A Techie's guide to ESOPs

A lot of start-ups along with larger unicorns and MNCs offer ESOP or RSUs as a part of their offer to an employee. From my many conversations with Scaler Alumni and other young techies, I have realised not a lot of people truly understand what ESOP essentially means. Majority of people end up making decisions on the offers without even understanding what it entails. So here in this article, I’ll try to explain in simplest possible terms what ESOPs mean and how you should evaluate offers which have ESOP or RSUs as one of the components.

To begin with there are two different forms in which you may get equity of the company you are joining:

1. ESOPs
2. RSUs

ESOPs are the most common instrument for sharing equity with the employees and hence we will delve deep into that today. ESOP is a plan which grants you Employee Stock Purchase Options. Here the words Purchase Options is important, what ESOPs essentially mean is that you get a right (or option) to purchase the company's shares(exercise your ESOP) at a pre-defined price (called the strike price), irrespective of how the actual price of the share changes over time.

Why this complicated scheme instead of just giving me shares of the company? Because ESOPs are a tax-efficient instrument for employees. Let's take an example:

1. You join a company which is valued at 10million USD(about 75cr INR) right now, and each share is priced at 10$(750 INR).
2. You join the company and are given ESOPs worth 12 lakhs which will be given to you in 4 years (vesting period). So you get total 1,600 ESOP units to be given to you over four years.
3. Hence each year you get ESOPs worth 3 lakhs INR, or 400 ESOP units.
4. In two years companies grows and valuation rises to 100 million USD(about 750cr). In a typical scenario, your total 1,600 ESOPs today will be worth 1,20,00,000 (1.2cr).
5. If things continue to grow well and in another 2 years the company further grows and have valuation of 1 Billion USD (typically called a Unicorn company). At this stage your ESOPs will be worth about 12cr INR.
6. All this is fine, how do I get the money? That's the important part right ??
7. So following are the scenarios in which you can cash-out all or part of your ESOPs
8. The company giving a buyback offer for ESOPs, you get a "choice" to give back some of your shares and get money in return. You might decide not to do so if you see share value increasing rapidly in the coming time and you don't need money right away. If you follow business news recently many startups like Meesho, UrbanCompany, Razorpay, BharatPe etc all gave such options to their employees. Collectively these companies paid out 365 cr to their employees as a part of the buyback. Do not let some gyani tell you "ESOP ka to kuch nahi hota bhai!" https://inc42.com/buzz/startups-and-its-affair-with-employee-stock-ownership-plan-buyback/
9. A merger/acquisition of the company with a larger company in all cash transaction. Examples here could be citrus pay acquisition by PayU where the office boy made enough money from ESOPs to buy a home.
10. The end big bang IPO of the company, while this often takes some time, however IPOs usually mean you can liquidate all your ESOPs and if you are an early person in the company at this stage you shares can easily increase to 100x in value from when you joined the company. I know techies who joined companies like Facebook, Airbnb, Pinterest when they were startups with less than 50-100 people and at the time of IPO they got a fortune ranging between 10 to 100cr. When you make this kind of money, you do not need to work for money again in your life!
11. The above three are most common events when you get a chance to liquidate your ESOPs. There might be more scenarios but rather rare.

Back to the original question, why give ESOPs instead of shares directly? In the above scenario, if you had shares you might get tax reporting liabilities as the share price of the company is growing, but when you've ESOPs you don't really own anything but have an option to own share when you want, hence no tax reporting responsibilities irrespective of how share prices are increasing. Apart from the benefit to the employee, ESOPs also give freedom to the companies of much less paperwork and management, as everyone only has an option to own shares but do not own it yet. ESOPs essentially are an innovative financial tool designed to help early-stage employee of a startup and the company manage ownership efficiently.

In my early days as an engineer I somehow had developed a false believe for a brief period of time that:

1. Let me focus on fixed salary, I don't care what shares some company is giving.
2. After reading a bit, ESOPs somehow are less valuable than RSUs, I'll only consider companies which are giving RSUs (half-knowledge is worse than no knowledge)

Thankfully I had mentors who corrected me on both points timely enough.

If you want financial independence in life, that will only come through ownership of something that becomes large enough. It will take you 30+ years to earn that amount through salary, and by then most of us already drained and ridden with responsibilities. Also, ESOPs are usually given by early-stage companies where there are high chances of the value becoming 10x or 100x of what it is today. Shares of an already large company (typically RSUs) are less likely to grow 100x.

Factual numbers say that India has produced 61 unicorns till date (40 are not registered in India, but that doesn't matter to you as an employee). And many 100s which have had successful exits. That, however, doesn't mean all startups will succeed, when evaluating a new company think how strong a conviction do you have that this idea and team can make something big if you think it will, why not take a share of that gold mine. And if you think it's going to fail, forget about ESOPs why board a sinking ship at the first place ??

Now that you have some idea about what ESOPs mean, let's talk about some of the important things you should know about the ESOP plan. Its likely that you decide to change the company before one of the liquidation event occur at your current company, what would happen to your ESOP then? When leaving a company you will need to exercise your option within a certain period of time which is defined in ESOP plan as 'exercise period', within this period after leaving the company you are supposed to pay the 'strike price' to the company to gain ownership of the vested ESOPs. Always enquire what is the exercise period and strike price before hand. An employee friendly ESOP plan will have low strike price and long exercise period.

All the best, hope this article will help you make better informed decision for your next offer!

Let me know in comments your experience with the ESOPs and suggest another topic you would like me to share my experiences and thoughts about!

PS: I've intentionally oversimplified some of the details to ensure the essence of the concept in not lost in going into the technical details. Further reading on the concept and understand exact details in the ESOP plan of your company is much encouraged :)