All about ESOP

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We've all heard of the Paytm office boy, or Facebook's first employee become a millionaire, because they had something called as "company stock options" or ESOPs. In today's article, let's explore what these are and how these work.

ESOP stands for Employee Stock Option Plan. A lot of folks think that ESOPS are company shares which employees are given and it automatically makes them rich. Sorry to disappoint you guys, but if getting rich was so easy, 9 out of 10 folks would work in a startup!

So what are Employee Stock Options? Well, ESOPs are nothing but a special provision for the employee to buy shares of a company at a later date, at a discounted price The date is determined by a term known as vesting period. Three important concepts here: Later date, vesting period and discounted price (also known as exercise price).

Let's take an example: Avinash joins a startup on 15th February 2020. As a part of his package, the startup has offered him 1000 shares as Stock Options. The vesting period for him is 3 years, and the stock option can be exercised (that is, shares can be purchased) at face value of Rs. 100 (which basically is the discounted price) after vesting. Let's understand how this works.

After the 3-year vesting period is over, that is, on 15th Februrary 2023, the share price of this company is, say, Rs. 400. However, since Avinash had been granted stock options, he can choose to buy these shares at Rs. 100. Therefore, he gets shares worth Rs. 4,00,000 at Rs. 1,00,000. This price of Rs. 100 was determined by the company at the time of allotment of ESOPs. Some companies can also keep a fixed price or a standard discount on the current price. In any case, Avinash now becomes the owner of these shares.

Now comes the most crucial question: How does Avinash (or any employee) sell these stocks and become rich? Read on.

Since Avinash has 1,000 shares purchased at Rs. 1,00,000, he can wait for another couple of years for the company to get listed on the stock exchange. Once the company is listed at whatever price (which will typically be higher than the face value), Avinash can choose to sell those shares on the exchange and book a profit. However, not all startups (especially in India) go public in a short span of time. Paytm has definitely not gone public. So how did the office boy from Paytm buy an apartment with ESOPs?

Two other ways (among others) of selling these shares are:

1. When an investor invests money in the company, and wishes to buy a certain percentage of your stock options (shares). In Avinash's case, if the investor says that he is willing to buy back 10% of ESOPs, Avinash (assuming his vesting period is over) can sell 100 shares to the investor (out of 100) at the current price.
2. The company founders can announce a buyback (like Ritesh Agarwal of Oyo did) of shares from the employees. Here again, typically, founders buy back a certain percentage of the stock options from the employees. This is typically done when they perceive that the valuation of the company (and hence the share price) is going to increase in the near future.

Are ESOPs a good way to become rich? YES. But, do ESOPS guarantee that you'll make a lot of money? NO. If you have ESOPS and you are a long-term employee of a company which is doing well, you'll have a chance to encash your stock options and make some good money. (The money you make is taxable, by the way). However, if your company is not planning to get listed, or the investors/founders are not interested in buying back the stock options, the shares are of no use. So just getting ESOPs as a part of your compensation does not guarantee good money. There are several other factors involved, which all of us need to consider while opting for ESOPs.

Fun fact: In India, it's a little more difficult for employees to make money with their stock options, because for any company, getting listed on an Indian stock exchange is not easy. Compare that with the US, where even loss-making companies can get listed on the exchange. Once listed, all its employees whose shares have vested can sell them on the exchange and make money (irrespective of whether the company is making money or not). So if you've been wondering how employees of Uber have become rich in spite of it being a loss-making business still, now you know how. In the same way, most Indian unicorns are not profitable, and hence them getting listed in the near future is comparatively difficult. Even if they do, a very small amount of the total shares are open to retail investors. Their employees therefore may not be able to easily sell shares on the stock exchange, at least in the near future.

I'll leave you with another concept called ESAR (Employee Stock Appreciation Right), which has a similar objective, but is a better option for an employee. In an ESAR, the employee has a right in the growth of the company, and the increment is generally paid out in cash. Therefore, the employee will get the difference in share prices after vesting, but he will not need to purchase those shares.

I'll need another article to explain the nuances of ESARs and differences between ESOPS and ESARs. However, this should be enough for today.

That's all about ESOPs for today. Drop in your comments in case you have any queries, opinions or fun facts!