The ESOP Cheatsheet

It has been rightly said “the greatest investment you can make is in people”. Employees are considered to be the assets and backbone of an organisation. To reward them and to give them a sense of belongingness to the Company, employers offer stock options / Employee Stock Option Plan (“ESOP”) to the employees. The employer in turn is able to align the vision of the employees with that of the Company. The choice of the plan, its timing, mechanics of the plan therefore becomes extremely crucial.

The key drivers for any Company before selecting a stock option plan are generally accounting and tax aspects, the next element being the administration aspect of the plan. Employers fail to consider the basic nuances before formulating a stock option plan which could be detrimental overall. It is imperative that before finalising a stock option plan (which is best suited for the commercial objectives of the Company), some of the basic components are taken into consideration such as –

Timing of creation of ESOP pool and size of ESOP pool are critical factors

What is the best time to create an ESOP pool?

It is recommended to create an ESOP pool as early as possible. Ideally an ESOP pool should be created on Day 1, however if the same is not created at the time of incorporation / commencement of business, the same should be created before any fund raise.

What should be the size of the ESOP pool?

While there is no fixed formula to determine the size of the ESOP pool for a Company, a pool size of 10-15% is usually reasonable and a Company can look to expand the pool size during future rounds of funding. The size of the pool depends on the investment stage, company objectives, market position, valuation etc.

Select the type of stock option plan prudently

Understand the type of stock option plans and select the feasible plan based on the needs of the Company

It is important that a Company selects the desired plan - Employee Stock Option Scheme (“ESOS”), Employee Stock Purchase Plans (“ESPP”), Restricted Stock Units (“RSUs”), Stock Appreciation Rights (“SARs”), Phantom Stock Options; based on the needs and commercial objectives of the Company. The most commonly used option plan by start-ups/ private companies is the ESOS or ESPP. Where the stock options are offered by a foreign parent, generally RSUs are preferred as they can be linked to occurrence of a specified event or fulfilment of specified conditions.

Phantom stocks or SARs are the best choice, where a Company wishes to offer employees with rewards that are based on merit or some other discretionary basis – the benefit being since they are given in cash for the shares and no ownership control is given to the employees, handling of these options becomes easy for the owners.

Decision on whether ESOPs to be given only to top management or to the middle management as well

Start-ups generally adopt the ESOP strategy to build up a strong team, therefore they offer the stocks to top talent of the Company to build up a loyal and committed workforce. But companies which have already established their foot in the market, can look to offer stocks to middle management as well.

Framing of the selected stock option plan

The stock option plan should be prudently designed keeping in mind the company’s objectives and in compliance with the laws and regulations of the country. The plan should be customizable, employee friendly and align with the philosophy of the organisation. Once the plan is structured, the same should be communicated to the employees and the relevant paperwork / filings should be undertaken.

ESOP scheme / agreement to contain important clauses on employee termination, liquidity event and buybacks

What happens when an employee leaves the organisation?

Exit situations are to be kept in mind while designing the ESOP scheme as this will help to decide how to structure the right of the employees over exercising the options which are already vested/ unvested at the time of their exit. The ESOP scheme should clearly state what happens when an employee leaves the company – the unvested options are generally forfeited while the outgoing employee retains the vested options until a short period (say 30 or 60 days) of time as specified in the scheme.

Liquidity event

Liquidity event is an exit strategy for investors to convert their equity and could occur in case of a merger, acquisition, initial public offer, sale etc. Given that all the employees may not be with the Company till the liquidity event, many private companies try to solve the liquidity challenges and sometimes do consider providing liquidity periodically rather than a one-off event.

Buybacks

ESOP buyback allows employees to sell their vested options to the Company. ESOP buyback can be due to varied objectives such as where the company wishes provide liquidity to its employees or wants to restock its ESOP pool etc.

Buybacks allow employees to monetise their holding at a higher price and participate in the wealth created by their companies. ESOP buybacks has been a recent phenomenon and a lot of start-ups like Razorpay, Udaan Cred etc have adopted this approach.

As it has been seen that majority of start-ups and now even a lot of private companies are adopting the ESOP / stock option route to compensate their employees, it is imperative that the fundamental parameters are kept in mind by every founder / Company while formulating its stock option plan. Establishing and administering a plan properly is critical and guidance from specialists may prove effective.

Authored by Barkha Tahiliani, Principal Associate-Tax

For any ESOP related query or assistance in structuring, implementing, or managing your ESOP plans, reach out to us at: esop@algolegal.in This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.

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