Why employees are betting big on ESOPs

In the ever-evolving landscape of employee compensation, 2024 has revealed a striking paradox—while base salaries remained relatively flat, employee wealth creation hit unprecedented levels. The catalyst? Employee Stock Ownership Plans (ESOPs), which have transformed from a startup retention tool into a wealth multiplication engine. The evidence lies in the numbers –- 26 unlisted companies executed strategic buybacks this year, marking a clear inflection point in how both employers and employees view equity compensation.

The traditional metrics of measuring employee compensation are rapidly becoming obsolete. Senior executives are increasingly negotiating compensation packages with ESOPs comprising up to 40-50% of their total remuneration. This shift, however, doesn’t just reflect increasing risk appetite; it reflects a deeper understanding of wealth creation mechanics in high-growth companies. The surge in ESOP liquidity events, totalling $252 million in 2024, coincides with a broader transformation in India's startup ecosystem. Companies like Swiggy, with its $65 million buyback, Urban Company's $63 million ESOP encashment, and Whatfix's $58 million program validate this evolution.

Companies offering regular ESOP liquidity events typically command premium valuations in their segments. Such organisations demonstrate stronger employee retention rates and more stable growth trajectories—a direct result of aligned incentives between employees and shareholders. Pre-IPO ESOP liquidation events signal market maturity and serve multiple purposes. They provide crucial liquidity to employees, strengthen retention during critical growth phases, and signal market confidence ahead of public listings.

Managing ESOPs: A Strategic Approach

The vesting period represents the duration employees must work before their ESOPs are fully allocated. A typical structure might involve 25% of shares vesting each year over four years. For listed companies, ESOP shares often come with a mandatory lock-in period post-IPO, typically ranging from six months to one year.

While the potential returns are compelling—with some employees seeing 10-15x returns on their ESOP investments—proper risk management is crucial. Limiting ESOP exposure to 10-15% of an employee's overall portfolio is crucial to avoid overdependence on a single asset. This approach necessitates implementing partial liquidation strategies during buyback opportunities and reinvesting proceeds into diversified asset classes. Employees should carefully evaluate company governance structure and growth trajectory while maintaining a clear understanding of potential exit timelines.

When it comes to exit and redemption strategies, companies typically offer buybacks at fair market value when employees leave, ensuring equitable compensation for their equity. However, employees should be mindful of fortification periods before share buybacks, liquidity constraints in unlisted companies, and tax implications upon exercising ESOPs and subsequent sales. Understanding the timing of potential liquidity events like funding rounds or IPOs becomes crucial for maximising returns.

Looking ahead to 2025, several factors suggest this trend will accelerate. The success of recent IPOs has created a blueprint for wealth creation through ESOPs. Companies planning public listings in the next 24-36 months are already restructuring their ESOP policies to attract and retain key talent. The increasing sophistication in ESOP structures is particularly encouraging as companies move beyond basic vesting schedules to create liquidation opportunities, including secondary sale windows that allow employees to partially monetise their holdings while maintaining skin in the game.

For companies planning their compensation strategies, competitive ESOP packages are becoming a crucial differentiator. The key lies in structuring these programs thoughtfully—balancing immediate attractiveness with long-term sustainability. For employees, ESOPs have evolved beyond being mere lottery tickets. They require careful evaluation and strategic planning, considering factors such as company growth potential, exit opportunities, personal financial goals, risk tolerance, tax planning implications, and vesting requirements.

The key to success here lies in creating transparent, well-structured ESOP programs that align with both company goals and employee wealth creation objectives.

(The author is the Director and Co-Founder of Valtrust)