Decoding ESOP's in the Start-up culture- Part 2

In my first edition, I gave you a glimpse of what exactly an ESOP is , its eligibility, conditions associated to make up for an ESOP plan, its structure and tax implications in general.

This edition will delve deeper into the Indian start-up psyche of why it is implemented and how different categories of start-ups embrace profitability on grounds of motivated employee driven benefits . Some of the few Top Unicorns today that grew in their initial years , one of the reasons for their success is offering RSU’s / ESOP’s.

So ready to deep dive with me….great:)

ESOP as mentioned earlier is an extraordinary tool for start-ups to attract and retain top talent within their organisation and make them masters of their own profitability and shareholding in the company.

Some of the benefits that Start-ups derive from implementing an ESOP plan:

• Employee Attraction and Retention - With ESOP’s instilling a sense of ownership in the company, employees are hooked for longer duration incentivising them for their hard work and good performance helping early-age startups build their growth trajectory.
• Motivational Push - When the company grows , the employees realize how their hardwork is giving them the gains keeping up the growth numbers for the company which in turn motivated them to work harder and push for accelerated growth. This works as a boon in disguise helping the founders and initial capital investors a huge incentive to make profits and expand their horizons.

Unacademy is one such company that grew their initial numbers basis ESOP’s and today after being in news for laying off people are back in action for expanding it’s pool of ESOP from 400Mn dollars to approx 961Mn dollars . Here is the news.

• Cost Control - Companies offer ESOP’s as a reward or bonus moreover as part of variable pay to the CTC since early age start-ups are not in financial position to offer highly competitive salaries. ESOP’s come in as a blessing in disguise where without affecting bottom line expenses, attractive and exciting compensation to? employees is awarded by increasing their earning potential keeping them hooked as long term runners.?

Companies Successful with the ESOP mission:?

According to data shared by Muds, the Law of the Land atleast 35 Indian Startups with Flipkart leading ,valued at an ESOP pool of 17000 crores or 1700Mn INR followed by Nykaa , Zomata , PolicyBazaar,Paytm, Byju’s, Swiggy, Ola have entered the 100Cr stock options club.

Also with the IPO’s recently being announced and investment booms in young enterprises have led ESOP’s to gain momentum and popularity among these Top guns.

As per the ET, Longhouse Consulting advisory report atleast 35 non-founder executives have embarked the 100 Cr club of stock options pushing India towards fastest growing digital economy.

Longhouse Consulting predicted that 100cr inventory options membership would have more than 100 members by the end of 2021.

The buy-backs in 2021, after 12 months of verification and documentation process, benefited huge number of employees.

Flipkart with 600Cr.INR buy-back , while Zomata and Nykaa on listing made their employees millionaires. Zomato’s stock market debut resulted in the creation of 18 millionaires.

ShareChat, a regional language social media network that became a unicorn in April 2021, amassed an Esop pool of Rs 462 crore.

Some of the other buy-backs are done yearly by Razor Pay, Udaan, UpGrad, Swiggy and many others.

Recently , Paytm offered 4 million new stock options under it’s 2019 ESOP plan hence the stock dropped to an all time low of Rs.556 on 9th May 2022 as compared to it’s initial public offering at 2150/-. The company allotted 1,77,114 equity shares to employees who exercised the options at an exercise price of Rs.9 per share.Refer ET Article?

One interesting fact, candidates who while applying for jobs should definitely consider these points before taking a decision to join a MNC as only Indian listed companies have options to offer their employees with vast benefits that doesn’t exist with MNC’s unless they have an Indian subsidiary holding company.

ESOP’s definitely offer an secondary source of income for the employee as a method of wealth creation while they need to multiply the same by exercising safe wealth augmentation plans.

The first Indian company to issue ESOP’s was Infosys. Started in 1981, is known to have given away Rs 50,000 crore worth of ESOPs to employees since inception. In the 1990s, it allotted ESOPs in three tranches, at Rs 50 a share. By the 2000s, thousands of employees had become millionaires by encashing these when the stock was at Rs 7,000.

But when the dot.com bubble triggered in 2000, there was a dramatic fall in IT stocks which led Infosys to discontinue the scheme in 2003-2004 giving reasons like Lack of employee participation and difficulties in accounting reconciliation.

However, ESOP’s never lost the sheen and today they are becoming gold mines for their holders and making executives millionaires within a few years of stability.

You can check out their latest 2019 ESOP plan here

CASE Study on Udaan -?

B2B trade platform Udaan , before starting in 2016, it’s three founders, Amod Malviya, Sujeet Kumar and Vaibhav Gupta, had completed successful stints at Flipkart. They were incidentally the biggest beneficiaries of a rather generous ESOP plan at Flipkart in 2016. They had received size-able amounts of money after selling a part of their holdings under Flipkart’s periodic stock buyout programmes conducted for employees.?

Udaan ,founded in 2016 with a vision to transform the way trade is done in India leveraging technology", is India's largest business-to-business e-commerce platform. Registered by the name Hive Loop Technology Private Limited , they wanted to build a bigger business than Flipkart in record time.They adopted some of the best practices they had learnt at their ex-employer, one of which was a largest ESOP programme. Udaan’s ESOP policy was even more radical than Flipkart’s—bigger, but, more importantly, far more demanding of employees.

The first 24 employees were offered 50% less than previous salary in fixed with a promise to make them ESOP beneficiaries within 2-3years. The reason was the company started with limited capital and they didn’t want to burn cash at the beginning stage. They took the conservative approach to be able to invest back into the business however they ensured their initial army of employees was not compromising on their lifestyle.

Although Udaan has now been almost on par with market standards in terms of salary payouts but cash incentives for more than 3000 employees are still below par , the reason ESOP’s is still their biggest carrot.

The ESOP policy allowed Udaan to pour more capital into the business, which has grown at a prodigious rate, touching more than $2 billion in annualised gross merchandise value (GMV) at the end of 2019. Its valuation soared to $2.8 billions in? 2020, the clearest indicator yet that the company’s ESOP policy may work out well for employees.???

While Udaan’s ESOP policy is commonly popular among start-ups in the US and China, Indian companies are still sceptical due to the employees' attitude of not accepting stocks as rewards in place of cash revenues. Most of its early employees had personally benefited from Flipkart’s ESOP policy; and the three Udaan founders led by example by forgoing cash salaries themselves.

On the flipside: Employees still view ESOP’s with scepticism since no standard ESOP policy is followed by start-up entrepreneurs and founders due to many legalistic loopholes that hover around the terms in fine print.

However , the government has laid down certain regulations under SEBI in 2021 to legalise the Employee benefits and sweat equity ie ESOP’s/ESOS/PSOPs here.

ESOP v/s RSU - how each is different!

Restricted Stock Units (RSU’s) are stock options provided by a company after the vesting period is over on certain pre-conditions of employees’ or company’s performance and certain duration in the company.

Companies like Infosys, Wipro,Hindalco,Tejas Networks have offered RSU’s to their employees. It offers much more predictability to the employer of employee’s stability and duration in the company as compared to Stock options.

RSUs do not give the employee the option to purchase or subscribe the share, rather they are a scheme under which the employee will be entitled to the shares at the end of vesting period so long as the restrictions relating to duration of employment and performance parameters are met.

Parametres

Restricted Stock Units(RSU) Employee Stock Options(ESOP’s)

What employees pay?

A Par Value that is considerably nominal than market value and tax is paid only after vesting on long term capital gains under RSU.

A pre-determined exercise price of the share when the option is exercised under ESOP.

Security for employees

Guarantee of share acquisition after vesting period is over on fulfilment of preconceived conditions under RSU.??

If vesting period is lapsed, and options have been exercised, the employee fails to acquire shares.No fulfilment of preconceived conditions required under ESOP.

Minimum Return/Benefit

Market fluctuations do not affect the prequisites at the hand of the employee.Usually par value is much lower than market price so employee takes home minimum profits under RSU.

Employees may suffer losses if market price falls below exercise price under ESOP.

Mode of Payment

RSU’s are paid in stocks or cash ESOP’s only paid in Stocks.

At first glance, RSU might seem like a more attractive option, with immediate monetary returns. However, RSU can create some?administrative issues?due to the direct granting of shares to employees. As such, the shareholder voting agreements can become complicated and messy. In addition, the process of reclaiming un-vested shares can be quite challenging.

For example, when an employee leaves the company, taking back the unvested shares will require the employee to sign an agreement to approve the transfer of unvested shares back to the company. If employers are faced with a bad employee departure, it could lead to the unprecedented state of limbo with the shares.

On the other hand, this is avoidable with ESOP, as shares are only granted when the employee decides to?exercise them. Furthermore, ESOP can lead to bigger financial gains for employees if the value of the company stock rises. During a liquidity event like fundraising or an exit, employees may also be given the opportunity to cash out their shares by selling them. ESOP is also commonly presented with standardised terms and conditions, thus reducing administrative and legal issues.?

Note: Restricted Stock Units are a kind of non-ESOP based employee benefit scheme which are regulated specifically by the SEBI (Share Based Employee Benefits) Regulations, 2014 along with other applicable general laws and regulations. There currently exist no prescribed rules for issuing RSUs and therefore no uniformity can be seen in the RSUs issued in India of late. Unless the legislature or the executive takes note of the same, companies have the flexibility to model the terms and conditions of their RSUs as per their discretion.For more details refer here .

Some Questions that may arise in your mind , regarding ESOP plan in case of below events:

• Incase I have to borrow money from ESOP to pay my bank loan

An Internal Revenue Service mandates the employer to make annual contributions to the investment of each participant employee, the employer reserves the right of granting a loan on the ESOP amount and the maximum percentage of loan that can be availed before an employee reaches his retirement age.So if your employer allows a loan on its ESOP scheme, it mandates the guidelines set by Internal Revenue Service or IRS regarding loan availability, payback schedules and loan amount.

You must note that irrespective of the status or level of employee, the employer must permit all participants in the ESOP plan to allow taking loans of a certain specific amount and upto a certain period of time only. Employers usually allow loans on ESOP scheme under specific life stage of an employee like Purchase of home or paying of fees for higher education etc.

For instance, if an employer allows an employee to take a single loan from his ESOP account up to Rs.75,000, the sum of the employee's multiple loans cannot exceed Rs.75,000, this is incase of higher studies but if it is for purchase of home, could be max 5,00,000/- depends of different criteria set by IRS.

• Incase I Resign from my company??

Typically a Summary Plan Document or SPD needs to be provided by your company’s administrator to redeem your ESOP shares.The frequency of the ESOP valuation may differ year on year depending on the guidelines set by the Internal Revenue Service. The annual accounting period or ‘Plan year’ or whether the ESOP borrows money to buy the stock are all parameters that the IRS sets before setting out the plan.

In cessation of employment for reasons other than resignation, like reaching Retirement,employee’s death or disability, then the company must start distributing the ESOP’s according to the Plan year of the event. However incase of voluntary reasons like resignation,your ESOP plan can choose to pay you the value of your shares in a lump sum or in equal annual installments if the vested balance exceeds a predetermined amount defined in your SPD. Generally, an ESOP plan must disburse the funds in equated annual installments within a 6 year period including interest payment. The currency amount in your account and your vested balance will determine the amount of cash you would receive on your ESOP.?

There are 2 methods of vesting -?

1. Cliff Vesting - Non Vesting in the beginning years of your plan, but then gives you 100 percent vesting within three years after employment.
2. Graded Vesting - 20 percent vesting after your second year of employment, and then 20 percent each of the following years until you become 100% vested after year six

Refer https://budgeting.thenest.com/laws-esop-payouts-23979.html

• Incase my company shuts down/gets merged with another entity?

Generally an ESOP plan would have an option of repurchase of shares at a regular interval, hence a company that has been declared bankrupt would either be taken over by a new entity and ESOP plan thus transferred to the new entity , the Trust would generally set the guidelines in advance.

The ESOP and it's participants are treated as “equity holders” in bankruptcy, which makes them effectively last in line for getting paid for their stock in the Company that is being liquidated in bankruptcy.However in one of the case laws, the bankruptcy court held that several former employees of an ESOP-owned company were debt holders, and not equity holders, for bankruptcy purposes.

When an ESOP company closes certain factors needs to be kept in mind by such company’s employees::

• ESOP plan rule details on checking how employees become fully vested, and how plan assets are distributed if an ESOP plan is terminated; this may apply in a sale situation.
• If an ESOP company is purchased by another ESOP company, employees of the purchased company are typically incorporated into the purchasing company’s ESOP
• The ESOP trustee as guided by law has to ensure best interest of it’s employees including decisions of repurchase or sell the shares.

The main benefit that an Employer derives from floating an ESOP plan is to conserve cash during it’s early stage and defer taxes on the payouts while keeping employees motivated and retained for the long term.

Some real-time stories on how company’s are cashing on this scheme-?

Bengaluru-based meat and seafood company Licious in January announced its maiden ESOP plan that will benefit more than 800 employees across functions including processing-centre staff, delivery boys and corporate employees.

“Our meat technicians, meat processors and delivery heroes are the heartbeat of this brand and deserve to benefit from the growth. The ESOP grant to our blue-collar force is a progressive and positive step in this direction,” co-founder Abhay Hanjura said. Refer the full article?

Wake-fit, the home furnishings company based in Bengaluru awarded ESOP to all it’s employees, including back-office production staff. “Early employees at Wakefit played an extremely important role in our growth till now. They cut across functions and seniority levels, from highly experienced people all the way to fresh graduates. So, we decided that it is fair to reward these committed team members irrespective of function and seniority,” said Chaitanya Ramalingegowda, its co-founder.

Refer the full article

Liquidity events or cash-out opportunities that have created value for ESOPs in real cash terms over the last couple of years are prompting an increasing number of startups to use it as a tool to attract and retain talent, said experts.

Contrary to a variable pay plan which is completely performance based, companies are using ESOP plans to shoot the productivity levels by employees who fuel the company towards wealth generation while employees feeling more safe and secure through regular cash out opportunities.

It works like a dual benefit tool that keeps the employee-employer relationship brewing and healthy.?

Now let’s debunk some things Employees and Employers must keep in mind before getting into the scheme of ESOP’s..

First, for Employees(as they have always been close to my heart) -

• ESOP’s are not Equity Share they are just options:?

Company is not giving shares immediately, it is just offering an option to buy certain number of shares on or after a vesting date. This ESOP option is in writing a letter issued to the employees by the company as an ESOP policy planned and drafted after being approved by the board and shareholders. The letter exactly mentions the number of options granted during the 5-year vesting period and percentage of options that can be exercised at the end of each vesting period.

So if a company is offering you 100 options, at a vesting period of 20% every year , then you can exercise the option of purchase of 20 shares for every year of employment.?

• ????ESOP’s are taxed twice in the hands of employees:??

An employee would have to pay a tax on the prerequisite even before receiving the shares in hand by way of TDS deduction made by the employer showing in the Form 16 of the employee. This is usually calculated as a difference between the Fair Market value and the Exercise price.

Let’s say - The company has granted you 2000 options of it’s company in Jul 2019.? In July 2020, you exercised the option of 10% from the total options which is 200 options at an exercise price of Rs.70/-. Now while exercising the purchase, the Fair Market Value (FMV) is 120/-. The difference of Rs. 50 per share ie(120 - 70) is your prerequisite which amounts to 50*200 = 10000/-, a TDS would be deducted by the employer as per your current tax slab and mention the same in your Form 16.

The 2nd Tax is the Long Term Capital Gains tax which becomes prevalent after you decide to sell the shares in a particular year. The profit you make between your sale price and the fair market value at the time of allotment of the share, is your capital gains. A LTCG would be liable to be paid when you file your IT returns on the prerequisite here too.

Let’s say- In Oct 2021, out of the 400 shares you received , you decide to sell 100 shares . Now if the Sale proceeds provide you with Rs.250/- on each share and the FMV at the time of allotment is Rs.150/- then 100/- per share is your prerequisite ie. 100*100 = 10000/- , you would be taxed on the capital gains by 20% of overall gain.

Other challenges -

• If you Resign before the Vesting period, you may lose shares
• Liquidity is a challenge
• ESOP rules and policy

Refer article for more details

So experts in the legal fraternity suggest employees to check all credentials of Seed Funding, valuation of the start-up and investors in the company before taking a plunge and making Not-so-Good career move.

From an Employer’s perspective, the following aspects should be kept in mind before devising an ESOP plan:

1. Understanding the dilution in the share-holding before blocking the ESOP Pool
2. Proper legal documentation and a well-structured ESOP arrangement should be in place else it would back-fire the Employer.
3. Understand the difference between Advisor’s/Consultant’s options over Employees stock options.
4. Understanding tax implications on ESOP issuance and future exercise options.
5. Keeping in mind the legal concepts like grant, vesting and exercising thoroughly well along with treatment of options at the time of exit of employees.
6. Time of exercise of stock options
7. Prefer creating ESOP pool over an ESOP Trust - Although an ESOP trust is tax-efficient for the employer , ESOP pool depicts the number of shares and the constitution of the share-holding pattern on a full diluted basis of the company. Investors prefer this technique to avoid dilution impact on their investments after a possible increase in their ESOP pool. Also a more tax-efficient approach for the employees as they need to pay the applicable taxes based on the tenure of holding of securities.
8. Investor’s less preference for minority shareholders- The founder has to usually keep in mind the impact of minority shareholding. Usually investors do not prefer too many small shareholders as it may mean difficulties in dealing with minor shareholders who are usually more troublesome than working with a few larger and more experienced investors. Many top-tier investors will not join around if it has too many small shareholders already on the cap table.

Refer employer's help guide

A logical and thorough study on ESOP’s is necessary by both the parties in the employment arrangement to make the relationship grow stronger and fruitful.

With amalgamations,take-overs and mergers prevailing in the business world, ESOP is an important factor that should be kept in mind by both Employers and Employees to make an informed decision before choosing your next move.

Signing off… meet you next time with another interesting legal topic!