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Startups and the Power of ESOPs

Varun Bhardwaj

25 Jan 2025 — 5 min read

Startups and the Transformative Power of ESOPs

This article has been contributed by Manish Panwar, Business Head at Xumane.

"ESOPs are about more than just shares—they’re about building something meaningful together. When employees become part-owners, they don’t just work for the company; they work with it, driving its success as if it were their own.”

– Manish Panwar

In recent years, Employee Stock Option Plans (ESOPs) have emerged as one of the most innovative ways for startups to attract and retain top talent. As these plans continue to grow in popularity, they have proven to be an effective strategy for both companies and employees. The wealth that individuals have accumulated through their ESOPs is nothing short of inspiring, with some even turning into overnight millionaires when their companies hit the jackpot.

So, why are ESOPs so appealing, and why are they here to stay?

The Startup Dilemma: Talent vs. Cash Flow

As a startup founder, the struggle to attract skilled employees often comes down to one thing: money. The lack of cash flow can make it impossible to offer competitive salaries, but do you need skilled employees? Absolutely. Can you afford to pay them what they deserve? Probably not—at least not yet.

This is where ESOPs come into play.

At their core, ESOPs are modern-day compensation tools that allow employees to become partial owners of the company by granting them stock options. These options give employees the right to buy shares of the company at a predetermined price, usually well below market value, with the hope that the company’s value will grow significantly over time.

How ESOPs Work: A Quick Breakdown

Granting of Options: Startups grant stock options to employees, specifying the number of shares they can purchase in the future at a predetermined price.
Vesting Period: These options come with a vesting period—usually 3 to 4 years—during which employees must stay with the company before they earn the right to exercise their options. This ensures employees are committed for the long term.
Exercise Period: Once the vesting period is over, employees can “exercise” their options, purchasing the shares at the agreed-upon price. This exercise period often comes with a defined window of time.
Liquidity Event: The true benefit of ESOPs is realized during a liquidity event, such as an IPO or acquisition. When these events occur, employees can sell their shares and cash in on the appreciation.

The Power of Belief: Why ESOPs Work

So, how is the value of shares decided? And how can employees ensure that they will see returns from their ESOPs?

The answer lies in belief.

Employees who accept ESOPs are, in essence, betting on the future success of the company. They believe that the company will grow and become profitable, and as it does, they will enjoy the financial rewards that come with ownership. This belief is what drives employee engagement, productivity, and loyalty. When you own part of the company, you have skin in the game. Your success is tied to the company’s success. It’s no longer just about working for a paycheck—it’s about working to build something bigger than yourself.

The Allure of ESOPs

Consider headlines like, “500 Employees to Turn 'Crorepatis' With ₹9,000 Crore ESOP Plan.” That’s the power of ESOPs.

It’s often said that extraordinary wealth is only achievable through owning a business. Many people believe that simply being an employee won’t get them there. But ESOPs bridge that gap. By offering employees the chance to own a stake in the company, startups offer their employees the opportunity to build wealth just like founders do.

How Can Companies Implement ESOPs?

Startups can implement ESOPs by following the legal framework outlined under Section 62(1)(b) of the Companies Act, 2013 for private companies, or SEBI regulations for listed companies.

To implement an ESOP plan, founders and HR teams must:

Define eligibility criteria
Set exercise prices
Create vesting schedules
Ensure compliance with applicable laws

The Tax Implications: A Key Consideration

Taxation of ESOPs can be tricky for both startups and employees. Let’s break it down:

a) For Employees

Exercise of Options: When employees exercise their options, the difference between the fair market value of the shares and the exercise price is taxed as perquisite income.
Sale of Shares:
- If shares are sold within one year of acquisition, the profit is taxed as Short-Term Capital Gains (STCG) at 15%.
- If shares are held for longer than one year, they are taxed at Long-Term Capital Gains (LTCG), which is currently 12.5% on gains over ₹1.25 lakh.

b) For Startups

No tax deduction on ESOP grant: Companies cannot claim a tax deduction when they grant ESOPs.
Tax deduction on ESOP expense: Companies can, however, claim a tax deduction for the fair market value of the shares allotted to employees as an expense, provided they meet the conditions set by the law.

c) Legal Documents Required for ESOPs

For startups to set up ESOPs, the following documents are essential:

Stock Option Agreement: Outlines the terms of the options granted to employees, including exercise price and vesting schedule.
Vesting Schedule: A detailed timeline specifying when employees can exercise their options.
ESOP Plan Rules: A comprehensive guide defining eligibility, pricing, and operational aspects of the ESOP plan.
Board Resolutions: Formal approval by the board of directors to grant stock options.
Employee Communication: Clear documents explaining the ESOP plan and its benefits to employees.

What Happens When the Company Goes Public?

If the company goes public, ESOPs are converted into publicly traded shares, giving employees the option to sell these shares on the stock market. However, for this to happen, the employee must have already vested their options and exercised them.

Conclusion: A Tool for Growth, Loyalty, and Wealth

To sum it all up, ESOPs are not just a tool for attracting top talent—they’re a vehicle for wealth creation, fostering long-term employee commitment, and aligning the workforce with the company’s vision for growth. When employees have a stake in the company, their investment in its success is far greater than any cash bonus or salary increase could achieve. ESOPs offer a unique opportunity to build something meaningful, together.