What is an Employee Stock Ownership Plan (ESOP)?

What is an ESOP?

ESOPs (Employee Stock Option Plans) are a tool often used by startups and growing companies in order to compensate the employees in a way that doesn’t put a strain on cashflow in the present.

In essence, an ESOP grants employees the right to purchase shares of their company.

ESOPs are administered by the company’s board of management who also lay down the rules of the scheme. A company sets aside an amount of its total equity to offer to key employees over a course of time. The company’s board of management sets the exercise price of the ESOP, but the price set is as close to the fair market value of the shares as possible.

There are two key concepts to an ESOP agreement:

The “vesting period”

How long it takes for an individual’s share to be drip fed to them over the course of their employment (typically 3 - 4 years)

The “cliff” or “lock in”

The amount of time an employee needs to stay before the ESOP ‘kicks in’ and they start to accumulate share options. (typically 1 year)

Benefits of ESOP

ESOPs have a lot of advantages for the company as well as for the employees:

Can be used as part of compensation package

When you have limited cash flow, you may have a desire to get the best talent but cannot pay their full market salary. A company may then supplement their remuneration package with other things – like share options – to bridge the gap between what they can pay their employee in cash and what the market salary is.

A drive to build value for the company

When employees feel like they own a part of their company, this sense of ownership in the employees can then have the flow on effect of aligning their incentives with shareholders – inspiring them to work more efficiently as they see their labour directly contributing to the business valuation.

Retaining employees

As ESOPs typically have cliffs and vesting periods, employees under the ESOP may be willing to stay until they are able to exercise their options.

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