What is ESOP and how is it granted to a startup employee?

ESOP (Employee Stock Option Plan) is a great way of rewarding and retaining top talent in a startup. Firstly, employees need to note that these are “options” and not “shares”. Options are granted through a letter of offer given by the company to its employee stating that he/she has the “right to purchase shares” of the company in the future at a predetermined price; this price is typically determined at the time of joining the company. However, this “right to purchase” can be exercised only after certain “vesting” criteria is met. For example, if an employee was granted 1000 stock options on joining, after completing one year with the company, he/she will be given the right to purchase 250 shares. As an employee you may choose to exercise (or purchase) the shares much later (say after 5 years) because of tax implications. Typically, the actual purchase and sale of shares takes place when a primary fundraising round is taking place and / or a new investor or your employer is willing to purchase these shares.

What is meant by “vesting”?

In very simple and general terms, vesting refers to the amount of time an employee must work before acquiring a certain benefit. When an employee is granted ESOPs on joining a startup it means that he or she has the “right to purchase” the shares of the company subject to a certain timeline or criteria being met - this is referred to as “vesting” or “vesting frequency”. It is only after this criteria or timeline is met that an employee has the right to purchase (or exercise) the options. Vesting is therefore the process by which an employee becomes eligible to exercise his/her stock options and become a shareholder in the company. For example, after one year 25% options can be exercised and after that every 6 months 12.5% can be exercised over the remaining 3 years. This is called the vesting frequency and the model above is referred to as “4 year bi-annual vesting with 1-year cliff”.

What is the typical cliff period and vesting curve in a startup?

Cliff period is the minimum time an employee needs to work in a company before any of the options can be vested. A minimum of 1 year cliff is required as per Indian laws and this is also the typical timeframe startups use for the cliff period.

How is ESOP rolled out in a company?

First and foremost as a founder you need to work with a lawyer to create an ESOP scheme document. This scheme document clearly defines how the scheme is going to be administered in your company. Typically this is done by Founder- Directors in an early-stage startup. The scheme document also defines the regular exercise period (ex. 10 years), what happens when an employee leaves (he may be asked to exercise within a shorter period), what happens when an employee is terminated, default vesting schedule (ex. 1 year cliff, quarterly vesting for 4 years) and so on. Once the scheme document is finalized, by the lawyer and founders, it needs to be approved by a shareholders’ resolution. Now you are ready to grant ESOP to employees.

What is the typical grant given to employees at various levels in a startup?

This depends on the startup stage and the importance of the employee joining the team. At the angel funding stage, it could be anywhere between 0.1% to 0.5% (even 1%) for core employees. Of course these percentages will go much lower for Series A, Series B+ startups.

Do you have to put an exercise price when granting ESOP to employees?

Yes you have to state the exercise price when granting ESOP but the exact exercise price can vary from employee to employee. Some companies may choose to keep the exercise price as the face value of the share. Some other companies may choose to keep the exercise price as a discount to the last round of funding, for example, if the share price in the last round was INR 200, the exercise price may be kept as 30% discount i.e. INR 140 per option.

Why is the exercise price of ESOP at a discount to the last round valuation?

Founders leverage ESOPs as a tool to retain and reward the most productive employees. For rewarding employees with monetary benefits, ESOPs are offered at a price lower than the last round valuation. Employees, thus, get privileged with the option to buy shares at a discounted price (compared to other buyers - namely investors). They can further sell those shares at fair market value (FMV) after completing their vesting period, thus earning substantial profits.

As a founder, how do I evaluate how to set the exercise price?

The Exercise price is the set price at which the right is offered to an employee to buy a certain number of shares. There is no particular rule around setting the exercise price as it is subjective to the organization and its founders. However, it is recommended for founders to set the exercise price as low as possible (at least till the completion of Series A round of funding). Post Series A round, the business is somewhat established. It is then that founders should increase the exercise price by some factor. However, it is recommended that exercise price should not reach face value; this is done so that employees can have some more upside on their ESOPs.

How does exercising ESOP play out?

For instance, an individual joins a startup on January 1, 2020, and receives 500 ESOPs with a 1 year cliff and bi-annual 4-year vesting period with the vesting price set at INR 200. The first vesting date in this scenario will be the June 1, 2021 and on that particular date, the individual will have the option to purchase 125 stocks of the company for INR 200 each. In case the price of the stock has increased to INR 500, the individual can exercise the option made available to him and purchase 125 stocks for INR 200 each, thus making a profit of INR 300 on each stock by simply exercising his option to purchase at the vesting price. This of course comes with tax implications. Now, in case the value of a stock reduces from INR 200 to INR 150, the individual does not necessarily have to exercise his / her option to purchase stock as doing so will result in a loss of INR 50 per share. Instead, he / she can wait for prices to rise again and then exercise their option to purchase for a potential profit.

What is the tax impact when an employee exercises his ESOP?

As per Indian laws, the employee needs to pay income tax when he/she exercises ESOP as well as when he/she sells the shares. Here are the basics: ESOPs are not taxable until an employee completes his/her vesting period When shares are bought by the employee, total tax is charged on the difference between the fair market value (on the date of exercise) and exercise value of those shares Taxes are levied again when the allotted shares that are sold off by employees. The profit earned in this case is considered as capital gains. A capital gain is defined as a profit which is the difference between the sale consideration and FMV on exercise date.

Who is eligible for ESOP?

Typically only permanent employees and directors (other than directors who together with relatives hold more than 10%) in the company are eligible to receive ESOP. The eligibility criteria must be clearly documented in the ESOP scheme document as per Indian laws.

What are the compliance related filings required for ESOP?

Firstly, the startup needs to approve the ESOP scheme through a board resolution and then through an ordinary resolution passed by shareholders in an AGM/EGM. This needs to be kept for internal purposes only, no need to file with the RoC. Your company secretary can take care of this. Second filing is required every year along with the audit report. There is a table in the audit report that needs to show the number of options granted to every employee, options vested, options exercised, etc. The P&L statement of the company also needs to factor the value of options given to the employees based on the option valuation report. Your CA and auditor needs to take care of this requirement. Third filing is required every time when an employee exercises his/her vested options. He needs to be given share certificates and the corresponding PAS-3 Form needs to be filed with RoC. Again, your company secretary can take care of this. For more details, consult your lawyer, CA, CS, Auditor.

What is a Valuation Certificate? How are ESOP grants accounted for in the company books?

During every financial year, the company needs to take the value of the vested options during the year and account for this in the company books as employee compensation expense. Now, how do you value these options for the annual accounting? The answer is the valuation certificate. This is typically a share valuation certificate that can be obtained from a CA or Merchant Banker. Note however that some companies (though rare) also use an option valuation certificate (Black Scholes model) instead of share valuation certificate for the annual expenses (in P&L accounts).

What happens to the ESOP when an employee leaves the company?

Typically, the unvested options will lapse. But he/she can exercise the vested options immediately or within a certain period of time as specified in the scheme document. Some Startups keep this exercise period as 3-6 months after leaving, however some keep it as large as few years (even 10 years or so). Note that if the employee is terminated for cause (misconduct or any such issues), both vested and unvested options typically lapse immediately upon termination.

What is the typical size of an ESOP pool in a startup?

This can vary but in early stage startups 10-12% of the total shares could be kept aside for the ESOP pool. Typically both the founders and early investors contribute to the ESOP pool.Note that this needs to be clearly specified in the SHA (Shareholding Agreement) and adopted by the shareholders approving the ESOP scheme document.

What are the shareholder rights given to the employee who exercises his ESOP?

ESOP shares are usually equity shares which are different than preference shares given to investors. Equity shares have very basic rights like the right to receive annual reports, attend AGMs, etc. Preference shares have additional rights like liquidation preference which is not given for equity shares.

What is liquidation preference?

Liquidation preferences are created to ensure that investors get paid before anyone when the company either sells or goes out of business. If the company is sold at a lower valuation than the “preferred shareholders” paid for it, they will be the first to get their money back. Generally, anything left after repaying the liquidation preferences will be distributed among common shareholders. Later stage companies may have multiple layers of “prefs” at multiple valuation points.

Do you give Advisory Equity from the ESOP pool?

No, the advisory equity can’t be taken from the ESOP pool. ESOP is only for permanent employees of the company. Advisory shares should be given directly and filed in PAS-3 form with RoC.

What is the tax impact for advisory equity?

In India, advisory equity where an advisor (or mentor) is given shares in lieu of him/her guiding or mentoring the startup attracts GST. But the GST needs to be paid by the advisor and not the startup. If the advisor is an individual, there are certain rules that need to be followed by him to file GST. On the startup side, you need to deduct the TDS though. For example, if shares worth INR 5 lakh is given to an advisor, the startup needs to deposit 10% TDS i.e. INR 50,000 to the IT Department immediately. Mostly this amount of INR 50,000 is then reimbursed by the advisor to the startup so the startup has no net cash outflow.

India has a limit of 200 for the number of shareholders in a private company, do employees who have exercised shares also count towards this 200 limit?

No, as per Indian laws, the ESOP shareholders don’t count towards the 200 investor limit on the cap table.

How is ESOP different from ESPP?

ESPP or the Employee Stock Purchase Program is typically used in public companies, i.e. ones whose shares are traded on stock exchanges like NSE or BSE. ESPP allows employees to buy the company’s shares at a discounted price and these can be traded on the stock exchanges. This is rarely used in startups.

What are the typical errors in cap table calculation?

Startups need to ensure calculation is done properly for cap table. Sometimes there may be rounding off errors in terms of number of shares allotted to investors, class of shares allotted, ESOP pool not factored in.

How can I share the cap table with a prospective investor?

While you can share this over an email, it is better to share the cap table only through mystartupequity.com as each access by the investor is logged and he can’t download data unless you give this permission.

What is the process for secondary transaction for ESOP?

Doing a secondary transaction for ESOP is complex - price discovery, finding buyers, Right of First Refusal (ROFR) waivers, board resolutions, SPA (Share Purchase Agreement), valuation report, RoC filings are among some of the things that need to be taken care of. LetsVenture’s secondary platform takes care of all these problems and gives you a smooth experience.

How do I allow an employee to sell his vested ESOPs to a secondary buyer?

This usually needs board approval and Right of First Refusal (ROFR) waiver letters from existing investors (if there such a clause in the SHA). Only then can the employee sell his vested options to a secondary buyer. LetsVenture’s secondary platform works with companies to exclusively take such ESOP secondary mandates and allow only company approved buyers to come in, thereby making the process very founder-friendly.

DISCLAIMER

These FAQs have been prepared for general guidance on the subject matter and does not constitute professional advice. The matters described herein are general in nature and have not been evaluated based on applicable laws. You should not act upon the information contained in this note without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this note, and, to the extent permitted by law, LetsVenture Technologies Private Limited, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. Without prior permission of LetsVenture Technologies Private Limited, this note may not be quoted in whole or in part or otherwise referred to any person or in any documents.