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ESOP For Startups: What is ESOP And How Does It Benefit Startup?
18 February 2022·4 min read

Marcin Laczynski

Partner, Next Road Ventures

ESOP For Startups: What is ESOP and how does it benefit startup?

Starting your own business is an exciting venture. However, it doesn't come without challenges. One of the biggest potential obstacles for startups founders is finding, motivating, and retaining talented employees. ESOPs (Employee Stock Ownership Plans) can solve this problem by allowing employees to be owners in the company they work for and giving them an incentive to stay with that company while also engaging more in its daily operations and future plans. Here is a short guide on how to use ESOPs to attract and retain the best talents.

What Is ESOP?

ESOP stands for Employee Stock Ownership Plans and is a form of employee share ownership that provides qualified employees with interest in the company's stock. The actual ESOP allocation mechanics may differ between geographies, but it does have one thing in common- employees can purchase a dedicated pool of shares at a discounted rate for a fraction of their market price. As the company grows, employees start seeing the benefits of owning shares. 

Advantages and Disadvantages of ESOPs

Why actually use ESOP? The answer is simple, as granting ESOPs is one of the best ways for startup founders to share their successes with the team. ESOP gives employees an ownership stake in the company and can be the best way for startups to attract and retain talents. Employees who own stock in the company they work for feel more invested in it and will be more likely to stay with that company over a long time. No wonder ESOPs are one of the most popular employee benefits for startups these days. 

Undoubtedly, ESOPs are an excellent possibility for startups to share the company's success and motivate employees, resulting in increased productivity. When employees have a financial stake in the business, their sense of ownership increases morale and trust in its development and scalability. Moreover, ESOPs are a great way to compensate employees for lower salaries, they make compensation package look competitive and attractive and, at the same time, relieves pressure on cash flow. Granting a part of ownership to employees reduces staff turnover, enhances loyalty, increases job satisfaction, and finally extends the company's likelihood of survival.

Additionally, engaged employees become better informed about the company's vision and plans, which helps build a strong culture. So everyone is heading towards the common goal and motivating other team members. 

Nevertheless, it is essential to remember that ESOPs also have some drawbacks. Employees are more likely to be demotivated when the price of their shares does not increase. The same goes if their engagement has no real influence on startup development. There are also some costs related to establishing and administering an ESOP, however, such costs, as previously mentioned, differ between geographies and types of legal entities. Another important drawback of Share Ownership Plans is their dilutive power – i.e., every time new shares are issued, the founder’s stake becomes smaller. 

When to Start ESOP?

Although there is no specific best time to offer an ESOP, you can answer some questions about where your startup currently stands.

  • Who will the plan involve?
  • How large should the ESOP be, and how much will it dilute other shareholders' holdings?
  • How will employees react to an ESOP plan?
  • What vesting schedule should apply?
  • What is the company's financial situation, and what are the costs associated with ESOP?
  • Will voting rights extend to participants of the ESOP?
  • Do the benefits of the prospective ESOP outweigh the costs?

 Answers to these questions will determine if your business is ready to provide this type of benefit and lay the foundations for the ESOP.

ESOPs are a powerful tool for startups and can serve as a great benefit for employees. If you are looking to attract and retain the best talents, make sure to understand the concept of ESOPs, the pros and cons of this employee benefit, and how to use it to your advantage.

Interested in ESOP-related topics? We will continue delving into the ESOP applications from startups' and VCs perspective. In order to stay updated, follow us here and subscribe to our blog.
 

Related Posts:

How ESG Will Affect VC Funds And Startups? (by Ewa Chronowska, Partner, Next Road Ventures)

Startup Fundraising: Due Diligence (by Ewa Chronowska, Partner, Next Road Ventures)

What Is A Convertible Note And Is It The Right Funding Source For Your Startup? (by Marcin Laczynski, Partner, Next Road Ventures)

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