Learn everything about ESOP including governing rules in India, using ESOP for recruitment, implications when employee quits or company gets acquired.

How does an ESOP work?

how esop works

The flow-chart above, with the following example, illustrates how ESOP works and benefits an employee.

Suppose an employee is granted 100 stock option on January 1, 2018, at an exercise price of Rs 10.

The shares will vest to her after two years of continuous employment (vesting criteria).

Therefore on January 1, 2020, the options will vest. At any point after that time, she can pay Rs 1,000 and exercise her option to get 100 shares of the company.

Now suppose, the company had an IPO and the shares of the company are trading at Rs 100 in the stock market.

The employee can sell her share in the stock market, making a profit of Rs 9,000. Of course, the employee has to pay taxes, as applicable.

Above scenario plays out little differently in case the company is still private as the employee can’t sell her share in the stock market. In such cases, the company may buy back shares under ESOP repurchase program.

Recently, over 100 current and former employees of Flipkart with vested ESOPs became millionaires, in dollar terms, as Walmart acquired 77% equity of Flipkart for $16 Billion. As part of the acquisition, Walmart was obliged to purchase vested ESOPs, worth nearly $800 million, from Flipkart employees at a rate of $126-$128 per share.

Who is eligible to get ESOP?

As per SEBI Guidelines:

  1. Permanent employees and part-time employees, whether working in India or abroad, and directors can be granted stock options under ESOP.
  2. Unlike the US laws, Indian laws don’t allow granting ESOP to advisors or lawyers.
  3. An employee who is a promoter or belongs to the promoter group is not eligible to receive stock options.
  4. Any director who either by himself or through his family or any investment company, directly or indirectly holds more than 10% of the outstanding equity shares of the company is not eligible to receive stock options.

SEBI Guidelines refer to the Securities and Exchange Board of India – Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, which come into force with effect from June 19, 1999.

What are the benefits of ESOP?

Faced with a scarcity of talent, poaching, and high attrition, employers have realized the importance of ESOPs to recruit and retain the best talents.

New age startups, as well as the USA based parent companies with subsidiaries in India, have found ESOPs as a useful human resource development tool.

What are ESOPs in India?

ESOP stands for Employee Stock Option Plan. It is also called ESOS – Employee Stock Option Scheme.

A stock option is defined as a right but not an obligation granted to an employee to apply for shares of the company at a pre-determined price.

A stock option can be converted to shares if the employee fulfills “vesting criteria.”

Vesting criteria could be either number of years of continued service after receiving the option or satisfaction of some performance targets or both. After the vesting criteria are satisfied, the options are considered as “vested.”

The exercise of a stock option is the process by which an employee, the option holder, can convert the vested stock option to shares by paying the “exercise prices.”

The exercise price is usually determined by the company at the time the options granted to the employee.

The employee holding stock option is not entitled to either dividend or voting rights until he exercises his options and gets shared allotted.

If the employee is terminated for misconduct, then even his vested option may lapse, subject to such policies in ESOPs.

ESOPs are non-transferrable, and only the employee is entitled to exercise the options.

In the case of death of the employee, all options granted to her including all unvested options will vest to her legal heirs on the date of her death, and they shall be able to exercise the options. If she was not an employee at the time of her death, then all the options that had vested will transfer to her legal heirs, and they may exercise the vested options.

What is vesting in ESOP?

A stock option under ESOP can be converted to shares if the employee fulfills “vesting criteria.”

Vesting criteria could be either time-based or performance-based, or both, as explained below:

  1. Time-based vesting: an employee has to be in continued employment for a period of say two years before stock option could get vested.
  2. Performance-based vesting: an employee has to meet a specific performance metric such as achieving sales of Rs 1 crore in a year before stock could get vested.
    As per SEBI Guidelines, there should be a gap of at least one year between the grant of the options and their vesting.

Vesting can be one time or in several installments, as explained below:

  1. One-time vesting: if 100 options are granted, they can all vest together after one year of continued employment.
  2. Vesting in installments: If 100 options are granted, 25 stocks will vest after one year and remaining 75 options will vest in equal installment every quarter for the next three years of continued employment.

If an employee with ESOP grants, cease to be an employee, she can still exercise his vested options, i.e. she can pay the exercise price to convert vested options into shares. All her unvested options will lapse, and the options will not vest, and consequently, she cannot exercise them. If her employment is terminated because of misconduct,  then her vested options may lapse subjected to ESOP policy of the company.

Can an Indian employee hold ESOP of a USA company?

Yes.

The employee of an Indian subsidiary company (such as ACME India Private Limited, a company registered in India) can get ESOP of the USA based parent company (such as ACME Inc., a company registered in the USA).

To hold ESOP of a foreign group company, Indian employee (or collectively for all the employees by the Indian company, ACME India Private Limited above) needs RBI approval. Also, the Indian employee has to abide by exchange controls and taxation laws.

Approval from RBI is generally available under several conditions, including:

  1. Dividend paid on the stock as well as capital gain on selling of stock has to be repatriated into India within a reasonable time.
  2. Permission has to be taken from RBI in case the employee wishes to hold on to shares after exercising the options. Alternatively, the Indian company can also seek permission collectively on behalf of all the employee in this regard.

To seek RBI permission the Indian company would have to submit documents such as ESOP plan, letter from the parent company whose shares would be made available through ESOP and list of employees who would be eligible for ESOP.

Further, to comply with RBI guidelines, the Indian company would have to submit details of stock options offered to employees every six months.

Stock option plans for the foreign company can be structured via the cash mechanism and cash-less mechanism.

  1. Cash mechanism, Indian employee, has to remit cash abroad towards exercise price for exercising her stock option. There is a limit on how much money could be remitted – $10,000 – and requirement that the foreign company should hold over 51% equity of the Indian company.
  2. Cash-less mechanism is more employee friendly. The foreign company would designate a few stockbrokers who sell the shares issued under the stock option plan, and the payment of the exercise price is made out of the sale proceeds of the shares. The broker, in turn, remits the net amount (after having deducted his fees) to the Indian employee. Hence, the employee doesn’t need to remit abroad cash towards the exercise price. Also, there is no requirement that the foreign company should hold majority equity of the Indian company.

How is ESOP money taxed?

Let’s say an employee received 1000 stock option on 1st January 2018 at an exercise price (Exercise Price) of Rs 100 and that will vest at once after 2 years of continued employment.

On 1st January 2020, all of 1000 stock options get vested, and the employee receives 1000 shares by paying Rs 100 per share. On that day, Fair Market Value (FMV) of the shares Rs 500.

So a net profit of employee is Rs 400,000. This profit would be treated as salary income of the employee, and the employer is required to withhold the income tax on it.

Same tax rule applies even in case the employee gets ESOP of the foreign company and sells those share after vesting. The Indian company is required to withhold income tax on the net gain (FMV – Exercise Price).

In case the employee continues to hold the shares of the foreign company after procuring RBI’s permission, dividends repatriated into India are subject to tax as ordinary income.

If under the laws of the country of the foreign company, taxes have been withheld at source, then depending upon the relevant treaty provisions, the Indian employee may get tax credits.

What is an ESOP valuation?

An employee can exercise his vested option to receive shares of the company by paying the exercise price.

While granting ESOP, the company will declare the exercising price. The company is free to fix exercise price at any level provided it conforms to accounting principles.

How to use ESOP for recruitment?

As a founder of a startup, you need to judiciously discriminate the size of ESOP grant based on the risk appetite of a potential employee to use your ESOP option pool effectively.

You need not offer the same number of options to a candidate who is fixated on cash and is unwilling to budge as to another candidate who as bigger risk appetite and is willing to accept lower cash component.

Rather than making ESOP offer over email, you should have a face-to-face discussion or a phone call, if the candidate is in a different location. This will give you an opportunity to educate the candidate first, as most of them don’t fully understand ESOP.

In your ESOP discussion with a potential employee, you should give a good sense of your business, and traction achieved so far competitive landscape, growth path going forward, valuation drivers estimated the valuation of the company four years from now and, finally, worth of the stock option that you are offering. You may want to help the candidate see his total compensation over the next four years.

Ideally, you want an employee who feels excited about your business and stock options. You don’t want someone who talks all good thing about your business but negotiate hard for high cash component in salary.

What should be the quantum of ESOP grant?

For a Series A startup, you may consider offering anything between 1%-2% to a CXO and 0.25%-1% for a key hire one level below CXO. A professional CEO may ask for 4%-8%.

It depends a lot on the valuation of your startup at the time of the grant. If you have a higher valuation, you can go for the lower end of the range given.

For a Seed round startup, you may need to offer double of what you could offer at Series A.

What happens to ESOP when an employe quits?

Most startups expect outgoing employees to exercise all the vested options within 30-90 days of quitting.

Though this could be financially difficult for most of the employee as they need first to pay exercise price to convert their vested options into shares, and second hold on to risky and illiquid shares. Hence, many employees prefer leaving the options and walking away.

Some startups allow exercising options anytime before expiry even after termination of employment.

What happens to ESOP when a company gets acquired?

Usually, the ESOP plan would have a “Change of Control” section that would govern what would happen in case the company gets acquired.

Some startups allow 100% accelerated vesting upon a change in control and some others may offer a 25% acceleration, which is more common.

Suppose an employee had 100 stock options that would vest yearly in equal installments. So after two years, the employee would have 50 vested options. With 25% accelerated vesting on change of control, the employee would have 75 vested option, if the company gets acquired after two years.

Depending upon the terms of the acquisition, unvested options may just be forfeited or converted into equivalent options of the acquiring company.

Are ESOP plans good for employees?

Your decision to work for a startup should be based solely on whether you would love working for that startup and nothing else. Do you like people? Do you trust them? Are you excited about their business? Will you learn from them?

Once you decide to work for a startup, you need to take a strategic look at the compensation you are offered. This includes computing your earning over a longer term, say four years, and taking some calculated risks.

How much risk should you take? Well, only you can answer that.

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