Explain Me like I’m 5 : What are ESOPs?

Let's assume youre stepping into your 5th grade. Parents tell you that they have 10 chocolates in the fridge and if you complete all the homework, pass exams with distinction and make them proud, they will give 10 chocolates and also extra.

So you work your ass off and kill your homework and exams.

If you have good parents, they will give you 2 chocolates per milestone [ESOPs buyback].

If you have good and rich parents, they will do as promised [company going IPO].

Very common scenario - If you have bad parents, they will continue promising the existence of chocolates to motivate you but in reality there are no chocolates [company not doing buyback nor going IPO. ESOPs are just paper money with no value].

You work your ass off in a risky startup making biscuits, and instead of paying more salary for taking the risk of joining startup, they give you one biscuit of the company which you can eat in bits when they buyback or get listed.

They promise you that biscuit you have will become 10 biscuits eventually, and the eventuality is you get laid off.

I own a farm of 1000s of hectares. You are a farm labourer in my farm. I make you a hiring promise as follows:

"I'll earmark a small portion of my land to be SOLD to you at the present rate of rs 2K per sqyd (max upto 500sqyd) irrespective of the market price in the future". These are ESOPs. Its a documented promise.

The promise is contingent to the following:

1. The commit of 500SqYd is contigent to you working for 48 months. Labor of 3 months confirm your ~10SqYd buying eligibility. However, you need to work at least 1.5 yrs to get anything at all. This is cliff & vesting
2. You need to buy the land within say 5yrs of you leaving employment. Any lapse here will make you ineligible. This is exercise window.
3. Till you actually buy out this land, you shall not receive its ownership and any benefits - like dividends etc
4. You may or may not get a subsequent buyer for this land. Not my problem.

This is exciting for you as you know the land price is going to skyrocket in future (because I am farming some exquisite stuff) and you maybe able to buy it at 2K/SqYd and resell it at 20K/SqYd

There are lot of complexities in esops. A good explanation without all the nuances has already been provided. But In the scenario you explained, consider it as a 20 pcnt hike only. Consider the value of esops as 0.

But before you join get an idea about its value. Like what is the exercise price and what is the current fair market price.

If you feel that is too complicated ask them how much you will get if the company exits at different valuations. Like 10 mil 100 mil 1 bil.

While all of the above comments are in good spirit, it doesn’t help OP. Here is something that will help

https://blog.pragmaticengineer.com/equity-for-software-engineers/

No one's explaining the crux here but just oversimplifying what ESOPs are (ELI5 makes sense). They're nothing but shares of the company which might increase in value and would convert to money from paper money through buyback/ipo or being acquired. I think op would've benefitted knowing that there's an exercise price which you pay when buying the ESOPs which is very cheap and is often taken from the value of the ESOPs only when you exercise it.

This is where chatgpt does good enough: “ESOPs are like getting a special treasure chest that grows when the company does well. But here's the catch: the grown-ups decide to give you a piece of the treasure chest bit by bit, like a few coins every month or year, but only after you've been playing the game with them for a whole year. So, you have to keep playing and helping the club grow to get more coins from the treasure chest. And remember, you might not get any coins until the game is over and the treasure chest is sold or the club has a big success!”

Most people are elaborately explaining only one aspect of it - that it is a flimsy promise and you might not even be able to exercise it if company doesn't become successful. While this is true, everyone is missing the most important part here. That these shares are not given to you for free. Even if the promise delivers, you'll have to buy the shares at the "present fair market value". It is assumed that this price would be much lower than the actual market value in the future, but there's no guarantee.

I actually have been able to sell my ESOPs for money through the company buyback program. ESOPs are a bet but in $500m above valued companies, it's a higher probability of you getting that money as the company matures. Less than that, they're basically paper money.

It is a promise which will be mostly broken 💔