Candid Tip #14: Are ESOPs going to make you rich?
PhonePe (a payments & UPI app) was acquired by Flipkart in 2015, resulting in massive growth for the startup, making it the market leader for UPI payments.
Cut to today, PhonePe has decided to split with Flipkart to focus on its next stage of growth.
This resulted in ESOPs worth $700M distributed amongst 19000 Flipkart employees.
While these numbers sound great, the bigger question still remains - are ESOPs going to make you rich?
Let’s dig in!
First, let’s get started with the basics -
How do ESOPs work?
ESOPs (or Employee Stock Option Plans) are instruments that give employees the right to buy a certain number of shares of their current company in the future at a pre-decided price. Essentially, this means that employees can purchase X number of the company’s shares after a certain period (called the vesting period), say 4 years in a company - at a pre-decided price.
Once you exercise the right to buy, you become a shareholder in the company - like you would if you bought shares of a publicly listed company. The ownership gives you the right to sell these shares at a premium when a liquidation event occurs - such as new investors coming in for a fresh round of funding or the startup debuting on the public markets through an IPO.
Why do companies offer ESOPs?
Companies offer ESOPs for a bunch of reasons -
Early startups that can’t currently offer higher salaries or salaries that compete with the market averages. Instead, these companies offer a stake in the growth of the business.
Larger companies that offer ESOPs find that they can reduce employee turnover and increase loyalty by literally giving ownership to their employees.
Many companies genuinely believe that the people who are behind building the company deserve ownership of it, so they either offer ESOPs or reduce stock prices for their teams.
Are all ESOPs good at wealth creation?
Well, it depends. ESOPs are essentially a bet that you place on the future of the company that you work with, and like all bets - it can go either way. However, as a professional, it becomes important to carefully judge the company’s ESOP policy before making a decision based on them.
Let’s look at two examples -
Swiggy for example, rolled out a two-year policy for the ESOPs given to their employees. In July 2022 and July 2023, all employees who held ESOPs of the company became eligible to liquidate them back to the company.
Uber, on the other hand, has received much flak for their stock option policies. Although Uber offers stock options to their employees, the options for employees to buy these out if they leave the company are very restrictive. Employees can either buy their stock options out in 30 days or have to forfeit them to the company. Last we heard, Uber was working on chartering new employee-friendly stock option policies.
What are some things to evaluate before signing up for ESOPs?
While it is impossible to accurately predict whether a certain company’s ESOP plan will generate wealth for you in the long term, there are some pieces of information that you can collect and make an informed decision.
For instance, it’s important to research the company’s growth, valuation, and future plans before you accept ESOPs. It’s easy to feel more valued by ESOPs, but if your company doesn’t grow at its planned potential, it’s a loss of your money and time.
Similarly, you can evaluate your decision further by asking questions such as these:
Where does the company’s revenue come from?
Is the valuation of the company based on funding rounds alone or are the revenues growing super fast as well? Valuations based on funding rounds are often artificially high and can be volatile.
Does the company have investors? Is it VC-backed? If so, who are the investors? If not, when does the company plan to raise funding?
Has the company raised a lot of funding over many rounds? If yes, then remember that the company needs to exit at a much higher valuation for common shareholders and employees to make any money. This is due to the liquidation preferences that investors typically get.
How quickly is the company raising money? If the company has raised VC rounds and is not profitable yet but hasn’t raised money recently, it could mean that raising money is becoming difficult and hence, ESOPs could be riskier there.
What are the company’s people and culture policies? What does their employee attrition rate look like? ESOPs aren’t a substitute for a good working culture.
What is the company’s policy on ESOPs vesting and forfeiture if someone leaves the company during the vesting period? Candidates usually prefer companies that have liberal vesting and exercise options.
Bottom line
ESOPs are a way for companies to attract and retain promising talent and it can be a great wealth generation tool for professionals who do their research and pick the right companies at the right stage of their lifecycle.
If offered by companies who take their ESOPs can bring in a great return on your time and dedication to a startup, but it’s important to evaluate options and do deep scrutiny of these policies as well as the employers before signing the dotted line.
This newsletter is a retelling of a blog originally published by Cutshort. Check out the entire blog here.