Explained: 10 Fundamentals To Build A Sound ESOP Policy

SUMMARY

ESOPs are slowly gaining prominence across the Indian startup ecosystem owing to the benefits they provide to employers and employees

For any company keen to introduce ESOP, it is essential to understand the fundamentals of the employee stock/share option scheme or ESOS

Although there is no set template to develop an ESOS, here is a list of the 10 fundamentals that a company should follow while developing the document

Employee stock ownership plans, or ESOPs, are gradually becoming a well-recognised instrument across the Indian startup ecosystem to reward, retain or attract employees. The benefits are many when team members become stakeholders as trust is established and the company’s focus on value creation and wealth-building benefit them in the long run. It also helps businesses appoint and retain talent without stressing their cash reserves and allows companies to leverage tax benefits.

For any founder or company keen to introduce an ESOP programme, it is essential to understand the fundamentals of the employee stock/share option scheme or ESOS. It is the key legal document that contains all the rules that regulate a company’s ESOP operations.

There is no set template to develop an ESOS, but companies can define their own set of rules in this critical document. However, they must comply with SEBI’s mandatory guidelines and the Companies Act, 2013. Here is a checklist of the top 10 things that founders should keep in mind while drafting an ESOS.

1. Size Of The Pool

For funded startups, this is usually defined in the Shareholding Agreement (SHA). Again, there is no set formula or rule, but a 10-15% pool size in the initial stages should serve the purpose. It is quite common to expand the pool size in subsequent funding rounds.

2. Eligibility Criteria For Employees

These parameters determine whether an employee is eligible for a grant or vested option based on the job tenure, performance, seniority, future potential and more.

3. ESOP Distribution

There are many ways of doing it. But in India, most startups opt for the direct route and companies themselves manage the process. This approach is much simpler. The board of directors approves the grants, or a small committee is formed to approve the same. The other approach is distribution through an ESOP trust. This is a complex method, requiring additional accounting steps. So, very few companies opt for it.

4. Vesting And Lock-In Periods

Even when employees are granted equity rights, owning the stock does not happen immediately. Simply put, vesting is all about the process of applying and buying the company’s shares after a pre-defined period has passed, and certain parameters have been met as per the company’s rules. There must be a year’s gap or more between granting and vesting the stock option, known as the vesting period. The ESOS must mention the vesting period post which an employee can apply for the shares granted. It should also enable the administration committee to specify the lock-in period during which an employee cannot redeem or sell the shares.

Learn How To Draft ESOP Policy

5. Exercise Period For Former Employees

Considering that ESOP shares are usually equity shares, even a former employee can retain these. A company can specify in its ESOS how long it wants its employees to exercise their stock options after leaving the organisation.

6. Exercise Plan And Process

An exercise plan includes the exercise period and the exercise price. The exercise period is the time allowed after the vesting period when an interested employee must exercise his or her right to apply for the company’s shares and make all necessary payments. It is important to note that purchasing these shares is an employee’s right but not an obligation. If all conditions are fulfilled, and an employee decides to buy the stock, he/she can pay a lower price than the fair market value (FMV), known as the exercise price. A company must have a process in place so that employees can exercise their ESOP options, be it partial or whole.

7. ESOP Buybacks

Many Indian startups announced their ESOP buyback schemes even amid the Covid-19 pandemic, allowing employees to encash their stock options. In an ESOP buyback, an employee first surrenders or forfeits his/her ESOP grant, and the employer compensates the person with a bonus worth the same amount.

8. Amendment/Termination Of ESOS

A company’s ESOS must answer the following questions: Who can amend the ESOP and under what circumstances? Can the plan be terminated before its lapse date? If so, who will be authorised to terminate the ESOP and under what circumstances?

9. Dispute Resolution

There must be a well-defined plan to settle ESOP-related disputes, either through mediation/arbitration or lawsuits. In the first case, there should be a process in place to appoint an arbitrator/mediator.

10. Tax Liabilities

Companies must specify ESOP-related tax obligations in the ESOS so that their employees have a clear understanding of the same. ESOP taxation is done in two parts — one as a perquisite tax and the other as capital gains tax. Capital gains tax occurs when an employee sells the company shares purchased through ESOP, while perquisite taxation occurs when the shares are first purchased by the employee (the difference between FMV and exercise price is taxed in this case and deducted as TDS). However, the Budget 2020 amendment has deferred the TDS payment on prerequisite from the year of purchase. It is now paid when one of the following conditions occurs first: Completion of five years of ESOP allotment; sale of ESOP shares, or termination of employment.

For people who want to learn more, Inc42 Plus is hosting ‘WTF: Startup Equity’, aiming to simplify ESOPs, term sheets and valuations for startups. Scheduled on June 5, 2021, the virtual event will highlight stories and learnings of startups and their employees.

Learn How To Draft ESOP Policy