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How can Startups use ESOPs to attract the best talent?



The Employee Stock Option Plan (“ESOP”) is an option offered by a company to its employees to purchase shares in the company at a predetermined price. Generally speaking, companies give ESOPs to well-performing employees, to inculcate a sense of ownership towards the company by rewarding them. In addition to big companies, ESOPs are now popular amongst startups as well. The major reasons are that startups plan to retain their employees for a long period and cannot afford to offer huge pay packages to their employees to do so.[1] Over the years, ESOPs have become a key component of benefits for employees amongst startups in India, as it is a unique feature compared to other employee benefit plans.


Today, companies in India and abroad utilize ESOPs to reward and retain their employees and ensure that all their employees work towards improving the performance and profitability of the company.[2] ESOPs are also beneficial for companies as they allow lower employee turnover and retention of their talent pool. A company measures its performance through return on assets and equity while it measures its productivity through the total assets turnover and sales and cash flow per employee.[3] Therefore, it is observable that ESOPs have a positive and beneficial impact on a company and the productivity of its employees.


Introduction to ESOPs:


Louis Kelso, a lawyer and investment banker from the USA, was the inventor and pioneer of the Employee Stock Option Plan. He allowed the employees of a closely held newspaper chain to buy out its retiring owners; he believed that all workers should share ownership of capital-producing assets to strengthen the capitalist system.[4] Eventually, in the USA, the concept of ESOPs evolved from certain tax benefits received by the employer because of his contribution.[5] In the UK, findings concluded that even though the shareholders of a company had a direct interest in improved company performance, very few of them had any direct incentives.[6] Therefore, the ESOP scheme was adopted to encourage employee participation in the ownership of shares in the companies. With time, the ESOP scheme was rapidly accepted in India, beginning with the info-tech sector and later spreading across the services and manufacturing sector.[7] The rapid adoption of the scheme required regulations for its management; these regulations were incorporated in the Income Tax and Corporate Laws of India. Therefore, the USA, the UK, and India understood the significance and adopted the scheme for their benefit.


Impact of ESOPs on Employees:


ESOPs are an important measurement of organizational performance in terms of performance management systems.[8]The interface between employees and owners creates an impact on organizational performance. Although both the company and its employees benefit from ESOPs, the employees benefit more in comparison. The employees receive noticeable ownership benefits as they have substantial gains in wealth and benefits, increased job security, and work satisfaction. These noteworthy ownership benefits are discussed below:


1. Substantial gain in wealth and benefits


The employees of a company unequivocally face overall compensation gain, not only in terms of company equity but also in terms of overall average pay compared to workers in non-employee-owned firms.[9] The ownership wealth accumulated from ESOPs does not substitute an employee’s income, but adds to worker pay and benefits, thus resulting in far greater overall compensation.[10] Based on this, it is observable that higher productivity levels exist on an average in employee ownership companies, as the workers may have some influence in setting wages and benefits on the management that adopts ESOPs.

Some employees may choose to take lower wages as part of employee buy-outs, such as in the United Airlines case of the 1980s, approximately 1000 public firms developed employee ownership stakes of 4% or greater, yet only 40 reports depicted wage and benefit restructuring related to employee ownership.[11]


2. Increased job security


Employee owners have the option to exert formal or informal pressures to increase job security, as workers value job security greatly. One example of this is, during the period 1983-95, U.S. public companies with broad-based employee ownership plans had increased job stability as compared to similar firms in their industries.[12] Firms with the employee ownership scheme had significantly longer average employee tenure than similar firms without the employee ownership scheme.


3. Increased work satisfaction and workplace participation


Work satisfaction and motivation are derived from increased participation, not from the size of ownership stake or even ownership per se. Studies have shown an association between employee ownership and motivation to work, participation and influence in decisions, and commitment and identification.[13] In addition to such factors being instrumental in improving the company’s performance, they directly benefit the employees themselves. The well-being of employees has extensively been attributed to feeling a sense of commitment, identification, motivation, and participation in their work.[14] These elements are necessary for work-life, and it is this attachment with the work-life that leads to a life of meaning and satisfaction. [15]


Attracting talented employees to Startups:


The lack of good personnel is a competitive disadvantage and a threat to the survival of a company. The search for skilled key employees is ‘the war for talent.[16] The companies that rely on a basic salary and bonus package can be at a competitive disadvantage compared to companies offering incentives and benefits like ESOPs. Employees expect options in the benefits available, and organizations have to provide various options to remain competitive in the labor market.[17] Individuals weigh out the pros and cons and perform a cost-benefit ratio analysis before selecting a company.


The influence of the ESOPs scheme in attracting and retaining talented employees depends on several factors including, political, societal, and cultural factors. At a political level, the proven success of companies in a specific area of work can influence the decision-making of individuals, such as startup successes of software companies like Facebook and Instagram can attract individuals to that field of work.[18] At a societal level, the family members of an individual, and at the psychological level, the work ethic, decisiveness, confidence level, and characteristics influence career choices.[19] Finally, cultural factors involve the behavior of co-workers, workplace atmosphere, complexity of projects, and compatibility with the company in terms of experience and philosophy.


In light of these factors, the following aspects influence the effectiveness of ESOPs in attracting the best talent:


1. Compatibility with individual characteristics


An employee’s reaction towards ESOPs may depend on five personality traits: openness, conscientiousness, extraversion, agreeableness, and neuroticism; an employee who is open to new experiences will participate more freely in the workplace.[20] People with different personality traits can fall under two categories, Type A and Type B.[21]Type A people do not deal well with higher levels of job insecurity and avoid working in such workplaces. If they do work under such conditions, their performance will suffer.[22]Type B people are comparatively tolerant, patient, and more outgoing.[23] They focus on enjoying life and would be a more suitable match for a startup. However, it is difficult to determine whether a person belongs to the Type A or Type B category, as there is no test to clarify the same.


In 1996, eight career anchors were developed to determine the factors that attract different personality types; security/stability, technical competence, managerial competence, entrepreneurial creativity, level of independence, dedication to a particular cause, lifestyle, and challenge.[24] Factors such as level of challenge, entrepreneurial creativity, and independence make startups the preferable choice, but lower security/stability and lifestyle work against them.[25] The final factor consists of the type of personality a company is looking for; a startup with an ESOP is more likely to attract more risk-neutral employees and seek less risk-averse workers, but big companies are not.[26]


2. Business strategy and organizational characteristics


It is necessary to involve employees in the business strategy, as they are a key component in reaching organizational goals.[27] Therefore, sharing relevant and strategic information with the employees and showing them how to contribute towards these goals is crucial. Employees can use their functional discretion in implementing the business strategy to accomplish company goals; share options work better when employees have practical freedom to act.[28] The implementation of ESOPs yields better results if the employees take responsibility for the results.[29] The successful implementation of ESOPs in the company strategies includes giving sufficient information, feedback at regular intervals, and connecting strategic and financial information to show the influence of the employees.[30] In addition to this, the organizational characteristics of a company are also an influential factor. These organizational characteristics include the industry, the history and organizational phase of the company, company and branch size, financing, and reasons to implement an ESOP.[31] The category of companies with an ESOP structure are knowledge-intensive with people as the main resource, a well-established organizational structure, and generally financially stable or becoming so.


3. Human Resource Management


Depending on the contract, employees can gain property and corporate governance rights by exercising their option on shares. These rights include participation in the yearly shareholder meeting, receiving dividends if it is distributed, and selling shares. However, these rights should fit with the organizational instruments for Human Resource Management to make the ESOP, and the goal of retaining employees effective.[32]


The organizational instruments for HRM are:

  • Influence in decision making

The retaining effect of share options depends on the level of influence the employees have in the decision making process, the work environment and strategic decisions, otherwise, the connection of their performance to the possible payout of shares could diminish.

  • Information sharing

The lack of information about company performance, financial matters, and company strategy could diminish the ownership and retention effects of the ESOP over the employees.[33] The sharing of relevant information should start well before the implementation of the ESOP.

  • Coordination with the Management

The managers of a company influence the success of ESOPs as employees who exercise their options are required to be treated as fellow owners and shareholders to make the ESOP effective. The management sets the tone and influences the perception of the plan, and the employees adjust their attitude and behavior accordingly.

  • Understanding of consequences

The employees should have a clear understanding of their rights along with the risks and consequences of participating in an ESOP.[34] This information will help employees make a well-informed decision regarding their participation and exercise of options.

  • Transparency

It is necessary to introduce transparency in the ESOP regarding the rules and procedures involved in this scheme. The processes should be clear and understandable to all employees involved to prevent misunderstandings and chaos.

  • Conflict resolution

Participation in an ESOP can lead to conflicts within the organization, occurring in the form of peer pressure, mutual monitoring among employees, or employees risking their job to influence decision-making in the company. The situation requires objective handling in a formal manner when conflicts arise.


Conclusion:


Employee Stock Option Plans have a positive and significant impact on companies and are especially beneficial for startups. The main reasons are that startups plan to retain their employees for a longer duration and cannot afford to offer big pay packages to their employees to do so. Therefore, they give ESOPs to well-performing employees to inculcate a sense of ownership towards the company by rewarding them, thus ensuring they work towards improving the performance and profitability of the company. In addition, ESOPs allow lower employee turnover and retention of their talent pool.


The lack of talented personnel is a competitive disadvantage and a threat to the survival of a company. Hence, startups need to provide options other than a basic salary and bonus package to remain competitive in the labor market. The influence of the ESOPs scheme in attracting and retaining talented employees depends on several factors including, political, societal, and cultural factors. The major influential factors are compatibility with individual characteristics, business strategy and operations management, and alignment with organizational instruments for Human Resource Management. On consideration of all the necessary aspects and proper implementation of ESOPs, startups can attract and retain the best talent in the industry.


[1] Gambhir, M., 2015. [online] Psalegal.com. Available at: <https://psalegal.com/wp-content/uploads/2017/01/ENewslineDecember2015.pdf> [Accessed 19 October 2021]. [2] Kumar, P., 2021. Employee Ownership in India. [online] Rady.ucsd.edu. Available at: <https://rady.ucsd.edu/centers/beyster/media/newsletter/2020/winter%20-%20final/employee-ownership-in-india/index.html> [Accessed 18 October 2021]. [3] Ismiyanti, F. and Anom Mahadwartha, P., 2021. Does Employee Stock Ownership Plan matter? An empirical note. [online] Available at: <http://dx.doi.org/10.21511/imfi.14(3-2).2017.08> [Accessed 19 October 2021]. [4] Rai, S. and Malwe, M., 2019. An Analytical Study of Employee Stock Option Scheme of Leading Indian Companies. International Journal of Commerce and Management Studies, [online] 4(1). Available at: <https://www.ijcams.com/wp-content/uploads/2019/03/An-Analytical-Study-of-Employee-Stock-Option-Scheme-.pdf> [Accessed 19 October 2021]. [5] Ibid. [6] Ibid. [7] Ibid. [8] Murphy, K. and Murrmann, S., 2009. The research design used to develop a high performance management system construct for US restaurant managers. International Journal of Hospitality Management, 28(4), pp.547-555. [9] Freeman, S., 2007. Effects of ESOP Adoption and Employee Ownership: Thirty years of Research and Experience. [online] ScholarlyCommons. Available at: <https://repository.upenn.edu/od_working_papers/2?utm_source=repository.upenn.edu%2Fod_working_papers%2F2&utm_medium=PDF&utm_campaign=PDFCoverPages> [Accessed 20 October 2021]. [10] Blasi, Joseph, Michael Conte & Douglas Kruse. 1996. Employee stock ownership and corporate performance among public companies, Industrial and Labor Relations Review, 50(1) 60-79. [11] Kruse, Douglas & Joseph Blasi. 1997. Employee ownership, employee attitudes, and firm performance: a review of the evidence, In Daniel J.B. Mitchell, David Lewin, and Mahmood Zaidi, eds., Handbook of Human Resource Management. Greenwich, CT: JAI Press, 1997, pp. 113-151. [12] Blair, Margaret, Douglas Kruse & Joseph Blasi. 2000. Is employee ownership an unstable form? Or a stabilizing force? In Thomas Kochan and Margaret Blair, Eds., Corporation and Human Capital. Washington, DC: The Brookings Institution. [13] Supra at 7. [14] Seligman, Martin E.P. & Mihaly Csikszentmihalyi 2000. Positive psychology: An introduction, American Psychologist, 55: 5-14 [15] Csikszentmihalyi, M. 1990. Flow: the psychology of optimal experience. New York: HarperPerennial. [16] Chambers, E. G., Foulton, M., Handfield-Jones, H., Hankin, S. M., & Michaels Ill, E. G. (1998). The War For Talent. Mckinsey Quarterly(3), 44-57. [17] Schwartzberg, B. J., & Weiner, E. (2007). Attracting And Retaining Key Employees By Offering Equity-Based Incentive Compensation. The Metropolitan Corporate Counsel, 15(6). [18] Meeuwenoord, I., 2014. Share options as an instrument to attract & retain talent for Dutch startups. [online] Essay.utwente.nl. Available at: <https://essay.utwente.nl/65187/1/Meeuwenoord_BA_MB.pdf> [Accessed 20 October 2021]. [19]Ibid. [20] Matthews, G., Deary, I. J., & Whiteman, M. C. (2009). Personality traits (3rd ed.). New York: Cambridge University Press. [21] Supra at 16. [22] Ibid. [23] Ibid. [24] Schein, E. H. (1996). Career anchors revisited: Implications for career development in the 21st century. Academy of Management Executive, 10(4), 80-88. [25] Ibid. [26] Core, J. E., & Guay, W. (2001). Stock option plans for non-executive employees. Journal of Financial Economics, 61, 253-287. [27] Kaarsemaker, E. C. A. (2009). Werknemersaandeelhouderschap in Nederland: Frequentie, kenmerken, ondersteunende praktijken en gevolgen. Assen: Van Gorcum. [28] Ibid. [29] Blasi, J. R., Freeman, R. B., & Kruse, D. L. (2013). The citizen's share: Putting ownership back in democracy. New Haven & London: Yale University Press. [30] Supra at 27. [31] Supra at 18. [32] Supra at 27. [33] Poutsma, E., Blasi, J. R., & Kruse, D. L. (2012). Employee share ownership and profit sharing in different institutional contexts. International Journal Of Human Resource Management, 23(8), 1513-1518. [34] Deep, K., 2017. Role Of ESOP In Start-Ups - Corporate/Commercial Law - India. [online] Mondaq.com. Available at: <https://www.mondaq.com/india/corporate-and-company-law/637574/role-of-esop-in-start-ups> [Accessed 21 October 2021].
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