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Do you understand how your ESOPs work?

Dhruv Suri
12th Sep 2015
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Employee Stock Option Plans or ESOPs are perhaps the most important form of remuneration for employees. From a startup’s perspective, it helps to maintain liquidity and from an employee’s perspective, it is a reward for loyalty. However, like pretty much a lot in life, ESOPs are not simple. Sometimes, employees do not bother to understand how their ‘options’ will work and often employers do not explain the intricacies and legal framework associated with these stock options. The end result is that most employees who have been granted ESOPs suddenly believe that they will walk out with millions!

ESOP

The present article discusses the law behind granting ESOPs as well as highlights some key areas where employers do not pay attention or there is potential for disagreement between the employer and employee. Since a number of articles have already been written on YourStory explaining the basics of ESOPs, I have refrained from doing that.

Simply put, an ESOP scheme gives employees the option to purchase a certain number of shares in a company at a predetermined price. The Companies (Share Capital and Debenture) Rules, 2014 (‘Company Rules’) govern the grant of stock options and, therefore, it is important to ensure strict compliance with them.

Before diving any further, let us understand what kind of employees are actually entitled to ESOPs. As per Company Rules, only (i) a permanent employee working in or outside India; (ii) a whole-time or part-time director of company; and (iii) an employee of a subsidiary (whether in India or abroad), holding company or an associate company, can claim benefits under an ESOP scheme. It is absolutely important to note that neither a ‘promoter’, nor a director holding more than 10 per cent of the equity shares of the company is entitled to take part in this scheme.

What does this mean?

In case you are a promoter or a director holding more than 10 per cent stake, you cannot rely on ESOPs to structure your salary package. There are other options like sweat equity or allotment of shares for non-cash consideration, each of which have to be evaluated in their own merit based on the facts and circumstances.

For example, sweat equity comes with its own set of restrictions. While it can be granted to founders for non-cash consideration such as for providing know-how etc., it can only be issued after the company has been in business for at least one year. Further, a company cannot issue sweat equity of more than 15 per cent of its total paid-up capital or having value of more than Rs five crore, whichever is higher. The shares issued by the way of sweat equity can also not be transferred for a minimum period of three years.

How do ESOPs work?

Startup’s perspective

A company cannot just grant options by issuing a simple letter to its employees. Often early-stage startups do this and then have to eventually handle disgruntled employees because they suddenly wish to exercise their options which, strictly under Indian law, were never really granted to them.

From a startup’s perspective, they have to do the following:

  • Get an ESOP scheme drafted and approve it in a shareholders’ meeting. Till June 2015, this scheme had to be approved by a ‘special resolution’ and filed with the Registrar of Companies (ROC). With effect from June 05, 2015, vide notification G.S.R. 464(E), private limited companies do not have to comply with Section 62(1)(b) of the Companies Act, 2013 which originally mandated ESOP schemes to be approved through a ‘special resolution’ and file its key terms with the ROC, making all this information available publically.
  • Once an ESOP scheme is approved, a Letter of Grant should be issued to the employee informing him how many options are being granted to him, what the vesting period would be and how the exercise price will be determined, should he choose to exercise the vested options.
  • In the event an employee wishes to exercise any of his vested options, he should make an Exercise Application to his employer company pursuant to which his options would be converted into equity.

What are the key points a startup should consider when getting its ESOP scheme drafted?

  • Most employees have employment contracts that allow termination upon giving some notice. How will a startup want to tackle a situation where some options have vested upon an employee but now he wishes to quit?
  • What happens if he is willing to work but the startup wants to terminate the employee’s employment for ‘cause’ or even otherwise by simply giving the notice period?
  • What if the employee has exercised some of his options and is a shareholder in the company but now wishes to resign or is asked to leave?
  • A startup would definitely not want an ex-employee to hold equity in its venture when such employee could very well be working for, say, a competitor. Accordingly, terms of an ESOP scheme have to be carefully thought out and discussed with the legal advisors.
  • ESOP schemes are audited and are referred to by auditors in their audit report. Accordingly, they cannot be back dated, especially when an audit report for the previous financial year has been prepared. Therefore, it is important to understand the legal regulations surrounding ESOPs before granting stock options to any employee.

Employee’s perspective

At the very outset, every employee should ask his/her employer for a copy of the ESOP scheme whenever he/she is granted stock options. This scheme will give a detailed insight into the terms and conditions associated with ESOPs. Once stock options are granted, there is a one-year cliff period. Any kind of vesting, i.e. the right to convert the stock options into equity, will only take place once the cliff period has lapsed. Thereafter, subject to the vesting schedule, i.e. how the vesting ought to take place, the employee will have a right to exercise his vested options by paying an exercise price to the employer. The exercise price is typically the face value of the shares. The entire exercise mechanism can be kept cashless as well, i.e. the vested options may be exercised and converted into equity without paying anything. All this information will be highlighted in the ESOP scheme and/or the Letter of Grant issued by the employer.

Let us explain the above with a simple example:

On September 01, 2015, a company grants its employee 100 options with a vesting period of two years and an exercise period of seven years at an exercise price of Rs 10 per share. Under the Company Rules, there is a one-year cliff period. This implies that the vesting will not commence till September 01, 2016. Since the vesting period is two years, half of the options (i.e. 50) will vest on September 01, 2016 and the remaining half on September 01, 2017. The exercise period of the vested options is seven years. This means that that the employee can convert his 50 options (that vested upon him on September 01, 2016) anytime before September 01, 2023. For the remaining 50 options that vested in 2017, the employee can exercise his right any time before September 01, 2024.

Let us now assume that on December 01, 2019, the employee decides to exercise his/her right to convert 70 options into common stock. At that stage, an Exercise Application will be addressed to the company. Assuming the exercise price was Rs 10 per share, the employee will pay Rs 700 (70 options * Rs 10 per share) to the company and the company will allot the employee 70 equity shares.

It is also pertinent to understand that in case an employee resigns, any unvested options (i.e. those that have not yet vested) will lapse. In case some options have already vested on the date of resignation, their treatment will be determined as per the terms of the ESOP scheme. Therefore, it is crucial that all employees who have been granted options read the terms of their company’s ESOP scheme very carefully.

In the end, I’d like to state that ESOPs are a great incentive for employees to put their heart and soul into an organisation. However, grant of options in itself does not mean that the employee will walk out of that organisation with millions in his bank account and employees should be conscious of this fact. Most young employees have only heard positive stories about ESOPs and often do not do their own diligence to understand the key terms governing their options. Some startups ask their legal advisors to make a presentation for their entire staff explaining how ESOPs work and how it can benefit them. This, in my view, is extremely beneficial. Failure to understand the intricacies is likely to leave you highly disappointed when you resign to move on to your next job.

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