ESOPs for Start-ups: Basics, Benefits & Issues

Employee stock option plans (ESOPs) are an integral employment benefit offered by companies to employees. Start-ups especially use ESOPs as a recruitment tool to attract and retain talent. However, neither employers nor employees understand the basics, benefits, and issues they may have to get in terms while implementing ESOPs.

A great example of this is the current global COVID-19 pandemic. The crisis has devalued the stocks, nonetheless from start-ups to major players – companies continue offering a large percentage of ESOPs, questions the relevance and efficacy of the same. A recent report claimed that the ESOP pools were generally set at 10% of a company’s shares. However, currently, companies are pushing it over 20% as they are not able to pay salaries. Another analysis drafted by Money control stated that India’s start-up companies have laid off around 10,000 employees in the last two months, with their ESOPs being terminated overnight. Even from an employer’s perspective, ESOPs enable them to offer an attractive compensation package while lowering the cash component of the employment offer. Nevertheless, as stock value reduces employers as well as face the crunch of offering such stock option schemes.

Therefore, does all this mean that ESOPs are not good for start-ups? And companies should not offer ESOP schemes? Before answering these questions let’s get to the basics! 

Let’s understand what is ESOP? Why ESOPs are are given? How does commercial law perceive ESOPs in India? What are the issues the start-ups face while offering ESOPs? And ultimately conclude on if start-ups should consider offering ESOPs?

I.What is ESOP?

Employee Stock Option Plan(ESOP) is a small percentage of company stocks offered to the employees of the company. ESOP is a system wherein employees are given access to acquire shares of the company at which they are employed. ESOP schemes grant employees a few rights in which they can get the shares of the company for free or at a concessional rate. Generally, the price of the ESOP is predetermined or the shares are allocated in a prefixed method.

Understanding the basics of ESOP also includes knowing the three stages of ESOPs. Those are granting, vesting, and exercising.

II. Three stages of ESOPs

• Company Grants ESOPs – The company offers ESOPs to the respective employees.
• Vesting Conditions/Benefits – Some ESOP participants are still unaware of this concept. Vesting simply refers to the period of time an employee must work before procuring a non-forfeitable entitlement to his/her name. Those who do not complete that said amount of time in the company and leave before fully being vested, they are deprived of these benefits. Employees have to wait through the vesting period to exercise the ESOPs. The vesting period cannot be less than one year from the grant date.
• Right to Exercise – Employees acquire the right to exercise their ESOPs after the completion of the vested period. Once ESOPs are exercised, the vested option is converted into shares by payment of the exercised price predetermined at the stage of the grant.

III.Why are ESOPs given?

There are multiple reasons why a company decides to grant ESOP options to their employees. The ESOP system is more prominent in start-up firms. Start-ups have limited cash flow and need to avoid paying huge salaries. Employees willing to be a part of the company’s growth settle for stock options as part of the compensation package. Under some circumstances, employees are given ESOPs that they can be exercised on a future date/s, to offer long-term assurance. Moreover, companies also give ESOPs as it helps in creating a sense of proprietorship and belongingness amongst the employees.

Nevertheless, each start-up firm may have its reasons for describing why ESOPs are given. We have listed down three major reasons why start-ups negotiate through ESOPs.

IV.Three major reasons why ESOPs are given:

1. Initial Stage: ESOP is where stocks of the company are offered to the primary employees (the first few employees of the company). ESOP is a methodology popularly used by modern start-ups. From Silicon Valley – when Google and Facebook were only start-ups, they used ESOPs to entice the best talent. And same was replicated in the Indian market by companies such as Flipkart, Citrus Pay, and many others. As these companies have been super successful, several employees became multi-millionaires – thanks to these Employee Stock Option Plans (ESOP’s).
2. Ability & Position: Start-ups offer ESOP schemes to selected employees based on their ability and position. Typically, the management of the company or employees that can impact the company’s growth is offer ESOPs. Also, based on the position of an employee – ESOPs become a part of their employee benefit or retirement plan, giving the ownership of interest to employees.
3. Motivational Tool: ESOPs have become a part of compensation offering in start-ups, to motivate employees to give their best at work. ESOPs serve as a motivational tool by ensuring that employees have their “skin in the game”. By offering ESOPs employees are invested in the growth and thereby foster long-term commitment. Several private limited companies in India as well as around the world offer ESOPs to their employees on the same grounds.
4. In Crises: In the post-COVID world where companies are bleeding, start-ups are offering ESOPs to their employees as they are not able to pay regular salaries. As start-ups aim at conserving cash to survive such uncertain economic crises – ESOPs have become their ultimate solution! During such crises, firms have started making larger ESOP pools. Start-ups are not pushing for ESOPs, but rather struggling to find funds or capitalize on available funds. A recent news report stated that in the last few months, Zomato, Oyo, and Grofers are among the companies to have offered ESOPs to their employees who have taken a salary

   V.How does the Indian commercial law define ESOPs?

Employee stock option plans (ESOPs) are well-defined under the provisions of section 2(37) of the Companies Act, 2013, “employees’ stock option”. It stated that the option is given to the directors, officers, or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers, or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price. 

As per the Companies Act, 2013 under Section 62(1) (b), it is stated that companies are subjected to compliance with certain conditions and offer shares to the employees under a scheme of employees’ stock options. The conditions termed under Rule 12 of the Companies (Share Capital & Debentures) Rules, 2014, states the legal framework for issuance of ESOPs if the company is unlisted. For a company whose equity shares are listed, the ESOPs shall be issued as per the Securities and Exchange Board of India (SEBI) regulations. Under both circumstances, it means that the employees can become the company’s shareholders through employee stock option plans.  

VI.Issues of ESOPs faced by start-up companies:

Though ESOPs are known to be an excellent tool for start-ups to draw and retain talented employees, however, there are few issues that start-up companies face while offering ESOPs.

Here are the 5 major issues of ESOPs faced by start-up companies:

1. Projection: The foremost hurdle of start-up firms is to showcase their projection to the employees. Convincing the employees about the future growth of the company is a primary issue faced by most star-ups. Moreover, start-ups are unlisted companies and their shares are neither readily availabl This further creates a doubt in the minds of employees to realize the projected profit from such shares acquired by them under ESOPs
2. Taxability:  The Finance bill 2020 has set an eligibility clause for companies (start-ups) to avail of the tax deferral scheme. Start-ups who are referred in 80-IAC determined by the Inter-Ministerial Board (set up under DPIIT) are eligible for the same. This announcement will hardly benefit 250 start-ups in India, leaving behind the 40k start-ups which are currently operational in India. Mohandas Pai of Aarin Capital’s TV called this a ‘classic example; a well-intended but badly-designed government policy that almost sabotages the start-up policy reforms.’
3. Complexity: Employee stock option plans make the capital structure of a company extremely complex. The company has certain obligations towards their employees, this gets further complicated when additional capital in the form of debt or equity is added into the equation. These complexities require start-up firms to be more aware, observant and have proper documentation of all such schemes. This documentation would be subjected to legal due diligence in the future during funding by investors or banks
4. No Evidential Gains: Subjectively ESOPs increase the morale and the productivity of the employees. However, there have been no facts that can evidentially prove these gains. Some data shows that ESOPs are not good for increasing employee morale and influence democratic work culture. Nevertheless, there is no experimental analysis to prove the same.

VII. Should start-up companies offer ESOPs? 

So, the ultimate question is should start-up companies offer ESOPs? What are the benefits of ESOPs for start-ups? And why leading companies in the world such as Google, Zomato, Facebook, Flipkart, Oyo, and many others considered offering ESOPs?

Here are the top 4 benefits that make start-up companies offer ESOPs:

a) To appeal and retain talented employees:

The ESOPs offer a sense of ownership to the employees, provided they stay in the company for a period of time (vesting period) to gather the benefits. In the initial phase, start-ups need to retain their qualified and talented employees. The best way to do this is by making the employees feel that they are also an integral part of the company. ESOPs cultivate a feeling of accountability, belongingness, and ownership – eventually appealing and retaining the employees.

b)To have active participation in the company’s growth:

Through ESOPs employees acknowledge that higher participation will bring the greater value of their shares. Hence, employees voluntarily and collectively work hard towards the growth of the company. There is also a realization among employees that if the company does not perform well, then the market value of shares may reduce to lesser than the price they paid to acquire shares under the ESOP. Thus, ESOPs assure the active participation of employees for the growth and success of the company.

c)To control cash variables in the company:

The ESOPs shares are offered as part of compensation and are generally substitutes for liquid cash or bonuses. Start-ups are not able to pay competitive salaries or offer monetary perks in the initial years of their businesses. However, start-ups also need talented and motivated employees to succeed and grow their business. Thus, offering ESOPs to worthy employees allows the company to control cash variables as well as retain them.

d)To raise new equity, refinance unpaid debt, acquire assets & more:

1. Start-ups can use ESOPs to raise new equity, refinance unpaid debts, and acquire new assets or outstanding stock by leveraging with third party lenders. Private Limited Companies also save on direct remuneration as a part of salary by offering a section of ESOPs to their employees.

VIII. Guidelines start-ups must follow while offering ESOPs:

The ESOPs can be executed effectively in start-ups, only when such plans are well-drafted from an initial stage. ESOPs scheme documentation needs to ensure the attainment of desired objectives and be mutually beneficial to the start-up as well as the employees.

There is a lot that start-ups must be aware of while granting ESOPs, however, here are a few guidelines they must follow!

Here are the 5 guidelines start-up must follow while offering ESOPs:

1. Start-ups must carefully draft the ESOPs Scheme and watch out for worrisome clauses such as – extending ownership after a long employment period and likewise.
2. Start-ups must be aware of the terms they can or cannot leverage. At times, significant employees can influence their position and negotiate terms. Start-ups can reconsider terms such as lower exercise prices or faster vesting period. Yet, being thoughtful before making decisions and consulting with an expert on the terms you can leverage is a must.
3. Start-up must also keep a tab of all the ESOPs granted to the employees. Right from having copies of the grant agreement, analyzing the vesting period to set the expiry date reminders – start-ups must be alert about the status of each of the ESOPs granted. 
4. Ensure all compliances relating to The Companies Act and Income Tax Act are complied within the given timeline.
5. Lastly, the most crucial guideline is to discuss the agreement clauses by consulting a financial expert. Having a financial advisor deliberate and contemplate the grant agreement of ESOPs will help all parties involved.

Consult our experts at Diligen:

Speak to our expert at Diligen – a leading company in India offering all types of financial services across the world. At Diligen, we understand that ESOPs are a key hiring tool for start-ups to appeal to the best talent without having to pay fat salaries. Hence, we at Diligen offer you a consultation on ESOPs, guide you with ESOP valuations, create the grant agreements, and ensure your start-up is compliant with the ESOP due diligence checklist.

To know more book a consultation and experience our expertise yourself! Call us now!