Whether you are an investor, a founder, or an HR leader, you must have heard this term being thrown around. Everyone seems eager to build an ESOP but looks like nobody really understands it and it’s also hard to get your hand around it because the information available online uses too many technical terms.Let us simplify it for you!
ESOP stands for Employee Stock Option Plan
In short, out of the total shares (or ownership) of a company, there is a percentage allocated for employees. However, ESOP is not directly converted into shares — instead it is an option for the employee to buy shares. Employees can decide whether they want to buy it or not. However, if they decide to not buy it, their entitled ESOPs may get expired.
What is the objective of ESOPs?
Generally, ESOPs are used to attract and retain key employees. It’s meant to drive employees to be invested in the company for a long run.
How can employees obtain ESOPs?
1). Employees are offered ESOP Benefits (either by Founder or HR)
this could happen either on the joining-date or during their employment in the company
2). When employees accept ESOPs, ESOPs are defined as Allocated (or unvested)
3). As the vesting criteria is met, ESOPs will be concurrently vested
4). Those vested ESOPs, then need to be purchased (or exercised) by employees to be converted to shares
5). After ESOPs are exercised, employees have fully converted their shares
Whoa I’m lost in words — can you help me to visualize it?
let's use an example of the following ESOP Structure for better understanding:
Employee Name: Arnold Schwarzenegger
Company Name: Terminator.io
Employee Stock Option
What does these terms mean?
Wait — so Employees NEED to pay to obtain their shares?
Yes, only after employees purchase (or exercise) it — the shares are owned by them.
What if employees decide not to buy it?
Employees have an option to not buy their ESOP share. In such a scenario, generally there is an expiration time. If until the expiration time employee decides not to redeem his share, then the ESOP would be pulled back to the pool to be distributed to other employees.
If so — then when can the employees gain profit from it?
The shareholders would only gain profit when there is a buy-back event. At this event, companies usually announce the buying price, after which employees can decide: 1). Whether or not they want to sell it
2). How many shares they want to sell
This buy-back event is not limited to an exit event (Merger, Acquisition, or IPO), companies often hold buy-back events on annual basis or every time they close a round. The objective of buy back is for the company to regain its ESOP allocation and distribute it amongst other employees.
What if the company went bankrupt?
Well — unfortunately, when a company goes bankrupt the share value intrinsically becomes zero, Yes ZERO. So, if an employee hasn’t cashed-out before bankruptcy, unfortunately none of this share has any value.
Whoa — Then how could an ESOP be attractive for employees?
It’s a long-term vision, though there is a risk, but employees are buying the shares at a much-discounted price. This is also the reason why ESOPs are mainly distributed to key employees, because it would drive key employees to be fully invested and drive the company towards growth and as the company grows, so does its shares values.
and plus — those that gain profit from ESOP are splendidly benefited from it.