scorecardresearchThe downsides of ESOP lifelines for startups

The downsides of ESOP lifelines for startups

Updated: 29 Mar 2022, 09:27 AM IST

An ESOP transaction includes valuation, legal and regulatory guidance, competent plan management, funding, and fiduciary obligation. Owners must be aware of the legal and tax consequences in order to effectively benefit from the ESOP.

ESOPs are not for everyone — no matter how appealing they might appear

ESOPs are not for everyone — no matter how appealing they might appear

When you consider the possible tax benefits and consequences for your workers, ESOPs might be an appealing idea, but it should be approached with caution. This strategy is not appropriate for every firm. It might turn out to be complicated, costly and unviable for certain firms. It can also expose a company to legal action, so firms should make sure that they are aware of the dangers and choices before proceeding.

ESOP plans are qualified plans created primarily for the aim of distributing shares of a company's ownership to both executives and employees. These plans are available for publicly listed firms, although they are most often utilised by privately owned companies that require a liquid market for their stock. Employee stock ownership plans (ESOPs) alleviate this problem by acquiring shares from registered employees when they retire.

Giving ESOPs is a common trend in start-ups, where firms provide employees the opportunity to prevent significant cash outflows in form of a high wage since the resources are limited. This encourages workers at all levels to perform at their best and assure the company's success, since they will profit from the company's success as well.

ESOPs are not for everyone — no matter how appealing they might appear. They come with stringent requirements, as well as several limits and obligations. The ability of your firm to use such a plan is determined by its structure, and not every organisation fulfils the legal criteria.

While tax benefits are appealing, they are also highly regulated and dependent on a variety of factors, including the business's structure. Let us discuss some major drawbacks of ESOPs.

Payout is lower

Employees in a closely held ESOP may not receive the same share price as they would if the shares were publicly traded.

Difficulties with Cash Flow

The cash flow allocated to the ESOP might limit what can be reinvested in day-to-day operations, which can be a problem for early-stage firms. Because shares must be repurchased when an employee leaves, a small firm might face a significant future expenditure if a large number of employees leave at the same time.

Expenses are high

Companies that adopt ESOP programmes may expect to pay a lot of money to set up and run them as they need continuous management and experience. Hence, it involves a variety of costs, ranging from yearly valuation and plan administration to legal and perhaps trustee fees.

Dilution of the stock price

The creation and issuing of extra shares for new participants can dilute the value of all existing shares, which is a particularly serious issue for closely held firms.

Requires great management

To thrive throughout an ESOP transition, businesses must have excellent management. There's a lot riding on the present owner's departure from corporate leadership, especially if he or she started the firm. Strong leadership is required to change the ownership structure.

Of course, there are drawbacks to every qualifying employee benefit plan. Valuation, legal and regulatory advice, competent plan management, financing, and fiduciary duty are all part of an ESOP transaction. To fully profit from the ESOP, owners must be informed of the legal and tax implications.

First Published: 29 Mar 2022, 08:36 AM IST