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In this article, Himani Singh discusses how to Implement ESOP for Startups.

ESOP Guide for Startups

Many companies which are young and newly established ones, especially startups and do not know how to manage and administer their capital amount and end up getting engulfed in problems related to money. Startups start losing workforce when they become unable to provide lucrative offers to retain and boost up their employees. Solution to this problem could be solved by implementing ESOP in the company which does not only play a major role in liquidating capital but also motivates employees to perform better and helps in the growth of the company.

Definition and meaning of ESOP

ESOPs are Employee Stock Option Plans – few call them Employee Stock Ownership Plans in India. At the point when an employee gets ESOPs from the organization where he/she works, he/she gets the privilege to buy a specific number of shares in the organization at a foreordained cost after a foreordained period or periods. It is given as a reward for tenure or performance with the company. It additionally works in as a motivational instrument as once you own stock, you really possess some portion of the company and if the company does well the stock value rises. ESOPs additionally help in holding employees.

The companies give ESOPs in parts and they have a vesting plan. So today an employee may get 3000 shares which would be given in sets of 1000 over the time. Usually, employees need to sit tight for a specific term to practice their entitlement to purchase shares. This period is called vesting period. If in the case that the employee does not practice the option of purchasing the shares within the vesting time frame, the options slip by and the employee does not get any rights. IT firms had begun this pattern however now numerous organizations in various parts offer ESOPs to employees even the new companies are relying upon ESOP to draw inability.

When to create ESOP

Create an employee equity allotment and implement ESOP somewhere in between of the Pre-seed stage and early venture capital stage.

Stages Takeaways Consideration
Pre-seed ESOP is not compulsory, but it helps to determine the sanity test that how much equity the company is giving to its early hires. Founder often get too busy on ESOP and the key employees are granted the option on ad hoc basis.
Seed The seed round could get closed before an ESOP and the advantage to do so is that in that stage seed investors share in the dilution. In the first round of the financial stage, investors are either institutional investors or angel investors. In this one who is the institutional investor, he/she will require an ESOP.
Early venture capital ESOP should be created to attract the investors and to give the guideline for the size of new employees option. In the first round of venture capital, the investors will require an ESOP and will be given large equity grant.
Late venture capital Important to standardize the ESOP and amount of equity given to the newly hired employees at each stage. Startups at this level begin to rapidly increase hiring yet employees of startups want equity.
Growth Till this level, most of the ESOPs are gone but the remaining shares are too valuable. The Company could make use of those shares in allowing new hires to share in the upward movement of shares. In this level/stage company usually exhausted most of its shares and move in the direction of growth.

How to implement ESOP for startups

ESOP is given to employees of a company which avails employees of the company with the option to buy company’s stocks at a certain price. The objective of an ESOP is to motivate employees to participate in affairs or matter of the company. The price on which the stocks are given to employees of the company can be of three types:

  1. a) Market price i.e. the price at which the stocks of the company are mentioned on the stock exchange,
  2. b) The Preferential price that is lower compared to the market price given to the employees,
  3. c) the management could set the price at whatsoever it wants to but only if the company isn’t listed on the stock exchange.

These all are governed by the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999.

ESOP holds great importance for the following reasons

  • A start-up requires funds and so, the capital requirement of the company can be increased by offering stocks of the company to employees, keeping them within the business.
  • ESOP turns out to be a perfect alternative for appealing, encouraging and retaining employees instead.
  • It is similar to a profit-sharing plan. Employees being aware of that they are shareholders and owners are bound to work with more enthusiasm and feel responsible for the growth of the company.
  • Provided with the limited marketability, it is better to utilize the scheme rather than listing shares on a stock exchange.

Eligibility

The person who is eligible to be a part of the Plan are as follows:

  1. Employees, other than:

(A) any Employee who belongs to the Promoter Group or holds/have 2% or more of the outstanding Shares, or

(B) except with the prior approval of the Reserve Bank of India, employees who are the nationalist of Pakistan, Sri Lanka or Bangladesh.

  1. Directors of any company, except

(a) any Independent Directors or

(b) Director/s who either themselves or through any body corporate, by direct means or indirect means, hold more than 10% of the shares

Rights granted by companies to employees in ESOP

  • Right to buy a specific amount of shares in the company at a predetermined price after a predetermined period.
  • It helps the employer in retaining the company and provide assurance of a good level of performance in the work.

Purpose played by ESOP for Companies and Employees

ESOPs are basically given for tenure or performance of the employee in the company thus, it serves the purpose of both the employees and the company.

  1. It serves as motivation for the employees for this basic reason that once they will own stock they feel responsible for the performance of the company, as it helps determines the value of the stocks of the company. When the company performs well, the value of the stocks rises and when it does not then stocks fall down.
  2. If an employee is willing to take no risk then he can exercise his shares when company’s share is trading at a premium. If the employee sells the shares at the right time, he/she can easily make a profit

For instance, when an employee gets 300 shares at Rs. 100 per share and the vesting period is 12 months, an employee could exercise the option of purchasing the shares after 12 months. It is beneficial only if the employee exercises this option when the market value is greater than Rs.100 during that time.

If the market value is Rs.150 during that time, the employee can get the shares at Rs. 30000 and can sell it at Rs. 45000, (Rs.150 x 300). He/she will make a profit of Rs. 15000. ( tax involved in this – 30% perquisite tax & 15% capital gain which is approximately 4500 + 2250 and still to reach the net gain of Rs 8250) Employees do not involve in any risk as they pay money when they exercise the option. When the market price of the shares is high, employees could take the shares and sell it on receiving high profits. They have the open option to not take the ESOPs as it is not compulsory.

  1. It helps the employer to get assured of the good level of performance in the work.
  2. The company can dilute ownership and preserve cash only when it is required. The company gives an advantage by offering ESOPs to its employees. Employees can avail from the increase in the share price and hence, employees will focus and pay attention to working towards establishing the successful position of a company.

ESOPs deliver advantages like

  • Place the interest of the managers with those of the owners.
  • It is a no-cash compensation equipment to compete for the best human resources.
  • It grants an opportunity to the company to pay without a reduction in accounting advantage.
  • To have felt a sense of belongingness and ownership amongst the Employees.
  • Lower in the attrition rates.
  • Encourage the morale of employees.
  • More efforts and hard work are done on the part of employees.
  • Equitable Distribution of the achieved profit.

Taxation in ESOP

Different Stages Date Value of each share Tax Tax outgoing
Grant of option 1st April 2010 100 Nil Nil
Vesting option 1st April 2012 150 No tax till kit get exercised. Nil
Exercising option 1st August 2012 200 Tax difference between the fair market value on the date it gets exercised and the exercise price. (100 shares*( Rs 200-Rs 100))* 30%= Rs 3,000
Sale option 1st December 2012 500 Tax difference between the Sale price and the Fair market value and 15% STCG if sale within one year, no tax if sold after a year. (100 shares*(Rs500-Rs 200))*15%=4,500

When the options/equity are offered by the company then there is no tax.

– When the option is vested then also there is no tax.

– When the employee uses his option of purchasing the number of shares then the difference between the exercise value and the market value is treated as perquisite and is taxable as according to the tax slab that the employees are in.

– When the employee sells their shares, the profit is considered as a capital gain. If in case the shares get sold within one year then 15% capital gains tax has to be paid just like in the usual purchase and sale of shares. If the stock is sold after 12 months, there is no tax as it is considered as long-term.

– If the employee has ESOPs of a company that is abroad and sells the shares, short-term capital gains get included to income and the person has to pay tax as according to the tax bracket that he or she falls into.

– If the capital gains are long-term and not short-term then 10% tax is implied to be paid excluding indexation benefit or else 20% tax has to be paid including indexation benefit.

How are ESOPs not similar to ESPS and RSUs?

Employee Stock Purchase Scheme permits employees to purchase shares at certain discount decided by the company as compared to the market price. Shares could be purchased by employees through monthly deductions from their salary.

Restricted Stock Units (RSUs) – When the employer offer RSUs, the employee acquires the shares free cost provided with certain conditions are supposed to be met like a vesting period. RSUs are attaining popularity in current times.

Legal framework in India

Sweat Equity Shares is defined in Companies Act 1956 under Section 79, which states –

  • Shares of the company get listed on the stock exchange according to the guidelines of the SEBI.
  • No less than 12 months should have been passed since the day on which the company was entitled to start the business.
  • It specifies that the current market price, consideration, the number of shares and the class of the employees, or the directors to whom such equity shares are to be given.
  • a special resolution passed by the company in the general meeting to issue the Sweat Equity Shares.

There are conditions to be followed for issuing sweat equity shares and the conditions are given in the Companies Act, 2013 under Section 54

  • 3/4ths of the majority is required to be present at the general meeting to pass the special resolution.
  • The company will not be able to get sweat equity shares for more than 15% of existing paid up equity share capital in one year or shares. Further, the Company should not exceed 25% of paid-up equity capital of the company at any time.
  • Copy of the share is supposed to be delivered to the shareholder with the information of the general meeting.
  • The consideration for the shares could be in both cash and non-cash form
  • The company has registration of the Sweat Equity in the Form no. 4.3 and should record the shares issued under Sec 54.
  • Lock-In period of 3 years is implied and this should be mentioned boldly in the share certificate.

Guidelines provided by SEBI for ESOP in 1999

  • It gives disclosure rules for the financial statement and Director’s Report
  • It needs compulsory disclosure of an impact of disclosure on profit for not obeying the fair value approach.
  • Guidelines provided by SEBI is necessary to be followed by all stock exchange schemes which came into existence on June 1999 or after it and hence it has no control over the schemes established before June 1999.

In the year 2013 SEBI confined the scope of the application of ESOPs by constraining listed Companies from acquiring their own particular offers from the secondary market.

The worry was that the construction and organization of such schemes through fake practices prompted inflation, changes, or depression in the price of the securities.

Consequently, the same year in November, SEBI issued an exchange paper to survey the ESOP Guidelines. There was a proposal to re-substitute the ESOP Guidelines with some rules and regulation in order to guarantee better enforceability, to give legal framework for all the stock exchange schemes, including securities of the organization to address the worries raised with reference to creation of representative welfare trust, disclosure, and so on and to empower secondary market exchanges with adequate protections.

ESOP in Indian startups

ESOPs are a really good equipment for startups to attract and hire talent, but at the same time it’s a bet for the employees and comes with the risk. Employees must get convinced regarding the growth of the company and must check if proper documentation is in place. As everything has two sides one good and other bad, same is in the case of ESOP, if it has benefits then it has another fold of disadvantage and both are explained below-

Benefits to employers

Recruit good talent

Start-up companies use Esops to recruit good talent because they cannot

pay very high salaries

Feeling of Ownership

The employees have the feeling that they are a partner in Company and are motivated to work harder as companies growth is linked to their growth

Benefits to employees

Opportunity of becoming a millionaire

Tales of how Infosys which is one of the very few companies to offer Esops initially in the 90s, has created a lot of millionaires employees such as drivers, plumbers, etc. Hence, ESOPs are beneficial only for high growth companies

Disadvantages

Dilution

When the ESOPs are exercised the founders shareholding gets diluted.

ESOPs come with a risk

Only one among 20 startups are really successful. Tales of drivers, plumbers becoming millionaires happen only in very few cases. In fact, in the case of start-ups, it is safer for employees to go only for the salary and keep Esops as an added bonus.

In the following case, the founder of startup Roy and Joy establish a company with 1 lakh share capital i.e. having 50% holding with each

To scale up in the market they need to have talented employees who’s current CTC is nearly 15 lakhs. As a startup Alpha cannot afford these high salaries, it proposes 10 lakh per annum plus 500 shares each with a vestin period of 4 years.

Founders share get diluted when ESOPs are exercised as it is explained above.

Walmart-Flipkart deal brings back ESOP in the spotlight

Trust in stock option plans, which once had lost their sheen and bright execution about a few years ago, is restored. “Flipkart has come out to be a very fine story from ESOPs vista. There are only few instances where professionals have created such wealth. Faith will improve further, people will be more receptive to buy the ESOP  again

Walmart’s acquisition of Flipkart at a valuation of 21 billion dollars has created the largest pools of wealth for employees in the history of Indian corporate. The deal of Flipkart and Walmart has made the total worth of Flipkart’s ESOP, adding unvested shares, to $2 billion which almost equal to Rs 13,455 crore and the retailer based in the U.S is planning to give a 100 % buyback of vested shares by employees of Flipkart.

In the year 2017, a company based in Bengaluru had completed its fourth ESOP plan of dollar 100 million which was the largest buyback by any private company in India. In this, more than 3500 employees of Flipkart and its other acquisitions of fashion i.e. Myntra and JABONG and payment arms PhonePe participated. Wealth created by the employee through privately held homegrown organizations in our country ‘s digital ecosystem is approximately $4-5 billions and out of this Flipkart alone accounts for more than 20 percent.

Walmart India claimed that it will generate employment by developing supply chain and opportunities in the commercial world along with the investment which creates new direct employment.

Acquisitions usually create fear in the head of the employees and lead layoff bt in case of Walmart – Flipkart it seems to be giving the employees with good news.

LIST of Companies in India which have ESOP when they Startup

INFOSYS

  • Infosys has led the concept and idea of ESOP in the Indian territory in the year of 1994
  • Infosys had awarded numerous electrician, plumbers, peons, drivers of its company with the Infosys stock.
  • There is a record that with the development and growth of company many of the shareholders have become millionaires now.

BPO

  • BPO offered shares to 550 staffs of the office
  • The idea and motive of BPO was to share the price and profit with the people who helped in establishing the company

BHARTI

  • Started in the year 2001
  • In 2006 every employee of the company was covered and ESOP was related to employees performance
  • In 2008 they observed that the policy of 2005 isn’t working because the new and junior staff preferred bonus or cash over equity
  • And so the company has now limited its plan to middle managers and above posts.

AXIS BANK

  • The management of the Axis bank had passed the burden of FBT on employees considering the benefit given in the tax law
  • In April 2001 more than one million options were brought to execution
  • In April 2004 more than three million options were exercised
  • And the amount of money gained was more than 100 crores in April 2004.
  • In the year 2005, they observed a fall in the plan of last 4 years and in the year 2007 less than 3 lakh options were exercised and the amount fell down to 10 crore rupees.
  • In the year 2008, they drifted to the plan where they restrict the plan to only middle management and above.

Conclusion

ESOPs are beneficial for the startups and the growing companies as it plays a vital role in enhancing the growth. The company by offering rewards, retain appeals talent, giving a sense of ownership and retirement benefit schemes and thus, it enhances the performance of the corporation as a whole.

This was all on ESOP Guide for Startups. What are your views on the Indian laws relating to ESOP Guide for Startups? Share with us in the comment box below.

Reference

https://www.quora.com/How-does-ESOP-in-Indian-startups-work-Are-they-of-any-value

https://www.tflguide.com/esops-in-india-benefits-tips-taxation-calculator/

https://www.indexventures.com/sites/default/files/pdf/index_ventures_hand_book_2_digital_1600x1200-2018-01-05.pdf

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