For most small and medium-sized businesses (SMBs), employee compensation is an area in which it’s difficult to compete with larger enterprises. In recent years, however, Employee Share Options (ESOPs) have become a popular way of attracting, compensating and retaining talent.

Here’s a quick rundown of what you need to know.

How ESOPs work

ESOPs are essentially contracts between the company and employee, which offer the employee the option to purchase shares in the company at a fixed price, within a specific period of time. They provide mutual incentives for both employer and employee, while also linking the latter’s interest with the performance of the company.

The contracts are structured through an ESOP agreement, which outlines the specific percentage of equity shareholding – or the stock option pool – that the employee is invited to participate in. The agreement also includes details of the eligibility criteria for employees, the process in which they can purchase the shares, the exercise price and other terms and conditions.

Typically, when hiring an employee, the employer would extend an ESOP invitation only on the condition that the former stay with the company for a certain number of years. There may also be a specified vesting period before the employee is allowed to exercise the share option, followed by an expiration date, after which the employee is no longer entitled to buy any company shares under the agreement.

For instance, your company may decide to set aside 10 per cent of its equity for the ESOP, to be divided among 10,000 shares. An individual employee can be granted the right to buy 1 per cent (or 100) of the shares on 1 June 2016, but he would only be allowed to use 30 of those shares on 1 June 2017, while the remaining 70 shares to be ‘activated’ on 1 June 2018.

ESOPs as a retention instrument

As most ESOP agreements require a lock-in or vesting period for employees before they’re allowed to exercise the shares, this might serve as an incentive for them to stay.

Former PayPal and Intuit CEO, Bill Harris, is a strong proponent of ESOPs for this reason. “One of the smartest moves you can make is to share the future upside of your company’s growth with key employees by granting stock options,” he tells Inc.com.

ESOPs cultivate a sense of ownership

Inviting your employees to own a stake of the company changes their relationship with it. As shareholders, they are much more likely to be motivated to improve their performance since they are now directly responsible for their own rewards.

As an added incentive, government regulations for ESOPs in Singapore are transparent and straightforward.

ESOPs allow SMBs to be more competitive employers

SMBs are often unable to provide their employees with the same salaries and benefits that larger firms can offer. ESOPs level the recruitment field for SMBs, allowing them to reward employees with financial incentives without tapping into cash, making ESOPs a cost-effective, long-term benefit plan.

As the company grows, the flexibility of ESOPs can also become an exit strategy for business owners who wish to sell the business gradually while ensuring that the company culture remains intact, as the employees themselves will own part of the business. If your employees share your vision and are invested in preserving the legacy of the company, ESOPs are a particularly good strategy to consider.

ESOP downsides to consider

While the benefits of ESOPs are numerous, implementing an ESOP warrants careful consideration of its potential downsides.

For one, the company is obligated to repurchase stock from employees who leave the company. Therefore, think about whether your company will be financially prepared to repurchase shares if multiple employees leave at once. For startups in particular, this requires careful cash flow planning to ensure that this occurrence does not compete with other capital needs that could limit your growth or worse, leave you in debt.

Another factor to keep in mind is that although ESOPs should motivate employees to create more value for the company, the reality is that the drop of the stock price will affect the owner far more than the employee, who forgoes a bonus in the worst-case scenario. It would be a mistake to assume that the employee is equally invested in the success of the business as you are.

It’s also important to work out the costs of implementing and maintaining an ESOP programme, as these could be more expensive than you might think. You would need legal and accounting expertise to begin with, as well as hours of administrative work.

For a startup, ESOPs could be a cost-effective way for rewarding, retaining and attracting human capital. It’s also crucial, however, to carefully study the implications of setting up an ESOP programme, and whether your company is truly in a position where such a programme will reap rewards for both you and your employees.