scorecardresearchWhy shouldn't you be misled by startup ESOP options

Why shouldn't you be misled by startup ESOP options

Updated: 25 Mar 2022, 11:32 AM IST

Maintaining an ESOP entails a significant amount of risk, but it also entails several benefits and rewards. Before deciding on an ESOP, all elements should be thoroughly investigated.

Employees may be at risk if they participate in an ESOP.

Employees may be at risk if they participate in an ESOP.

Employees may be at risk if they participate in an ESOP. When the ESOP takes on too much debt, it puts employees' ESOP funds at danger. When an ESOP takes on considerable debt, it leaves little room for the sponsoring firm, which is now owned by the employees, to weather a financial collapse.

When considering an Employee Stock Ownership Plan (ESOP), these are just a few items that come to mind - ownership by employees, exceptional plan of exit, company expansion, tax benefits, an increase in the value of the company's stock and an increase in the motivation of employees.

An ESOP may provide considerable advantages to both employees and employers; nevertheless, ESOPs may not be the ideal match for every business. Although there are numerous good arguments for ESOPs, the hazards that ESOPs might pose have received little attention.

ESOPs are a type of qualified defined contribution employee benefit plan that invests largely in the sponsoring company's stock. By definition, ESOPs violate one of investing's fundamental rules - diversification. Diversification aims to decrease risk and volatility by reducing exposure to a single asset or investment.

ESOPs naturally increase asset concentration in a single security—company stock—which critics say makes them overly risky. Firms contemplating an ESOP should be aware that the risks encountered by privately owned companies differ from those faced by publicly held companies, and companies considering an ESOP should be aware of these distinctions while weighing the risks involved with an ESOP.

Major ESOP risks

The value of a company's stock might be affected by its financial conditions, reducing the stock's value and jeopardising the value of employees' ESOP accounts.

If a company with an ESOP is having financial difficulties and needs to lay off employees, the plan must cash out those employees' ESOP shares, which can cause even more cash flow issues and lead to more layoffs.

If a company's ESOP is invested in privately traded stock, the dangers stated above are amplified since the stock's value is set by a third party who may or may not be unbiased, rather than the stock market.

What happens if an ESOP firm runs into financial difficulties?

When employees rely on the same employer for both their income and their retirement account, they face an additional risk. When a firm faces financial obstructions, In most cases, the stock price falls, putting members' retirement savings at risk. Layoffs are common, exacerbating the situation. Employees may now be out of job, their retirement funds may be dwindling, and they may have little financial stability to fall back on when they need it most.

What happens if an ESOP firm is sold?

When a firm is sold, the ESOP is typically terminated, and employee owners get cash for their stock. This might be a good way to diversify your assets and get greater control over your money outside of the ESOP. Your firm may be sold to a company that has its own ESOP in some situations. This usually results in a rollover of part or all of your ESOP shares into the new company's ESOP shares.

An ESOP may be a good fit if certain requirements are satisfied and a skilled group of advisers is hired to help the firm through the legal, accounting, and administrative processes. While there is always a danger of failure, the potential is enormous. Maintaining an ESOP comes with a lot of risk, but it also comes with a lot of advantages and rewards. Hence, all the aspects of ESOPs should be studied carefully before choosing one.


Key things you must know about ESOPs
First Published: 25 Mar 2022, 11:32 AM IST