Introduction
Two mechanisms applied to structure the financial architecture of a company are equity financing and ESOPs, which may or may not affect incentives for employees. Although each applies a similar concept-ownership stakes-they are offered in different contexts for different purposes.
This short guide deals with an outline of what equity financing and ESOPs are, why they are important, how they work, and the impact of these factors on companies and employees.
What’s Equity Financing?
Equity financing is raising capital by selling shares in the company; that is actually selling ownership in the business. This is unlike debt financing, wherein a firm borrows money and repays it with interest.
Types of Equity Financing
Initial Public Offering
When the company first issues its capital issues by selling its shares in the stock exchange, it is known as an initial public offering, or IPO.
This will benefit the firm to generate sufficient funds from the public market and provide liquidity to its early investors and employees.
Private Equity:
Here, the firm raises funds from private investors, venture capitalists, or institutional investors.
Private equity investors can also provide more than their money; strategic insight, or a network in the given industry, may also be part of the deal.
Venture Capital(VC)
Venture capital is a type of private equity mostly used by start-ups or companies in the early stages of development.
A VC investor provides equity to companies in return for equity and remains an extremely high-risk endeavor for the possibility of significant returns in case the company delivers.
Angel Investors:
Angel investors are those who provide personal funds typically, personal funds in exchange for equity in a small or start-up firm .
Venture capital finance stage is the earliest of all before most other kinds of more formal financing.
Equity Finance Key Features
Ownership Stake: An investor receives an ownership interest in the firm in shares normally.
No Liability to Repay: A liability to repay is not associated with equity financing as no repayment is made to investors as compared to debt financing. Returns are received by the investor only if the company grows and makes profits.
Dilution of Equity Control: With the issuance of new shares, existing shareholders’ share of control in a company gets diluted, whether founded or early investors.
Dividend Payments: Dividend payments are offered by investors based on the profit of the company. However, most start-up and growth companies follow the dominant investment psychology of reinvesting profits into the business .
Advantages of Equity Financing
No Interest and Principle Burden: No obligation of interest and principal that is a significant saving in terms of cash-intensive or high-growth companies .
Access to Expertise: Along with capital, the equity investor offers a flow of strategic advisory, business, and industry know-how.
Lower Risk: One cannot be technically insolvent by defaulting on equity. There is no financial liability and is not obliged to pay back the equity amount.
Equity Financing Downsides
Dilution of Equity Ownership : The more shares issued, the more ownership percentage drops of the original founders and shareholders
Loss of Control: The voice of new shareholders in terms of company decision-making is demanded and dilutes management control over the business
Profit Sharing: Profits are forwarded to the shareholders in the form of dividends or an increase in value of their shares.
Employee Stock Option Plans (ESOP)
The Employee Stock Option Plans are also known as ESOPs. It is a form of equity award that companies offer to their employees. The plan gives them the right to purchase the shares of the company at an agreed price, at some future date. Several organizations prefer to use ESOPs as a catalyst for bringing the interests of the employees in alignment with those of the shareholders, thus forcing them to work for the prosperity of the firm.
Stock Options: The workers are given stock options. These options will make the employees entitled to buy a certain number of shares at an agreed exercise price after a specified vesting period.
Vesting Period: This is the waiting period before the employees are allowed to exercise their stock options. This is an incentive by the company, as it ensures that the employees retain the company for a more extended period.
Exercise Price: It is the price at which an employee can buy the shares of the company awarding them, normally equal to the market price prevalent when the options vest.
Exercising Options: Once the vesting of options takes place, employees may exercise these so-called calls, meaning they now have the right to the purchase of company shares at the exercise price even if, in the meantime, the prevailing market price of the shares has appreciated.
Employees can either hold the shares, or sell them to obtain profits should the value of the stock appreciate.
Taxation: The taxation of an ESOP is largely beneficial in the sense that when the employees exercise the options, they pay capital gains tax only at the difference between the selling price and the execution price; they pay tax only then.
Advantages of ESOPs:
ESOPs, therefore, help in retaining employees to achieve long-term goals and be a part of the betterment of a company because they will have financial gain in the form of increased value in the stock of the company.
Aligns Employee and Shareholder Interests: Now employees turn into shareholders whose direct interest will match the growth of the company. Therefore, they will be more willing to contribute for the betterment of the business.
Cash Conservation: The company can pay competitive wages without devouring its cash surplus. This is particularly relevant for firms’ ventures .
Advantages of ESOPs
Non-Dilution: Fresh issue of shares by the ESOP does not dilute the ownership of existing shareholders.
Ease of Administration: ESOPs are more complicated to administer as it requires high professional know-how in law and finance to keep within the folds of tax laws and other regulations.
Chances of Employee Alienation: If the company’s stock fails to sell, the employees would get demotivated, especially if they have “underwater” options, which means the current market price is lower than the exercise price.
Use of ESOPs in Equity Financing
ESOP can be strategically used as a tool in equity financing for the following purposes and achievement of several objectives mentioned below:
Incentivize key talent: ESOP helps the startup and growing company to attract as well as retain key talent basis an equity stake in the future growth of the firm.
Plan for smooth exit: ESOPs are generally part of mergers or the acquisition process which is meant to incentivize employees to stay on till the transaction is completed, as well as facilitate an easy exit through private equity or M&A.
Savings Cash Outflows: Companies would save cash if they pay employees in terms of stock options instead of a bonus in cash; cash is very critical when the companies are expanding or for businesses with high capital intensity.
Between ESOPs and Direct Equity Ownership
An ESOP is providing options which can be exercised in the future with the intention of that it would be converted into shares. The ownership through equity, on the other hand, provides shares directly to the employees; a few of the things differ regarding them.
Timeline of Ownership: In ESOPs, the employees legally accrue the right to acquire shares at some future time. In direct equity ownership, the employees had their equity immediately recognized from them.
Incentive Structure: With this structure, employee incentives are tied with future stock price performance because ESOPs give employees a right to buy shares in the future. With direct equity ownership, the employee makes the owner a shareholder because the employees will be instantly recognized as shareholders.
Risk and Reward: An ESOP in theory promises future returns greater than the stock price, but there is a risk of its being worthless if the stock price goes so low that it is below the exercise price.
Conclusion
Equity financing and employee stock option plans (ESOPs) are both powerful tools a company can use to attract, motivate employees, and keep interests aligned between the shareholders and the employees.
While equity financing frees the enterprise to source capital free of debt encumbrance, ESOP’s provide an essential role in forming ownership culture and long-term commitment from the workforce.
Combing all these agreements can form a great impact on the company’s financial health, on the level of workforce engagement and strategic outlook, and therefore becomes an integral component in today’s modern strategies of corporate finance and management.