What is ESOP and what are the challenges in ESOP Implementation?

ESOP fully known as “Employee stock option plan” is one of the best mechanisms to reward employees and to attract the talent, this enables employees to participate in the financial success and long-term growth of the company. Indian Start-ups have been adopting the ESOP faster and rewarding their employees, however there are multiple challenges with respect to compliance being faced by the company while implementing the ESOP policy. 

What is ESOP

There are multiple complex definitions which includes exercise period, vesting period, exercise price, strike price and each one of this carries their own importance hence one should be very careful while implementing the ESOP policy in the organisation.

Let us see the definitions of the below mentioned terms.

Vesting: means the process by which the Option Holder is given the right to Exercise the Options granted to him in pursuance of this Plan.

Vesting Period : means the period from the date of Grant of Options till the period of option mentioned in the letter of grant issued by the company to the eligible employee.

Vested Option: means an Option in respect of which the relevant Vesting Period is over and which the Option Holder has become eligible to Exercise.

Grant Date: means the date of grant of any Options to eligible Employees under this Plan.

Exercise Period: means the period after Vesting within which the Option Holder can Exercise the Vested Option in pursuance of the Plan.

Exercise/ Strike Price: the Price which an employee will have to pay at the time of exercise of shares. 

Exercise: means the making of an application by the Option Holder to the Company for the issuance of Shares against the Vested Option in pursuance of the Plan.

Various dimensions of ESOP Policy:

1. Vesting cycle: Opinion on fixing the vesting cycle differs based on the stage at which organization is operating currently, organization at the early stage having less cash paying capacity to their employees would like to have monthly/ quarterly vesting cycle, however organization operating at the matured at stage would like to have annual vesting cycle. Reason is obvious one is not eligible to exercise the shares for which vesting cycle is not yet over hence employees mid of the year would not like to resign as they are in the mid of vesting cycle and would like to complete the cycle to exercise all the shares in the case of annual vesting cycle which is not in the case of monthly/ quarterly vesting cycle.

2.  Exercise period: Exercise period has tax incidence, so it would be prudent to have a longer exercise period, At the time of exercise of shares employees will have to pay Income tax under the head salary, tax computation would be based as under- (FMV on the date of exercise of shares – Strike price)* No of options being exercised. The tax liability at the time on the exercise of shares sometimes is in lakhs or even in crores without monetizing those shares, this provision of Income tax can utilized by the organization positively effectively by restricting the exercise period to 90 days, by restricting the timeline of exercise period, employer discourage the employee to resign as employee will have to pay heavy tax at the time of exercise without even monetizing it. Point to note here is that while the obligation to pay the tax is on employee however it is the duty of the employer to deduct TDS and pay the appropriate amount to government from employee salary. Hence it is important to have ample amount of notice period to cover TDS deduction part and remit the amount to government.

3.  Type of securities: It is important for the management to decide which type of equity is being offered to employees, the real intention behind ESOP is to provide maximum financial benefit to employees and but it is also important that important strategic decision of the company should not be diluted for the reason that one of the employee who is on the cap table does not want to vote in favor of the founder, hence sometime startup opts to issue “differential voting rights shares”- Shares without voting rights so as to pass the maximum advantage of financial benefit without limiting the right to take decision.

4.  Deciding right amount of strike price:- Strike price is the price which an employee will have to pay to the company to subscribe the vested shares, startups at the early stage would like to have it at Face value to pass on the maximum financial benefit however company at the matured stage would like to keep it at fair market value of the previous round at which company has raised funds, this ensures that the prior effort applied by the previous employees or the founders should not be passed on the new employees, the new employees only gets rewarded by the value addition made during his tenure and not of the preceding tenure.

5.  Treatment of ESOP option during strategic event: In the era of market consolidation, takeover, Merger and acquisitions, Liquidations: it is important to have a provision of these events in the ESOP policy and startups generally would like to opt for accelerated exercise rights to make sure that employees gets maximum financial advantage of the ESOP options while monetizing the shares.

Below are the points which a company must incorporate while implementing the ESOP Policy: 

1.  Differentiation between Good cause and bad cause.

2.  Vesting schedule and grant date. Companies Act 2013 prescribes to have minimum one year of time gap between the date of joining and grant date.

3.  Certain Discretionary powers with either ESOP committee or Board.

4.  Right of first refusal with the founder of Investors.

5.  Power of the Board to restrict the transferability of the shares to avoid any hostile takeover.

6.  Detailed process to exercise the shares along with the address to whom the communication needs to be sent.

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