There are plenty of success stories of employees who made a fortune alongside the founders of their startup companies. In 2004 when Google listed, co-founders Larry Page and Sergey Brin saw the value of their shares skyrocket. They joined the ranks of the richest people in the world. At the same time, approximately 900 other early Google employees became millionaires. What was the difference? An Employee Share Option Program (ESOP).
Now it might seem obvious that as a company succeeds, all its employees succeed. However, history is also full of companies where only those at the top benefited when the company listed. Sometimes this is because only the c-suite have any equity.
Many companies don’t offer ownership models of any kind or at best a limited stock program. Startups are often different, as employees take salary reductions for equity, especially in the early days. That is what happened at Google.
Fundamentally these ownership programs come down to distribution of employee stock options. An employee stock option is a form of compensation that offers a company’s stock to certain employees. Granted to those in management or officer-level positions, they can be widely given out to employees of an early-stage business. They are often as long-term incentives. In fact, in the US there are companies where all employees receive some kind of stock option, therefore own part of the business.
What are Employee Share Options and ESOPs?
Essentially, employee stock options give an employee the right to buy a certain amount of stock during a specific period of time at a specific price. Options typically have some kind of additional rules. For example, the options may have expiration dates. These are dates by which the options must be exercised, or they will be cancelled or become worthless.
Why Deploy an Employee Share Option Program for Employees?
Stock options build a real sense of ownership with employees. It is easy to draw a line between your performance and the company’s performance when you have real skin in the game. The personal investment is real. Options increase employee engagement and retain employees at a higher rate than more traditional financial inducements. In fact, according to a survey by Kaiser Permanente, employees who have equity have a 53% longer median job tenure. Organizations are likely to see a profit margin 8.5% higher than those that don’t offer ESOPs. Plus they are three to four times more likely to retain staff.
Stock options are a powerful compensation tool as they promise potential cash or stock in addition to pay. Additionally, as options are a mutually beneficial situation and therefore represent a literal win-win situation for everyone.
It is important to remember that an ESOP should be attractive to employees. It is a tool for retention and recruitment as well as a legal structure of ownership. So, it should benefit employees as well as the organization.
ESOP Benefits
While an ESOP is not the answer for every company. They offer many advantages for businesses. They can act as a form of wealth generation for those who do go down this road.
Employees may not reap immediate financial benefits. However, the potential longer term pay offs can be staggering. However, employees do have to consider the loss of cash, bonus and other more traditional and immediate financial gains. An early joiner places a bet in good faith, risking initial security on a longer-term gain. It doesn’t always work – as seen by the staff at Deliveroo. Startups with ESOPs represent an attractive a straightforward investment opportunity, working as a way for employees to invest their careers.
Employees receive preferred pricing. This means the price of their stock is reasonably higher than the pricing offered by the company. They are also able to diversify their investments. Offering an opportunity to be able to buy stocks starting early in their respective careers.
Lastly, ESOPs are an easy way to save your money through payroll deductions facilitated by the company. This can help employees stay on track with long-term savings plan and goals.
It is also worth noting again that for organizations ESOPs are a powerful tool to attract and retain talent. ESOPs incentivize, motivate and retain.
How to start the ESOP journey
The decision to implement an Employee Share Option Plan (ESOP), is clearly not made on a whim. However, once made, an organization works with lawyers to draft legal documents delineate the terms and conditions of the options.
While ESOPs themselves are not complicated per se, it is vital to seek appropriate advice. To protect employees, founders, as well as the company.
So, the first step, is to seek advice from legal, accounting, and tax experts who have expertise in setting up ESOPs. It is important to take the time now to ensure the plan is appropriate to the organization’s workforce, environment, industry and business. Expertise to set up the ESOP correctly from the beginning will save time ultimately in the end.
Points to Consider:
- Which employees will be included? Will there be restrictions?
- Is the organization clear on the alignment of interests between employers and employees?
- Does the company need to veer off from industry best practices on ESOP?
- There will be tax implications. Both positive and negative – to the founders, the company and the employees as a result of setting up the ESOP. Especially if you have a global workforce. Do you understand the implications and have the right advice?
- Does the company have the appropriate tools to be able to manage and issue shares? Can they track who has what shares, vested over what period of time?
It is important to remember that an ESOP should be attractive to employees. It is a tool for retention and recruitment as well as a legal structure of ownership. So, it should benefit employees as well as the organization.
A lawyer for example will draft legal clauses and rules but it is up to the company to decide ESOP details. Consider pool size, grants, vesting, what happens when an employee leaves, exercise periods, cliffs and so on.
It is also important to ensure that you have the appropriate tools to not only issue the shares but to be able to manage, track and report on them. As employees leave, join and change roles, their equity will also shift over time. The ability to manage this is vital, especially as a company grows.
With the ESOP drafted, the next step is to roll out the ESOP. We will cover this in our next blog post. Communicating, issuance, and rolling out an ESOP is, again, not complicated but can seem overwhelming.
Summary
Fundamentally, increased efficiency and productivity linked to compensation begins with employees feeling satisfied and appreciated. ESOPs are an essential tool in an organization’s arsenal to unlock and increase employee motivation and passion.
ESOPs can play an effective part of your compensation strategies to engage employees in the long term. They provide a true sense of ownership, belonging and sense that what they do genuinely does make a difference. No longer just a cog in a wheel, employees feel that they are part of what drives a business. Organizations that can successfully align the longer-term vision of stock options with instant gratification, short-term benefits like cash, truly make magic happens.
Read our blog next week – So you’ve got an ESOP -what next?
Interested in knowing more? Confused by ESOP terms? Check out our ESOP dictionary. Or talk to one of our team.