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Creating incentives for employees through stock options and sweat equity schemes



After reading this  module, you should be able to understand:

1. How an ESOP scheme works
2. How to structure an ESOP plan
3. Tax aspects of ESOPs
4. How sweat equity shares are issued
5. Relevance of an Employee Stock Purchase Scheme in incentivising employees


Introduction to incentives for employees in early stage businesses

Early stage start-ups often do not have the ability to pay their employees competitive salaries when compared to established businesses or large corporations although they often require very high quality human capital (due to resource constraints, less funds, unstable cash flows among other things). Startups can benefit significantly from having motivated employees who are able to over-perform and exceed their expectations. For this purpose, they try to incentivise employees by offering them several other rewards such as disproportionate performance bonuses, revenue shares, stock options or directly a stake in the company.

In addition to performance bonuses (which are common at larger companies), mechanisms such as revenue sharing, profit-sharing, ESOPs, sweat equity have gained popularity. Revenue sharing with an employee implies sharing a percentage of the revenues (i.e. the sales or the turnover). A key disadvantage of revenue-sharing is that the employee’s share is computed and paid even before the other expenses of the business (such as office expenses, salaries, etc.) are deducted, which takes away a larger portion of the cash flows of the business, and reduces profits. Profit-sharing, on the other hand, allows the business to deduct its expenses first, and then share a portion of the income with the employee.

A revenue or profit-sharing model can also be deployed on a project basis, where, instead of a percentage share of the total revenues or profit, only a portion of the revenues or profit (as applicable) generated from a specific project, specific geographical area or specific business vertical will be shared.

Profit-sharing and revenue sharing mechanisms can be negotiated and specified in an employment or consultancy agreement entered by the business. However, other mechanisms – such as ESOPs, stock purchase schemes and sweat equity schemes are more extensively regulated. We shall cover these comprehensively in this module.

ESOPs are the most commonly used methods of employee incentivisation - so we shall start with that.

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