The Problem with ESOP’s

Employee Stock Option Plans (ESOP’s) are one of the most popular ways in which modern startup companies reward their early employees. In Silicon Valley, many companies such as Google and Facebook have used Employee Stock Option Plans (ESOP’s) to lure the best talent from the market. Since these companies have become very successful, there are several multi-millionaires in the Silicon Valley area thanks to these Employee Stock Option Plans (ESOP’s).

However, this does not mean that Employee Stock Option Plans (ESOP’s) always work. In some cases, the objectives of both the employer as well as the employee are met. On the other hand, in many cases, Employee Stock Option Plans (ESOP’s) create a lot of problems. In this article, we will have a closer look at the downside of these ESOP’s. We will have a look at the downside from the point of view of the company as well as the employees.

Employee Stock Option Plans (ESOP’s): Disadvantages Faced by the Company:

Employee Stock Option Plans (ESOP’s) are always marketed as being financial instruments which bring democracy into companies. Many companies have reported high growth led by motivated employees and democratic decision-making process after Employee Stock Option Plans (ESOP’s) were introduced. Also, ESOP’s allow better financial management. The employees can defer smaller present payoffs for bigger payoffs in the future. Also, there are considerable tax advantages to using Employee Stock Option Plans (ESOP’s). However, there are many disadvantages as well. Some of them have been listed below.

• Complex: Employee Stock Option Plans (ESOP’s) make the capital structure of the company very complex. Since the company already has obligations towards its employees, raising additional capital in the form of debt or equity becomes very difficult indeed. This added complexity in a way nullifies the tax advantages that Employee Stock Option Plans (ESOP’s) provide.
• Uncertainty: If a worker decides to leave the company, the company must buy their stock options. This transaction usually happens at the market price. Hence, whenever an employee leaves the firm, the cash flow position of the firm is negatively affected. This forces companies to keep a lot of cash on hand. Hence, the opportunity cost for keeping these funds on hand is lost. Also, more workers tend to leave the company during a downturn. Hence, it is likely that the company may already be facing cash flow woes during this period. If the company is forced to buy back the Employee Stock Option Plans (ESOP’s), their cash flow situation might get significantly worse.
• No Clear Productivity Gains: There has been anecdotal evidence that Employee Stock Option Plans (ESOP’s) drastically increase the morale and the productivity of the employees. However, there have been no facts which can conclusively prove this. Empirical studies have failed to show this correlation. In fact, data shows that only stock options are not good enough for increasing employee morale. They need to be able to have more influence in the workplace for the setup to be truly democratic.

Employee Stock Option Plans (ESOP’s): Disadvantages Faced by the Employee:

The anecdotal stories of Employee Stock Option Plans (ESOP’s) multi-millionaires are more the exception than the norm. Employees also face several disadvantages when they accept a large chunk of their compensation in the form of Employee Stock Option Plans (ESOP’s). Some of them have been listed below.

• Lack of Diversification: When employees are compensated through Employee Stock Option Plans (ESOP’s), a large portion of their retirement savings are invested in the company that they work for. Hence, in case the company goes bankrupt, not only do the workers lose their jobs and insurance but they also lose a large chunk of their retirement savings. This is exactly what happened in Enron. It is estimated that employees who are compensated in ESOP’s have as much more invested in the company’s stock than regular employees have in their 401(k). This lack of diversification can prove to be very dangerous for employees who are closer to retirement. The lack of diversification can bankrupt employees during a recession.
• Conflict Of Interest: Employees who receive Employee Stock Option Plans (ESOP’s) have as much invested in the company as the promoters do. However, promoters have visibility over the performance of the firm. They also have decision-making rights. Hence, it is possible that promoters may make decisions that may be good for them but bad for other shareholders like employees who hold ESOP’s. The objectives of the promoters and the employees are not really aligned.
• Voting Rights: Although companies claim that Employee Stock Option Plans (ESOP’s) bring a democratic work culture to the workplace, most of the companies do not give voting rights to employee shareholders. This leads to two problems. Firstly, shares without equal voting rights are considered to be less valuable in the market. Secondly, employees who hold these shares don’t really have any influence over the decisions being made by the company.

To sum it up, Employee Stock Option Plans (ESOP’s) are not as beneficial as they are claimed to be. They too have a lot of drawbacks which both parties need to consider before they decide to use the Employee Stock Option Plans (ESOP’s) as a method of compensating workers.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.