An ESOP, which stands for Employee Stock Option Plan, is a type of employee benefit program that gives employees, directors and officers an option to take stake in the company by granting them ownership of company stock. Here's how it works:
- Ownership: Employees become part-owners of the company by acquiring shares of stock. This stock is typically held in a trust until it vests (becomes fully owned by the employee).
- Vesting: Vesting refers to the process of employees gradually gaining ownership of their allocated shares. The vesting schedule determines how long it takes for employees to fully own their shares, often based on factors like time with the company or performance. Every company makes an ESOP policy to set out the terms of ESOP including the vesting period.
- Taxation: Contributions to ESOP by the company are tax-deductible, and employees typically pay taxes on their distributions when they leave the company or retire.
- Purpose: ESOPs are often used to create a sense of ownership and align employee interests with company performance over the long term.
Phantom stocks, also called shadow stock, are a type of employee compensation plan that mimics some aspects of stock ownership, but without actually giving employees shares in the company. Here's how it works:
- Units instead of Shares: Instead of receiving actual stock, employees are granted phantom units, which are hypothetical units that track the company's stock price.
- Cash Payout: When the phantom stock vests (becomes accessible to the employee), the employee receives a cash payment based on the difference between the grant price (predetermined price when awarded) and the stock price at vesting or another predetermined time.
- Appreciation only plans: Only pay out if the stock price goes up from the grant price.
- Full value plans: Pay out the difference between the grant price and the current stock price, regardless of whether it's higher or lower.
- Taxation: Taxes are usually deferred until the employee receives the payout, at which point it is taxed as ordinary income.
- Purpose: Phantom stock can be used to provide a performance-based incentive without diluting ownership.
When considering whether to implement ESOPs or phantom stocks for your startup, it's important to take into account several factors to make an informed decision:
ESOP
Benefits:
- Aligns employee interests with company success (they own a piece of the pie);
- Can incentivize long-term commitment (shares often vest over time); and
- Tax advantages for the company under certain conditions
Drawbacks:
- More complex and expensive to administer compared to phantom stocks.
- Share dilution (existing shareholder ownership percentage decreases); and
- Employees may not fully understand or value stock ownership.
Phantom Stocks
Benefits:
- Simpler and more flexible to set up than ESOPs;
- No share dilution; and
- Easier for employees to understand the potential benefits.
Drawbacks:
- Doesn't provide the same level of ownership or long-term alignment as ESOPs;
- Less tax advantage for the company compared to ESOPs; and
- Employees don't benefit from dividends or voting rights (usually).
It's essential to consider additional factors for your startup:
- Stage of Development: If you're in a very early stage, phantom stocks might be easier to manage;
- Employee Base: Consider your employees' financial literacy and risk tolerance. ESOPs might be more attractive to those seeking long-term ownership; and
- Company Goals: If you highly value employee ownership and long-term commitment, ESOPs could be a better fit.
Conclusion:
ESOPs are ideal for established startups seeking to align employee interests with long-term growth and potentially benefit from tax advantages. Phantom stocks are a simpler option for earlier stage startups or those with employees who might prefer a more straightforward cash-based incentive.
Ultimately, the best choice depends on your specific circumstances. It might be helpful to consult with a financial / legal advisor specializing in startups domain to determine the most suitable option for your company.
Authored by:
Rohit Jain, Managing Partner and Kumar Shubham, Sr. Associate at Singhania & Co.
