ESOS (Employee Stock Option Scheme) or ESOP Scheme is the main legal document that covers all the rules and regulations governing the process for ESOPs in your company. The Scheme Document is quite flexible and each startup can define its own rules around ESOPs. You must ensure that it doesn’t violate the mandatory SEBI guidelines and the Companies Act. So, here is a handy checklist of the top 5 things founders should think about before creating their ESOP Scheme document.
#1 Size of the ESOP Pool
Usually if you have raised a round of funding, this would have been defined in the SHA (Shareholding Agreement) itself. While there is no formula, a pool size of 10-15% at the earliest stages is usually decent enough and you can always expand the pool size during future rounds of funding – it is quite common to do so. (You can read more about creating & demarcating the ESOP Pool here)
#2 How the ESOP is administered
There are couple of ways in which ESOP can be administered and you will have to consider which one suits you:
ESOP directly administered by the company
Here the company directly manages the entire ESOP process – grant, exercise, etc. Most of startups in India use this direct way of administering ESOPs in their companies. It is much simpler compared to the Trust approach. There are two ways ESOP grants gets administered:
- By the Board of Directors – Here all the ESOP grants need to be approved by the board directly.
- By an ESOP committee – Here the board first creates an ESOP committee (also called ESOS committee or Compensation Committee). This way, even if the board is large, the ESOP committee could be small, say just two or three founders and directors. The ESOP committee is given the authority to decide on all ESOP grants to the employees.
ESOP administered by an ESOP Trust
In this case an ESOP Trust is formed which directly manages the entire ESOP process – grant, exercise, etc. Note that for this, the company needs to transfer shares (meant for the ESOP Pool) to the trust either through a primary or secondary transaction. The trust route has complex accounting steps – First, is the loan provided or the tax treatment of the shares transferred. Second, is the overhead of managing another entity – accounts, compliance, audit, etc. Therefore, we have seen very few companies in the startup space going for the trust route. It does offer some benefit though, for example, disclosures with employee names who got ESOP grants don’t need to be part of main entity.
#3 Exercise period for employees upon resignation
How long do you want employees to be able to exercise the options after leaving the company? This topic is very debatable and startups use anywhere between few months to even say 10-15 years. The longer the time period, the more flexible it becomes for the employees receiving the ESOP. This way they can exercise the options possibly at the time of a future liquidity event like a big VC offering to buy out ESOP shares. Please note that in case the employee is terminated (with or without cause), both the vested and unvested options will usually lapse. (Co-founder of Urban Company, Abhiraj Bhal had a very interesting take on this issue of exercise period for exited employees, you can watch the webinar here.)
#4 Transfer restrictions
If an employee has left but has exercised his vested options thus holds company shares, how do you handle that. First of all, there is no real issue if an ex-employee holds company shares. These shares are usually equity shares and have only basic information rights (receive annual reports) and voting rights (in a shareholder meeting). Also, since the number of such shares is very small, the voting rights don’t really matter in any significant way. However, if as a founder, you do want the ESOP scheme to have a provision to allow the company or founder to forcibly buyback (call option) such shares at the current market price, it can certainly be added in the ESOP Scheme.
Similarly, the ESOP Scheme can also have a provision whereby the employees who have exercised the shares have certain lock-in periods and transfer restrictions for their shares. For example, a ‘Right of First Refusal’ or ROFR clause allows the company to first see any sale or transfer offer that the employee has obtained and only if the company provides the ROFR waiver, can the employee go ahead with the sale or transfer of his shares. Some companies also want the ESOP shares to be non-transferrable unless there is a liquidity event offered by the company. Typically, a liquidity event is an incoming investor wanting to buy out ESOP holders or the secondary sale of ESOP shares. But this approach could be less flexible for employees.
#5 ESOP Buyback
You must have seen news reports of a number of startups using ESOP buyback to allow employees to encash their options. In this approach, the employee first surrenders or forfeits his/her ESOP grant and the company provides an equivalent amount as salary bonus. The ESOP Scheme needs to allow for this option.
The ESOP Scheme is the most important document governing ESOP grants to your employees and you should exercise best judgment to ensure it is employee friendly and at the same time protects company’s interests. Also, the ESOP Scheme needs to be flexible enough so that the Board or ESOP Committee can override some of the provisions. For example, it is quite common to have different vesting schedule for different employees without needing a change in the ESOP Scheme document itself. It’s important to note that a change in the Scheme document is somewhat difficult later on as you may have to take written consent from all the employees who have been given ESOP grants already.