Everything a Startup Employee Needs to Know About ESOPs

Making a job offer seem like an invitation has always been a part of how startups do business. "Come on board early on, help us to build this thing, then you get to share in the end result." The sharing of what you help create will typically be through the use of ESOPs.

Many early employees of companies such as Infosys and Flipkart have become millionaires through their ESOPs. Individuals who are starting at a new start-up are often presented with the option of an ESOP and may be excited but confused about the whole process. The word "ownership" is an exciting term. However, the fine print is where things become confusing.

Let's have an honest discussion about the subject.

What Is an ESOP and Why Do Startups Offer It?

An Employee Stock Ownership Program, or ESOP, is when the company grants the right to employees to buy the shares of the company at a predetermined price. The important word in that sentence is "right." You are not actually granted the ability to buy the stock. You are granted the right to buy the stock at some point in the future at the price that was determined today.

Why is this important? Well, if the company succeeds and the value of the stock increases, you get to buy it at the old price. The difference between the old price and the new value? That is your profit.

ESOPs are popular with startups because of one simple reason: they can't compete with the salaries that the large corporation offers. However, they can offer the employee a seat at the table and the ability to be part of what the company might become.

When the company wins, you win. You win, everybody wins!

That's the idea behind startup equity, and when it works out, it works out beautifully.

How Do ESOPs Work?

Let's walk through it in a way that actually makes sense.

Step one: You get granted stock options.

When you first join, you're told how many you get. But they're not yours. Think of them more as a promise. A promise that will be fulfilled in time, provided you stay with the company.

Step two: The vesting period begins.

This is where your stock options start to 'vest' over time. It usually takes four years. Most startups have something called a 'one-year cliff.' This means that during your first year, you get nothing. Then, 25% of your total amount is given all at once. The other 75% is spread out over three years.

This is all done for a reason. It's so that you stay with the company long enough for it to actually profit from your work.

Step three: You exercise your stock options.

The next step is to exercise the stock options. This is where you essentially purchase the shares at the agreed-upon price, which is called the strike price. Here is an example of how this would look in real life:

Let's say the startup gives you 1,000 stock options at an exercise price of ₹50 per share. Three years go by, and the startup has taken off. Each share is now valued at ₹500. You're buying at ₹50 per share, the shares are now worth ₹500 per share, and the gain per share is ₹450. This is the gain per share, so if we multiply this gain by the number of shares, we get ₹4,50,000.

This is the beauty of startup equity.

Step four: A liquidity event makes it real.

This is the part where most people do not talk enough about. If you are part of a startup and own shares, this is the part where most people do not want to talk about. This is because owning shares in a private startup is not the same as owning shares in a publicly traded company. You cannot simply go onto the startup's app and sell your shares whenever you want. You need something called a liquidity event.

This is where the startup either goes public, gets acquired, or has the startup itself buy back the shares. If none of these happens, then the shares are simply shares. They are shares on paper, and they are valuable, but they are not in your pocket.

Key Questions to Ask Before Accepting ESOPs

An ESOP is a legal contract, and it is your responsibility to make sure that you understand what you're getting into. Here are some of the pertinent questions that you should be asking:

What percentage of the company do my options represent?

Numbers do not always lie. Having ten thousand options may sound good until you hear that there are ten million shares outstanding, making your percentage 0.1%. Always make sure that you understand what percentage of the company your options represent.

What is the vesting schedule?

Make sure that you understand what your vesting schedule is. Also, make sure that you understand what happens if you leave the company with unvested options.

What is the exercise price?

If the exercise price is already close to what your shares would be worth in the open market, then there is not much room for growth even if everything goes right. A low exercise price in relation to where your company is headed is what makes all of the math work in your favour.

What happens if I leave the company?

Some startups only allow employees 90 days after leaving to exercise their vested options. If you don't do that, you lose them forever. However, some startups offer more time. It is always worth inquiring.

What are the tax implications?

Stock options in India are taxed at two stages – when you exercise them and when you sell them. These are tax events, and the amounts can be huge. It is not optional but essential to understand the tax implications of ESOPs before you commit.

Has the company done ESOP buybacks before?

If a company has done ESOP buybacks in the past, it is an indication that the company is willing to provide liquidity to employees in real terms. It is not a guarantee but is definitely a positive signal. If the company has not done an ESOP buyback and there is no IPO in sight, your options could be paper ones for a very long time.

The Pros and Cons of ESOPs

ESOPs are a long-term bet. For the company, its leadership, and the market.

Pros:

• Ownership in something you are actively helping build
• Potential for high returns if the company grows as planned
• Creates true alignment between your goals and the company's growth

Cons:

• No guarantee of liquidity and could be many years away
• Complexity of the structure and the law surrounding it can be overwhelming if not guided properly
• Significant tax implications at the time of exercising if not prepared properly

ESOP is not something that is going to provide immediate benefits. Looking at the ESOP as the long-term vehicle that it is will always lead to the best decision.

Final Thoughts

So, should you accept this offer?

Well, that depends on a number of variables. The growth rate of the company, how early you're joining in, what percentage of equity you're being offered, and your own financial situation.

If you're in a good financial position to exercise your options at the appropriate time, if the company is likely to have a liquidity event in your future, and if you think that the vesting schedule is appropriate for your career goals, then ESOPs can be one of the most rewarding aspects of working at a startup.

So go in with your eyes open. Read that ESOP agreement, or have someone who knows what they're talking about explain it to you. Ask all of the following questions, and then some. And make sure that the equity being offered is appropriate in relation to what you're contributing.

Equity at a startup is not just compensation. It's a significant reward for your participation in something that you've had a part in building.

Find the Right Workspace to Grow Your Career

At Beginest Coworking Spaces, we witness such dialogues on a daily basis, over cups of coffee, in meeting rooms, between entrepreneurs and their new recruits, between professionals seeking to define their next step.

Whether you're reading an ESOP contract for the first time, building your team, or seeking a space that mirrors your enthusiasm for your work, our coworking spaces in Indiranagar, as well as our coworking spaces in MG Road, are designed to facilitate such momentum.

Join us in creating your base of operations in a space that takes your ambitions seriously. Reach out to us on 91080 29762, or drop by any of our Beginest coworking spaces in Bangalore, to experience what it feels like to be in a room with people who are creating something.