Introduction
Every startup has potential to increase wealth for not just its founders but also its investors and employees. The best talents of the industry are reluctant to join early stage startups due to several reasons like no profit, lower salary structures, uncertainty of business model, uncertainty of job so on and so forth. Employees are always looking for an established big companies which has strong market presence so that they can move higher ladder on their career with the tag of reputed organizations. To overcome with this problem, startup should consider giving Equity Compensation popularly known as Employee Stock Option Plans (ESOP) to attract best talent.
ESOP is a scheme of offering shares to the employees by which they become a shareholder in the Company and thus hold a certain small level in the ownership in the Company. Under this scheme, a right is given to an eligible employee to buy certain number of shares of the Company at a fixed pre-determined price (Exercise Price) over a period of time (Vesting Period). The option provided under ESOP scheme confers a right but not an obligation on the employee. The options are subject to vesting that requires continued service over a specified period of time.
Key Terminology Defined
- Grant – It means issuance of stock options to the eligible employees.
- Vesting Period – The period after which the options can be converted into shares.
- Exercise – The action of paying the price and converting the options into shares by eligible employees.
- Exercise Price – The price at which shares are offered to the eligible employees.
- Exercise Period – The period after vesting within which the employee has to take the decision of exercising options.
Eligibility of Employee
All the directors and employees of the Company, its Holding or Subsidiary Company (whether in India or outside India) are eligible to participate in the ESOP Scheme. However, the employees belonging to promoter / promoter group and directors holding more than 10% of the capital are not eligible to participate in the ESOP scheme. However, this restriction is not applicable to the registered startup upto 10 years from the date of its incorporation.
ESOP through Example
Let’s discuss ESOP with the help of one practical example:
There is startup called ‘DVG FinTech Private Limited’ which was incorporated on November, 2023 and working towards FinTech solutions offered to the banks and financial institutions. DVG approached various investors in the market and based on its business model and founder’s profile, DVG got its seed funding at the pre-money valuation of Rs.5 Cr. So, below is the price per share:
- Pre money valuation = Rs.5,00,00,000/-
- of issued shares till date = 1,00,000
- Price per Share = Rs.500/- (Pre money valuation divided by number of shares)
Now, to attract and retain talent, DVG offers its key employees stock options at a price of Rs.500/- or even lesser than that. The employee has a right to buy shares at Rs.500/- during the vesting period which is typically span over a 4-5 years.
As the DVG grows and raises more capital from Private Equity and Venture Capital firms at a higher valuation, it will increase its share price which will induce employees to exercise their options. After 2 years, DVG raises pre-series A funding at the valuation of Rs.20 Cr. So, below is the price per share:
- Pre-series A Valuation = Rs.20,00,00,000/-
- of shares = 1,20,000/- (20000 shares issued in between)
- Price per Share = Rs.1667/- (Pre-series A Valuation divided by number of shares)
Now, employees can choose to exercise their options by paying exercise price of Rs.500/- and get a huge discount of Rs.1167/- per share.
The above example is for illustrative purpose only. In reality, startups can offer stock options to highly discounted price with some performance conditions of vesting and on satisfaction of conditions, stock options can be vested. Stock options may be issued in tranches and vested in tranches. Companies may have different percentage on different years of options vesting. Ideally, in initial years, vesting percentage shall be low with increasing over later years to retain the employees.
Startup also add 1-year cliff i.e employees are not eligible for stock options in its first year of joining and 4 year vesting in tranches which protects the startup in following two ways:
1. It ensures that key team members stick around for a certain amount of time to earn the full amount of their equity grant; and
2. If a team member does in fact leave company earlier than expected, unvested equity reverts back to the company and can be used to incentivize a new team member being brought on board to replace the person who left.
Ideal Stock Option Pool
There is a great confusion among startup founders that how much would be the ideal pool size of stock options. The size of ESOP pool can be determined based on the number of factors like the size of the employees, age of the startup, business model of the startup, funding stage of the startup, investor’s reservations and concerns etc.
In initial 4-5 years of startups, 5-10% of the total issued capital is the ideal size for the ESOP pool which can be diluted over a period of years. ESOP pool should not be as high as 20% so that investors may feel that it would be difficult to give an exit to such high number of employees and it should not be so low to demotivate employees by giving small minuscule number of options. It should strike a balance between the interest of investors and employees.
Implementation of ESOP Scheme
ESOP scheme can be implemented by following two routes:
1. Trust Route
Under trust route, ESOP trust is incorporated under Indian Trust Act. First, Company grants loan to the trust for acquisition of its shares then, trust acquires shares of the Company through private placement / secondary transfer from promoter. When an employee becomes eligible to exercise his options, he can apply to the trust to get its full paid up shares by paying exercise price to the trust and trust in turn pay back loan to the Company. In this route, there is no primary issuance of shares each time when employees exercise his right but rather its secondary transfer of shares from trust to employee and hence, there is no requirement to file return of allotment i.e form PAS-3 with the Registrar each time. This method is widely used by the listed companies and big unlisted companies.
2. Direct Route
While under direct route, Company directly issues shares to the eligible employee when he chooses to exercises his right. In this method, each and every time, employee exercises his right, Company issue and allot full paid up shares to the employees and file return of allotment i.e form PAS-3 with the Registrar. This method is widely used by small private and unlisted companies.
Exit Mechanism
In some point in time, employee who allotted shares need to sale it due to many reasons. If the Company is listed, then there is no problem and employee can sale their shares directly on the stock exchanges but when the Company is unlisted, giving exit to the employees is little bit challenging.
There are some of the following methods to give an exit to the employees in case of unlisted companies:
1. Buyback of Shares
Buyback is the repurchase of its own shares by the Company. In this method, Company repurchase its shares from the shareholders after complying with the provisions of the Companies Act, 2013. This is the best method to give an exit to the employees. Since 2020, Many startups launched ESOP buyback programs like Acko, Swiggy, Razorpay, CRED, Cashify to name a few.
2. Secondary purchase / transfer of shares from employees to promoters/other investors
Under this method, promoter / other investor purchases the shares of an employee to give him an exit. This is secondary share transfer between employee and promoter / investor. When employee wants to sale their shares and promoters or other investor is ready to take his shares, then employee will get an exit.
3. Floating an IPO
The last option to give an exit is floating an Initial Public Offer (IPO). IPO is the liquidity event where in Company list its shares on recognized stock exchanges so that investors and employees can sale their shares in the stock exchanges. Many startups launched an IPO in recent times like Zomato, Paytm, Nykaa, Policybazaar, Cartrade etc.
Procedural aspects for Issue of Stock Options
1. Prepare the list of eligible employees to whom stock options will be offered.
2. Draft the ESOP scheme.
3. Convene the board meeting to approve the ESOP scheme.
4. Convene the general meeting to approve the scheme by the special resolution in case of public company and ordinary resolution in case of private company.
5. File e-form MGT-14 with the Registrar to submit the relevant shareholder resolution within 30 days of passing.
6. After approval of ESOP scheme by the board and shareholders, Company shall grant options to the eligible employees through grant letter.
7. After grant, there comes vesting of options. There shall be a minimum period of one year between the grant of options and vesting of option as per Companies Act, 2013.
8. Once options are vested, employee becomes eligible to exercise it.
9. Once employees exercise its right, Company will make allotment of shares to the employees and Company shall file e-form PAS-3 i.e return of allotment with the Registrar.
10. The Company shall maintain a Register of Employee Stock Options in form SH-6 and shall forthwith enter therein the particulars of option granted.
ESOP Taxation
Taxation impact of ESOP can be triggered at the time of following 2 events:
1. On Exercise
The difference between exercise price and prevailing market price / FMV in case of unlisted shares shall be taxed as perquisite on the hand of employee.
2. On Sale of Shares
On sale of shares, the difference between selling price and prevailing market price / FMV in case of unlisted shares as on date of exercise will be taxable as Capital Gain on the hand of employee.
Advantages of Stock Options
> It gives sense of ownership and belongingness amongst the employees. They will feel that they are not working for the Company but they are working for themselves.
> It acts as a motivational tool for the employees that once they own a stock they will work for improving performance of the Company which will in turn increase price of their own stocks. So, the efforts of employee will increase manifold.
> It helps Company to retain the employee and assure a good level of performance in the work.
> Since it is a non-cash compensation tool, it helps in early stage of startups with low profit to attract best talent with low cash compensation.
> It gives an opportunity to the Company to pay without a reduction in book profits.
Disadvantages of Stock Options
Every coin has two sides and the same way, there are certain disadvantages of stock options too.
Disadvantages to Employee
One of the biggest disadvantage of stock options in case of unlisted company is free transferability. If an employee wants to sale his shares, it is very difficult to find a buyer. In case, Company is unable to float an IPO or there will be no exit mechanism in place to give an exit to the employees, such shares are valued in paper only as it can’t be sold in an open market. Sometimes, there is also fall of valuation of the Company and in that case, shares become cheaper than exercise price of an employee which will demotivate the employees.
Disadvantages to Company
One of the biggest disadvantages of stock options for a Company is to take care of ex-employees who become shareholders of the Company and started interfering in the shareholder meetings. Thy may ask for unnecessary documents, ask unnecessary questions and even vote against the promoters, in the shareholder meetings. Another disadvantage of stock option is when an employee leaves the Company, it becomes difficult to trace him as sometimes, Company is going to be 100% acquired by some another entity and in that case, some minimum untraceable shareholding by ex-employees may derail the entire deal.
Alternatives of ESOP
There are following two most popular alternatives of ESOP:
1. Phantom Stock Plans
Under this plan, employees are given ‘phantom units’ which resembles real stock options. The value of phantom units is linked with the price/value of company’s stock. In this case, employees do not, however, have any actual Company shares, in contrast to ESOP. A phantom stock plan basically promises the employees a bonus in the form of value of the Company shares when he chooses to sale back their phantom units.
2. Stock Appreciation Rights (SAR)
A stock appreciation right is a lot like phantom stock. The only difference in this is that it provides the right to the monetary equivalent of the increase in the value of a specified number of shares, over a specified period of time. Just like phantom stock, stock appreciation rights are paid out in cash, although it does have the option to be paid out in shares too.
Conclusion
IT industry was the first to use this ESOP feature in India. Now, almost all the sectors are using this to attract and retain best talents of the industry. Nowadays, Startup companies are actively using ESOP for attracting best human resources and to stop brain drain. Many startups fail just because of non-availability of qualified and experienced employees because startup companies can’t afford to pay higher packages to them like MNCs offer. The only option for startups to retain and attract them is to use ESOP so that employees can feel ownership rights and help startup to grow and foster.
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