Employee Stock Option Plan ( ESOP ) is a instrument by which company stocks are allotted to employees at a discounted price.
The purpose of ESOP is to attract talent and retain employees.
The important terms in an ESOP agreement are:
- Stock / shares
- Mean the same thing, they are used interchangeably
- This is a fractional ownership of a company. A share is literally a share of a company; it confers certain ownership rights as well
- This is the option to purchase stock. You don’t actually own shares until the options convert (exercise) into shares
- Options are the right but not the obligation, meaning a requirement to purchase stock, at a specified price (exercise price), for a specified period of time, or when the options expire, which is typically 10 years
- You exercise your options if the value of the shares is higher than the option price (i.e. the spread is greater than 0)
- Exercise / strike price
- Exercise price I the price at which the company offers the shares to its employees. Generally a discount of 15-20% is given on the fair market price.
- Exercise means the employees actually opt to buy the shares at the exercise price agreed before
- Exercise date
- This is the date at which shares get vested and the employees can actually convert their options in to the shares.
- Vesting schedule
- This means the total period over which the stocks is vested. For example, the if the company offers 100 shares to a employee and the vesting period is 4 years. In this case every year the employee gets 25 shares for 4 years. Once the vesting is complete the employee can then convert the options into shares.
- Most companies vest their shares over a period of 4 years. There can be some variances, and it is up to you to decide on the schedule.
- A vesting “cliff” means that there is a period of time of no vesting, but when the specified time (the “cliff”) is hit, the benefit becomes fully vested
- For example, in a 48-month vesting schedule with a 12 month “cliff”, no vesting occurs for the first 12 months, but at the 12-month point, the stockholder receives full credit for 12 months of vesting. In effect, the staff has now vested 25% of the shares they were issued
- After the “cliff” is met, vesting would continue thereafter on a ‘monthly’ basis
- A “cliff” is often used with new employees. It acts as a probationary period during which the new employee has to prove himself or herself
- This means how long the exercise period will be. Employee need to exercise within a defined period which is typically 7-10 years. If the options are not exercised during this time the options will disappear.
- Accelerated vesting
- Some founders and key executives negotiate into their equity arrangements (stock based, not options) that they will be entitled to some form of acceleration of the vesting on their equity upon the occurrence of a triggering event, which is typically acquisition
- Simply put, you might get to vest fully before the vesting schedule says so.
Who are eligible to get the ESOPS?
The employees who are eligible to get the ESOPs are:
- Permanent employee of a company irrespective of where he works except the employee who is a promoter i.e who holds shares
- Directors of a company, whether whole time director or not, but excluding an independent director (Director who holds more than 10% shares is not eligible for ESOPS)
What should company take care of when issuing esops?
The important points that company should take care of are:
- Who are the employees to whom the ESOP will be applicable
- What happens to vested shares if the employee leaves before exercising
- What happens to unvested shares if employee dies
- Communication to employees about TDS to be deducted
- Mention of the exercise price
What should employees look for in the ESOP agreement?
The most important point to be checked is the exit option. 99% of ESOPs never give any return as there is no exit option available for the employees.
What is the process to issue ESOPs?
The steps to implement ESOPs are:
- Prepare the ESOP Scheme
- Have the ESOP Scheme approved by Board of directors
- Convene Shareholders Meeting with details as specified in Rule 12, Companies (Share Capital and Debenture Rules) 2014. The details to be included are –
- total number of stock options granted
- identification of the class of employees eligible
- appraisal process for determining the eligibility of the employee
- details of vesting and vesting and lock in period
- maximum no. of options that can be granted per employee
Forms like MGT 14 are to be submitted to ROC. Once the ESOP scheme is approved by the shareholders the ESOP offer letter is given to the eligible employees mentioning the number of options allocated and other details.
How can Business Setup assist you for ESOP implementation?
- Initial legal and regulatory on drafting the ESOP scheme
- Assisting on valuation
- Preparing notices, Board resolutions and minutes for getting ESOP approved in Board Meeting
- Drafting necessary resolutions and minutes for Shareholders meeting for passing the special resolution regarding ESOP
- Filing MGT 14 with MCA
- Advise on the ongoing compliances and filings with MCA to be done by the company as and when shares are allotted
- Any other service required to facilitate smooth execution of aforesaid.
Download ESOP agreement word format