high-reward’ where most of the companies are seeking to achieve a big exit in 6-7 years through acquisition, leveraged buy outs or mergers. Startup Advisors suggest offering ESOP to employees help them bring confidence in the company in a competitive market. In addition to that, ESOP provide a solution to the Principal-Agent problem of a business. By helping to reduce the Agency Costs involved in managing the day-to-day operations of the business.
Another use of these ESOP is that they are incorporated into the company’s articles or by laws to act as ‘Poison Pills’ to prevent takeovers by large corporates. These pills are triggered when a hostile acquirer tried to gain control of the company without the board’s approval (bear hug). It gives the holder of these stock options vis a vis employee to put forward their ESOP and have them converted to equity which in turn dilutes the acquirers share. In fact, investors encourage the founders and promoters to carve out 5% – 20% of equity for ESOPs pool.
This percentage differs based on how well balanced the founding team is and the gaps if any that need to be fulfilled.
Basic research suggests that most of these employees who are rewarded with ESOP, use them to fund their retirement plans. Since most of the companies providing stock options do not assist in any benefits post retirement like the public sector,employees refrain from converting the options into shares even post their vesting period. Each ESOP distributed by different companies has a lock in period for which the holder cannot exercise the option to turn it into liquid shares. This principal is known as a vesting period.
ESOP participants generally have the same rights, such as the right to receive dividends, as other shareholders with respect to the stock in their accounts. Participants have full voting rights for shares allocated to their accounts in ESOPs of public companies. But ESOPs in privately held companies are only required to permit participants to vote on such major corporate events as a merger, acquisition, recapitalization, or sale.
Even so, issuing ESOP must also entail benefits to the owners of the company while simultaneously delivering to its employees as well to enable them to issue these options. Often, entrepreneurs like to remain involved in the day-to-day operations of the business and don’t just want to work for a ‘new boss’ that doesn’t understand company history and culture.
Startup Advisors suggest that ESOPs facilitate an entrepreneur’s transition strategy from becoming a CEO to board chair while helping to preserve the value and values of the company. Special tax incentives as prescribed by certain conditions & regulations enables the shareholders of a closely held company to sell stock to an ESOP, reinvest the proceeds in other qualified securities and defer taxation an any gain resulting from these sales. Also, ESOP leveraging provides a way for a selling shareholder to receive cash, rather than incur the risk of a deferred payment arrangement
Over the years ESOP has created unanticipated wealth, economic security and even increased the purchasing power for millions of employees working for employee-owned companies. Eventually, alternatives may be developed to outgrow the reach & benefits of these stock options, but it is probable that the ESOP can play an even greater role for startups and privately held companies in the coming 5-10 years as confirmed by many startup advisors in India. Increased knowledge on the topic and educating new businesses can help promote employee ownership, ensure its wise adoption and successful implementation, and intelligently influence public policy over the long run.
-Shubham Gupta,
Legal Team,
AnBac Advisors