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21 October 2022·5 min read

Mateusz Kaczmarski

B2RLaw

ESOP For Startups: How Employee Stock Option Plans Can Improve ESG Metrics?

Employee Stock Option Plans (ESOPs) are gaining popularity in the recent years. Having discussed in the previous articles many issues related to ESOP investments, its models, basics and intricacies, there is an opportunity to dive deeper and analyze the impact ESOP can have on the ESG metrics.

Why improving the ESG metrics is important?

The term ESG, which stands for Environmental, Social and Governance, is a well-recognized global investment trend that will continue to grow to reframe the investment strategies of many VS funds. An increasing number of countries require companies to report their social and environmental challenges. In the EU itself, the Non-Financial Reporting Directive (2014/95/EU) came into force, obliging large public-interest companies to publish ESG reports. However, the significance of ESG metrics does not come from the government regulations alone, as investors, customers, employees, and suppliers are the ones who shifted the focus on working with the businesses that benefit not only stakeholders but society and the planet as well. The connection between being ESG-aligned and obtaining funds is strong and is predicted to escalate in the coming years. Therefore, improving ESG metrics is important for helping companies to achieve economic development and get ahead of the competition.

ESG and ESOP

ESG metrics consist of many indicators, quantitative and qualitative, that are divided into three categories: environmental, social and governance. Each of them influences the general outcome of the overall ESG report. As for social criteria, on which we are going to concentrate, they demonstrate the company’s relationships with internal and external stakeholders. The discussed social indicators include workforce turnover, company focus on community, as well as its commitment to diversity and inclusion. These indicatorscan be improved by adopting ESOP which main goal is to attract new employees or retain the current ones by granting them company stocks. Such operation results most likely in strengthening the commitment of employees to the company, which transfers into them being more active in supporting company’s local communities and more emotionally invested in helping the company to achieve organizational outcomes. Furthermore, ESOP visibly decrease employment turnover, which is one of the main social criteria of ESG. 

ESOP and reduction of workforce turnover 

It appears that employee retention is a new hot topic that has been talked about more often than ever before. With great digitalization of employee market and post pandemic realization of both personal and professional priorities it is harder than ever for employers to retain their best employees. That is where ESOP come in hand, providing employees with opportunity of ownership of the business. 

Studies by Rutgers School of management and labor relations show that majority of ESOP firms drastically outperform other firms at retaining jobs by a 4 to 1 rate compared to their non-employee-counterparts.  

It should come as no surprise that when an employee feels respected and valued by their supervisors and subsequently the company itself, he or she is more likely to stay with the company for many years to come. A way to retain and show appreciation to key employees is to offer additional benefits or variable remuneration components to encourage staff to stay with a given company. ESOP enables the deferral of part of the salary/bonus which, in the long run, not only adds to the retention of employees covered by such a program, but at the same time allows building the value of the company.

Vesting period as a great tool to retain employees 

The vesting period is the time between the date when options or shares are issued and the date the participant, or in another words the employee, is able to exercise all the rights that are linked to them. Participants who received options through ESOP are not permitted to exercise option until the vesting period is over. This indicates that if the employee leaves the company during the vesting period his or her share options are considered to be terminated. The same principle applies to shares that would be acquired through ESOP. If the participant leaves the company before the vesting period is over his or her shares are forfeited or sold at a discount. 

A very common option used by companies these days is a vesting period of four years with a cliff of one year (Cliff is a designated period of time which employees must work before they receive an option to vest at all.) This means an employee receives no shares for the first 12 months, and for example 25% vesting at the 12th month, and 1/48th more vesting each month until the 48th month. If the employee leaves before the first year he or she will receive nothing, but if they leave after two years, they will receive 50% of all vested shares.

As you can see from the above, ESOP is a great way to show employees gratitude and motivate them to work without spending money on conventional salaries thus improving the company’s cash flow, which might be crucial, especially for young and developing startups. A long vesting period with a cliff will also ensure low employee turnover, which is especially important in a competitive employee market among startups. Overall, implementing ESOP is an effective way for companies to increase the Environmental, Social and Governance indicators and ensure long-term growth and profitability.

The article was co-authored by Paulina Sobiech, Paralegal at B2RLaw.

Related Posts:

ESOP For Startups: ESOP In Foreigner’s Companies – The Consequences For Employees In CEE (by Magdalena Zawiślak, Associate, B2RLaw)

ESOP For Startups: All You Need To Know About Granting Shares And Options (by Teresa Pilecka-Juda, Senior Associate, B2RLaw)

ESOP for Startups: Shares, Options Or Cash Equivalent? (by Joanna Markowicz, Partner, B2RLaw)

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