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Important Steps to Consider While Creating ESOP

by / ⠀Investment / September 9, 2022
ESOP computer

Employee Stock Ownership Plans (ESOPs) are a form of employee benefit that allows employees to acquire stocks in the company they work for. The idea is to encourage an ownership culture and to ensure that the company’s employees are invested in its success. It has become a more popular and common form of employee compensation in recent times. In order to set up an ESOP, there are a number of crucial steps that need to be followed. 

ESOP in Startups

The importance of creating ESOP is to promote employee loyalty. This in turn can lead to better performance and increase the growth of the business. ESOPs enable employees to invest in the company and be an integral part of it. A number of businesses and startups worldwide include an ESOP as part of their employee benefits. 

While startups usually have smaller budgets, ESOPs must be introduced when the business is stable and sustainable. It is important for a startup to have a core or mission-critical team that can help it survive in order to keep costs low during the initial stages. Thus, with an ESOP, employees can enjoy a higher level of stability and growth. The goal is to retain the best staff and make them feel valued.

Understanding ESOP and How It Works

ESOP refers to a type of employee benefit where employees can purchase stocks in their company at a lower cost. In a sense, employees also have the opportunity to profit from the company’s growth. It can be said that ESOPs are designed to improve employee morale, increase efficiency and lead to a better quality of work.

Generally, a trust fund is set up in order to make it possible for employees to purchase stocks in the company. New shares of its own stock are added to the trust fund, and then the shares are sold to employees at attractive prices. Therefore, ESOPs can be said to be one of the many ways through which companies can reward their employees. As a result, employees feel valued and are motivated to work hard with a sense of ownership at the workplace.

How is ESOP Different from Other Forms of Employee Ownership?

In an ESOP, employee ownership is realized through the trust fund that is set up to purchase stocks on behalf of employees. The flexibility of this feature enables employees to choose when to sell their stocks. Thus, benefiting from the company’s growth as well as receiving additional profit. 

With ESOP, the working relationship within an organization becomes mutually beneficial and fulfilling. Since employees work to create a sustainable, successful company that benefits the entire community. It can be said that there is a better chance for employees to be engaged in their work and make a difference among others. 

Thus, it is important to encourage a culture of employee ownership. This way people are invested in the company’s success and feel that they are an integral part of it.

Do Startups Need to Create an ESOP Plan? Why?

In this competitive and dynamic world, startups that wish to be successful in their business must have the capability of retaining their employees and creating a culture of ownership at work. Following are some of the most important reasons that a startup should consider creating an ESOP plan:

  1. A comfortable workplace that inhabits a conducive atmosphere for employees to engage in their work creates one of the primary reasons a startup needs to introduce an ESOP. With this type of ownership at work, people are likely to keep working hard and make the best effort on the job.
  2. To attract the best talent and increase efficiency, startups should consider setting up an ESOP plan as it enables employees to be shareholders and share in the company’s profits.
  3. Employees’ job security is another important reason for startups to consider setting up an ESOP. In this way, employees show more loyalty to the company since the company established that ownership helps them keep a secure job.
  4. The role of ESOP is to make employees feel as though they have a stake in the company’s success. This makes people feel that they have an important role and are motivated to work hard for their contribution.
  5. By encouraging a culture of ownership, people are more likely to be motivated and make a difference in their work on a daily basis. They will strive to create a healthy workplace where ownership can create an atmosphere of mutual respect, harmony, and commitment to the team’s mission-critical work.

Overall, startups should consider setting up an ESOP plan. It can help to create an ownership culture at the workplace and give employees a sense of belonging and motivation to perform better.

How to Create ESOP for Your Startup?

Now that it has been clearly established that an ESOP plan is an important way for startups to create employee ownership and to make their employees feel valued. However, the process of setting up an ESOP plan needs careful designing. 

To get a valid and legal plan, it is important to involve a qualified and experienced team of attorneys that can handle the process of setting up ESOP for startups. From the first step to the actual implementation of the plan, it is crucial for startups to get professional assistance. The following are some of the ways in order to create ESOP for your startup in an effective manner.

Important Steps in Creating ESOP

The steps to creating ESOP include several procedures that must be carefully followed to ensure that the plan is valid and legal. The following are some of the most important steps that can help startups create an effective ESOP plan.

1. Prepare and understand the ESOP structure/scheme

The process of setting up an ESOP for your startup should start with the preparation of a robust plan that can address all potential issues. The first step would be to choose the structure of the plan in order to understand how it works. It is important for startups to choose how shares are held, and who can buy them. Additionally, the maximum number of shares that each employee may purchase, and what kinds of shares are available. The plan’s structure also needs to address all possible issues. This includes how to grow the company and what guidelines need following. This complete outline helps prioritize the company’s goals to set a course for developing a sound plan.

2. Get 409a valuation for your startup

The second step is to get a valuation from the IRS based on your startup’s plan. 409A valuation refers to determining the fair market value of the company’s common stock. This is the value of each share. This should reflect the intrinsic value and market price of a stock for a specific period. It is based on the reporting procedures, basic information about the company itself, and the company’s ability to generate cash. Plus, a number of other factors. A qualified person should conduct the valuation. The findings of the study need presented in a report to use them to make decisions in the initial setup of ESOP. The valuation report needs periodically updated. So that the company has a fair idea about the current value of its shares.

3. Get expert’s help

As stated earlier, it is important for startups to involve an experienced team of attorneys to set up ESOP in order to get an authentic, legal plan. The experts should be capable of determining various aspects. These potentially include how to design a plan in order to get the maximum benefit and how it can be effective. This involves the process of setting up the plan from scratch and making sure that it is free from all legal issues. The expert must be able to provide a feasible solution to various concerns about the plan. This includes how it can be implemented effectively, who the potential buyers of shares are and what the risks are associated with an ESOP.

4. Consider all the benefits and pitfalls

Once the company has chosen its structure and has received the 409A valuation, it is important for the entrepreneur to consider all the possible benefits and pitfalls of setting up an ESOP plan. The experts should provide a list of potential problems and discuss solutions with the entrepreneur. This enables the company to get an idea about all factors that potentially affect the plan and how to solve them. As such, the startup will be able to avoid the pitfalls that could hamper its implementation.

5. Get shareholders’ and board approval

After creating the plan, it is important for startups to get the approval of their shareholders and the board of directors about its implementation. The plan requires the input of all stakeholders. It is crucial for the company to ensure that the relevant people have been consulted. It is important to get the approval of key stakeholders since they will have a great impact on the startup’s business model and how it operates. Thus, the ESOP plan needs presenting to the board. All parties involved must agree on the strategy, goals, and way forward for the plan.

6. Document and finance ESOP

It is important to make sure that the plan is well documented, as this will help startups to be able to follow the appropriate procedures in the process of implementing ESOP. It is important for startups to create an adequate fund, which should be sufficient for the implementation of the plan. The process will involve making regular contributions to the plan. Startups need to devise a sustainable method of financing ESOP. In addition, proper documentation of the plan helps the company to understand the financial implications. Additionally, it enables them to identify various other factors that possibly affect the implementation of ESOP.

7. Establish a proper process

Also, startups need to establish a proper process for implementing ESOP in order to get the maximum benefit. This could include establishing a proper framework for the above steps. Additionally, providing a detailed implementation plan. This step is all about making your plan official and setting up a system that can facilitate the process. The startup must draw up a detailed plan. This involves getting all the relevant approvals and making sure that the plan is sound. This will give a clear idea to all stakeholders about how the ESOP scheme will work in your startup.

8. Start granting shares

Once startups create a well-designed ESOP scheme and approve its implementation, they then start implementing their ESOP plan. It is important to begin granting shares to employees as soon as possible so that they can start benefiting from the plan. The companies need to keep a proper record of the number of shares granted to employees.

In addition, it is important for startups to provide adequate grants that will satisfy all the contributors. Plus, that will avoid any problems in implementation. As such, it is important for startups to start granting shares right away. Additionally, ensure satisfaction with shares of the stock options with all the parties involved.

The above-mentioned steps provide a clear idea about how startups can create a sound ESOP plan and implement it effectively. The process will help startups to promote transparency and offer better benefits to employees and other stakeholders. Yet, startups need to ensure that they have all legal documents in place and implemented as per the plan.

Conclusion

It is important to note that ESOP is a good way of providing benefits and incentives in a startup company. It can help the company to build a positive corporate culture. Plus it helps people to work with more zeal and passion. The plan will provide additional motivation for employees to work harder and contribute more to the growth of their startup. Yet, to set up an effective ESOP plan, startups must involve an experienced attorney and get the advice of other relevant parties.

About The Author

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Sarath CP is a digital Strategist and growth analyst with Eqvista. He has worked for both startups & big brands, helped them to build a strong brand presence, and achieve sustainable business growth.

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