Companies offering Employee Stock Ownership Plans (ESOPs), especially start-ups, have increased significantly in recent years. Employers are taking recourse to ESOPs when it comes to hiring and retaining employees for the long haul. For start-up employees, as we have seen from multiple initial public offerings (IPOs), exits, and buybacks, ESOPs have become a serious source of wealth creation.

For a start-up, it can often be challenging to pay higher compensation at the initial stage, and conserving and investing cash in operations are its top priorities.

By way of ESOPs, they give employees a part of the company’s equity in lieu of or sometimes even along with higher salary and salary hikes, benefiting both.

Seemingly, ESOPs are a great way to own a part of the company and benefit from potential gains if the company goes public. The question is this — should employees, such as you, accept or ask for ESOPs in lieu of a higher salary?

How do ESOPs add value to you as an employee?

An ESOP sets up a contract between a company and you that will allow you to acquire company shares at a decided time and price. You can potentially grow your wealth significantly when you get to exercise these stock options and sell the shares at a price higher than their market value.

If you are getting stock options as a part of your annual package, it can be a source of sustained wealth creation. It can even compensate for a sub-market salary if you are joining an early-stage company and getting a strong equity component.

The major benefit is that when the company executes a buyback of ESOPs or launches an IPO. This makes ESOPs a great tool for you to build wealth.

Did you know that last year, 29 start-ups in India announced ESOP buybacks for their employees, which provided them with financial gains of over $335million?

There have been many examples of companies buying back ESOPs at a massive scale, i.e. Flipkart’s Rs. 600 crore buyback in 2020, Cred’s Rs. 100 crore buyback in 2021, and so on. When Freshworks, a Software as a Service start-up launched a $100 million IPO, more than 500 of its employees became millionaires.

But this is the case only if things work out for the start-up and it ends up actually listing.

What’s the downside risk of ESOP?

Every coin has two sides, and so do ESOPs. While there are potential monetary gains in the future, ESOPs attract certain risks.

Additional tax burden

ESOPs attract two tax implications. The first one is that the gains made on ESOPs are treated as capital gains on which you pay taxes in line with your tax slab.

The additional tax burden here is the second implication of ESOP taxation—income from salary. ESOPs are often provided to you for less than fair market value at the time of vesting. And thus, the difference is considered an incentive.

After vesting, if you convert the ESOPs into stocks, and cannot sell (no cash inflow), it will attract tax that needs to be paid in the corresponding financial year.

Of course, a good ESOP policy would let you hold the ESOPs until the liquidity event i.e., IPO, exit, etc. so that the tax liability arises only at the time of value accruing in your hands.

Failure in a buyback or public listing

Often when you get ESOPs from an early-stage company, buyback or public listings are low-frequency events. They are just a possibility. Your return on ESOPs becomes contingent here if the company doesn’t perform well.

If you receive ESOPs in addition to an at-market salary, it does not have a significant downside impact. But if it is in lieu of a higher salary, you may lose the value of the effort and time you have put in through the years.

Company performance affects ESOPs

Typically, an ESOP buyback or IPO takes place when the company has considerable growth prospects. When the company’s value sinks, it will reflect on the stock options and you may not be able to liquidate your shares profitably. You may lose monetary gains over ESOPs along with a competitive salary.

The bottom line

ESOPs are, no doubt, a great way for companies and start-ups to attract or retain employees. However, you as a current or potential start-up employee also have a need for benefits beyond a competitive salary. This can sometimes make ESOPs a good match, especially if you value equity and believe in the long-term future of the company you work in.

Before you take a final call, go through this checklist:

Is the growth trajectory of the firm looking good and does it share enough data around this with employees?

What do you need more at this stage of your career – a higher salary or the potential for substantial wealth creation? Remember a start-up’s journey can be highly unpredictable.

Finally, will a higher salary be truly a jump from your current one and worth forgoing the ESOP? You’d have to do some research to answer this. Keep in mind your life situation and where you stand vis-a-vis your wealth.

It is a good practice to read the terms and conditions related to ESOP vesting and exercising before asking for, or accepting it, in lieu of a higher salary.

Along with that, you should also consider where the company management sees progress a few years down the line. While a view on progress can be hazy for many start-ups, some ideas are better than not knowing anything about growth prospects.

Working for a start-up does come with its own set of risks and challenges. The experience can be highly rewarding and ESOPs are just the potential monetary aspect.

Do your research and ask yourself the key question – what are the odds that the start-up will do exceedingly well and the ESOPs will be worth something? It will require a bit of faith as well as a bit of math on your part. The final answer will depend on your own understanding of the start-up and attitude towards risk.

This article was first published in moneycontrol on 7th April 2022 here