ESOP 101: Option Scheme Drawback and Maximizing Value Part 7
By Joanne Hue, published: 2023-04-11
An Employee Stock Option Plan or an ESOP is a method of equity financing that allows companies to include their employees in the ownership. Depending on the size of the business, setting an ESOP can be challenging and bear its unique drawbacks. While a company may intend to mutually benefit its employees and shareholders through an ESOP structure, setting an ESOP with proper research may be counterproductive.
If you are planning to set an option scheme within your company, it is integral to understand the drawbacks of an ESOP and adopt means to maximize its value.
What are the Drawbacks of an Option Scheme?
Obtaining and setting an ESOP structure might have many obstacles that come along with setting any employee incentive. Some of the drawbacks and challenges associated with an Option Scheme are as follows:
- Limitation in price per share
Price per share does not remain constant and is influenced by the performance of the business. If the company is not making viable profits, its value experiences a depreciation. This means that the value of shares is constantly fluctuating. If a company does not have proper management plans then employees do not benefit from a stock ownership option. Likewise, if the financial outcomes of a company are not consistent, employees cannot make proper decisions on the exercise of their vested rights before the option’s termination. If a company is performing poorly, the share option does not incentivize employees to invest in it. Therefore, if a company is not on the trajectory of making profits, all the advantages associated with an ESOP structure may not apply to it. The fluctuation in share prices can therefore be a drawback in the option scheme.
- Issues with timing
Similar to the price of shares, the advantages associated with the stock option are determined heavily by timing. Employees seek to make the best out of their stock options. To do so, they need to cautiously time their exit. If employees wish to make the most out of their share option plan, they will have to cautiously plan their exit based on the company’s performance. If they exit the company when the valuation of its stocks is depreciating, they will receive a low payout from their option plan. Since timing is an influential variable, employees need to note their timing before selling their sales. If the employee is not educated in matters concerning the fluctuation of stock prices with time, an ESOP may become disadvantageous for them.
- Inconsistent Share values
Since the price of stocks fluctuates with the value of the company, an employee should not solely depend on the ESOP for their finances. They may be safer ensuring their financial stability through retirement saving plans or tax-free saving accounts. These plans can be a safety net or an additional income for individuals who have stock options. For individuals seeking to retire, dependence on their share option plans can be particularly risky. Due to inconsistent share values, they cannot rely on their option plans. In other words, an employee should not place all their eggs in one basket.
Ideas to Maximize the Value of an option Scheme
ESOP can be a contributing factor in making a business more productive and employee-friendly. Due to this reason, the popularity of Share option plans for employees is increasing in the UK and the USA. Most governments throughout the world facilitate laws that are accommodating for ESOP structures in businesses. This accommodation can come in form of tax redemption on shares contributed to ESOP structures or reduction in taxes for shares acquired through stock option plans. However, their increasing popularity does not always translate to guaranteed benefits for the employees and the company. Before setting an employee option plan, it is recommended for the companies identify means to maximize the advantages they can receive from their option plans.
For a budding startup, the valuation of a stock option plan is the same as the valuation of the entire company. Companies are required to provide stock option plans in their profit and loss statements as an expense. For smaller companies, this can be a problem because placing the entire finance for the company as an expense means that the determination of distributable profits, EPS calculation, Minimum Alternate Tax Payment, profit calculation for senior management remuneration, and dividend declaration is impacted.
ESOPs are valued using a variety of methods like company assets, income, fair value methods, etc. So valuation of ESOP has direct relations with the valuation of the company. Issuing ESOPs over a vesting period also requires its valuation. It is important to note that implementing a stock option plan in the company changes the tax structure within the company. As the inclusion of ESOP adds tax deductions and deferrals, a company can acquire maximum benefits from an ESOP setting by achieving the maximum tax benefits. A company may acquire maximum tax benefits from its stock option plan by deferring income and accelerating the company’s deductions. To do so, the business must ensure that its accounting standards permit it. It all boils down to proper planning before setting up an ESOP.
Proper organization is key to gaining maximum benefit out of a stock option plan. A company needs to hire an experienced committee to oversee its option distribution. Selecting a skilled and competent advisory team is important. This means that a business should hire financial, legal, administrative and fiduciary professionals to ensure that their ESOP setting provides maximum benefit in the long run.
Communicating the intricacies associated with the ESOP plan is also an integral part of setting a successful ESOP. Larger companies separate a significant amount in their budget for the sole purpose of efficient communication. This entails educating your employees about the processes concerning the ESOP. Employees need to be provided with information about the valuation of a company. They need to be provided with the opportunity to compare the market value of the stocks with their fixed prices. In that way, employees can acquire the most benefit out of their stock options. Additionally, the employees that are participating in the option plan, but are yet to be vested with their rights need to be informed about the qualifications concerning the vesting of their stock options. In this way, the share dedicated to the Employee share option plans is not wasted.
The primary step to garnering the most benefit out of a stock option plan includes having a proper ESOP pool. As ESOPs intend to augment employee productivity, the company needs to ensure that they are selecting the required and targeted employees for the stock option plans. The prerequisite to setting an appropriate ESOP option pool is analyzing the performance of employees and predicting the value an employee may bring to the company. If an employee does not have the required savings to purchase stocks in the company, allocating stock option plans to such employees means that the stock option will not be utilized. The employee and the company can only mutually benefit if they have similar objectives. The final step to maximizing the benefits of the employee option plan is to develop and train a competent generation of employees that are capable of taking over the management. Training senior management professionals is an arduous task as it requires years of effort and resource investment. The company will require future leaders to sustain and thrive.
The benefits that can be obtained through an ESOP are subject to the overall value of the business. Employees need to account for the fluctuation of share prices and determine the suitable time to exercise their rights to make the most out of their option plans. Pre-determining the scale of your company’s option plan, hiring a competent advising team, and educating your employees about your option scheme will help you acquire the maximum benefit and minimize drawbacks.
You may also like:
- ESOP 101: Introduction to Employee Share Option Plans (Part 1 of 10)
- ESOP 101: Understanding Vesting, Exercise, and Expiration Terms Part-2
- ESOP 101: The Process to Set Up an Employee Share Option Scheme Part 3
- ESOP 101: Communicating and Administering an ESOP – Part 4
- ESOP 101: Tax Implications and Accounting of an ESOP Part 5
- ESOP Benefits for Employees, Business, and Shareholders (Part 6 of 10)