ESOPs in India and globally have been recognized as one of the most preferred funding tool in the present era. While ESOPs were conventionally used as a tool to incentivize long-tenured senior management, recent trends indicate that ESOPs are actively deployed as a hiring strategy to recruit, retain and attract talent. It drives ownership among employees as options make them part owners which help in accelerating business growth and performance.
ESOPs have gained prominence as a result of recent IPOs and investment booms in young enterprises .Startups generally provide an early stage access of ESOPs to employees thereby aligning their wealth to future prospects of the Company. The year 2021 has witnessed more than 35 Indian Start-ups entering into 100 Crore ESOP POOL which includes giants like Nykaa, Zomato, PolicyBazaar, and Paytm, Flipkart Group, Byju’s, and Ola. While the entire concept of these Options can be difficult to comprehend, ESOPs being a pricy tool must be utilized with caution.
UNDERSTANDING THE CONCEPT OF ESOPS & MSOPS
ESOPs in the common parlance are used in two contexts.
Employee Stock Option Plan refers to a plan or a scheme under which the Company offers their shares to employees at a pre-determined price, generally at no or low additional cost, on a future date.
Employee Stock Options, on the other hand are Options or rights given to employees to purchase shares at a future date. These are NOT shares themselves.
A Company before issuing ESOPs shall determine who should be covered in a nutshell. The act defines certain eligible employees to whom ESOPs can be granted. “Employee” refers to :
- A permanent employee of the Company working in or outside India
- A Director of the Company whether a whole time director or not but excluding an independent director
- An employee or director of Subsidiary Company or Holding Company, whether in or Outside India
These schemes do not cover:
- An employee who is a promoter or belonging to promoter group, or
- A director who either himself or indirectly through his relative or body corporate holds more than 10% of outstanding equity shares of the Company
In line with ESOPs, many business ventures have now been rewarding founders in businesses by way of ‘management stock option’ or MSOPs where investors hold a higher stake than entrepreneurs
Recently Big basket founders have been granted a new set of MSOPs following the acquisition by Tata Group’s arm Tata Digital. The MSOPs have been allotted with an intent to ‘retain, attract and motivate’ talent in the online business-to-business segment BigBasket – Supermarket Grocery Supplies (SGS) where Tatas possess more than 64% stake.
MSOPs or ‘management stock option’ are similar to ESOPs issued by businesses with an aim to incentivize founders or the top management. Such grants are often made with a view to ensure that founders maintain their skin in the game. IPO bounds companies generally issue MSOPs and other milestone-linked rewards before filing the Draft Initial Public Offering (“IPO”) Papers. The options granted are often performance & time based with different vesting schedules and lockin period.
As per ET, Founders invest their own money in pre-IPO round valuation. Most founders end up having low single digit holdings at the time of IPO. Without such lucrative rewards, little incentives are left for entrepreneurs to continue scaling their ventures while early investors gain through IPO.
While, post IPO, public shareholder scrutiny goes up every quarter, investors should acknowledge the commitment of the founders. In case the founders exit the Company after listing, it can lead to severe decline in stock prices and have untold consequences on the Company. Thus, in order to instill confidence in the management of the Company after listing, granting of MSOPs becomes favourable.
LAW GOVERNING ESOPs
- Companies Act 2013 & Rules made thereunder
- SEBI (Share Based Employee Benefit) Regulations, 2014 (For listed entities only)
- ICDR Regulations, 2018 (In case of listed companies only)
- SEBI(Prohibition of Insider Trading) Regulations, 2015 ( For listed companies only)
- Income Tax Act, 1961
- Foreign Exchange Management Act (FEMA), 1999
- Department of Public Enterprise (DPE) Guidelines (additional Guidelines for PSUs only).
WHY DO STARTUPS NEED CAP TABLES FOR ESOPS
Startup Companies generally have small number of equity owners which often include family, friends and angel investors. Such owners need to have a fair view of their stake as and when the Company grows and receives further funds from other sources like venture capatilists or public IPO. The cap table will then be handy and get updated after each subsequent funding round, showing how ownership becomes diluted and spread across new owners as it grows.
A Cap Table, also known as Capitalisation table is a spreadsheet for startup companies or early stage ventures that indicate the equity capitalisation of the Company. The table lists all the equity shares, warrants, stock options, convertible securities of those who own them and price paid by the investors for these securities.
A more complex table may include details on potential new funding sources, mergers and acquisitions, public offerings, or other hypothetical transactions.
A well represented ESOP Pool in Cap Table attracts investor which leads to startups raining funding for their operations. Investors gain interest when they are sure that no further dilution shall take place until next round of fund raising.
Some of the essential points that should be included in the Cap Table regarding ESOP’s are:
- Grant Date: Date on which options are issued to employees
- Date of joining of employee
- Vesting: Refers to the time an employee must be associated with the Company to acquire a certain benefit.
- Vesting period: Refers to the period between date of grant of option and date on which employee is eligible to exercise the option as per the ESOP Scheme. The law prescribes a minimum vesting period of 1 year
- Exercise Period
- Number of shares
- Percentage stake
- Exercise Price
HOW TECHNOLOGY IS HELPING COMPANIES MANAGE ESOPS
In a dynamic economic and legal ecosystem, various firms have started providing ESOP management platform to Companies. Such platforms provide services related to management of Stock Options like:
- Trustee Services
- Cap Table Management
- Plan Review & Compliances
- Plan Design, Implementation & Rollout
- Vesting Schedule
- Exercise Period
- Manage Valuation
- Buyback Programs
CONCLUSION WARNING BELLS
It has been observed that employees often prefer short term cash over long term benefit which leads to increase in attrition. Thus, in order to retain talented employees, ESOPs can be issued. Employees must be apprised of advantages, functioning and taxation structure governing Stock Options. While it is advisable for Startup Companies to implement ESOP by issuing Options as a part of Compensation package, employees must consider factors like rate of ESOPs, voting rights, dividend on stock holding and vesting terms which provide employment stability.
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