How to give Employee Stock Option Plans (ESOPs) in India:

Employee Stock Option Plans (ESOPs) stand as a strategic cornerstone for Indian startups after Register a Private Limited Company , designed to cultivate a sense of ownership and loyalty among employees. The regulatory framework, primarily governed by the Companies Act of 2013 and the Companies (Share Capital and Debentures) Rules of 2014, outlines a meticulous approval process.

What is ESOP?

Employee Stock Option Plans (ESOPs) stand as a strategic pillar for motivating and retaining employees based on performance. Unlike traditional stock allocations to investors, ESOPs grant employees the exclusive 'right to purchase' company shares at a predetermined price, paving the way for ownership based on specified conditions.

Is ESOPs allowed under Companies Act ?

• Under the Companies Act of 2013, Guided by Rule 12(1) of the Companies (Share Capital and Debentures) Rules, 2014, ESOPs find a home under the Companies Act, selectively accessible to permanent employees, directors (whole-time), and individuals associated with subsidiaries or holding companies. Notably, ESOPs are off-limits to promoters, promoter group members, and directors holding over ten percent equity directly or indirectly.
• ESOPs involve a systematic process, including grant, vesting, exercise, and exit stages. Employees exercise their options, converting the right to purchase into actual shares. This enables them to participate in the company's success and receive dividends. The strike price, expiration date, and statutory requirements under Section 62(1)(b) of the Companies Act are crucial elements in the ESOP process.
• Employee Stock Option Plans (ESOPs) serve as a powerful mechanism for incentivizing and retaining employees in companies, these plans, also known as Employee Stock Ownership Plans, provide employees with the "right to purchase" shares in the company at a predetermined price, subject to specific conditions. Unlike traditional stock issuance, where investors become owners, ESOPs offer employees the potential to become owners in the future, contingent on meeting certain criteria.
• ESOPs Process have gained prominence in the Indian corporate landscape, driven by the surge in private companies going public and the increasing adoption of employee benefit programs. Post Covid era, the year 2021 witnessed significant investments in new startups in India, contributing to the growth of ESOPs.
• Key terms integral to understanding ESOPs include the creation of an "option pool" to attract early employees, eligibility criteria limited to employees, the grant of options based on specific conditions, and the concept of "vesting," where employees earn their stock over time. Vesting periods can be time-based or milestone-based, contributing to a structured and motivating work environment.
• To implement ESOPs successfully, companies often create an explanatory statement with Notice under Section 102 accompanying a separate resolution, outlining key details such as the number of options, employee identification, vesting requirements, and valuation methodology, Compliance with accounting standards, non-transferability of options, a minimum one-year lock-in period between grant and vesting, and maintenance of a register of employee stock options are essential aspects regulated by the Companies Act.

For listed companies, adherence to the SEBI (Share Based Employees Benefits) Regulations, 2014, is mandatory, requiring the establishment of a compensation committee and the disclosure of detailed ESOP information in the Board report.

Decoding ESOPs - Key Terms

Option Pool: Before embarking on the ESOP journey, startups often carve out an option pool, earmarking shares for early employees. This strategic move aims to attract top-tier talent, especially in the nascent stages where substantial revenues may be elusive.

Eligibility: ESOPs are an exclusive privilege for employees, excluding promoters, consultants, advisors, freelancers, and contractual staff from participation.

Grant: Granting ESOPs involves the company bestowing options upon employees, linked to specific conditions like achieving revenue milestones, launching products, or driving market development.

ESOPs - The Process Simplified

Embarking on the ESOP journey involves four pivotal steps:

• Step 1 – Grant: The company declares an employee's ESOP eligibility, often tied to conditions such as years of service or substantial contributions.
• Step 2 – Vesting: Vesting marks the stage where employees gain eligibility to exercise their ESOP options, following either a time-based or milestone-centric approach over a specified period.Vesting of Options:Vesting of options refers to the process by which employees earn the right to exercise their stock options over time. It is a mechanism designed to incentivize long-term commitment and performance, vesting period is the duration an employee must wait before being eligible to exercise a certain percentage of the granted options.Example of a Vesting Schedule:Let's consider a hypothetical vesting schedule over a four-year period with equal vesting at the end of each year:- Years: 1, 2, 3, 4- % Vesting: 25% each year- Options Granted: 200The vesting of options would be distributed as follows:- -2021: 25% of the options (50 options) would vest.-2022: Another 25% of the options (50 options) would vest, bringing the total to 50% vested.-2023: An additional 25% of the options (50 options) would vest, reaching a cumulative 75% vested.-2024: The remaining 25% of the options (50 options) would vest, resulting in 100% of the options being vested, schedule ensures that by the end of the fourth year, the employee has gained the full right to exercise all 200 options. Vesting schedules can vary, and they may be based on different criteria such as time-based vesting (as in the example) or milestone-based vesting tied to specific achievements or performance goals.The vesting process is a key component of employee stock option plans (ESOPs), providing a structured approach to aligning employee incentives with the long-term success and growth of the company.
• Step 3 – Exercise: With options fully vested, employees exercise their right to purchase company shares at the predefined strike price, transitioning from right holders to bonafide shareholders.
• Step 4 – Exit: Post-exercising their options, employees may choose to exit, selling shares in the open market, during an IPO, or to other shareholders in subsequent rounds.

Real-World Illustration

• Meet Aisha, a rising star at XYZ Ltd. Aisha, on completing five years of exemplary service, becomes eligible for 300 ESOPs. These options vest equally over three years. If Aisha decides to exercise 100 shares in 2023, she becomes a shareholder and can later sell them in the market, realizing potential profits.This illustrative guide seeks to demystify ESOPs, offering founders valuable insights into leveraging this tool under the Companies Act 2013, ultimately reshaping the landscape of employee benefits and ownership in the corporate realm. As India's startup tapestry continues to evolve, ESOPs remain a dynamic force in attracting and retaining top-tier talent.

Who will be the employee ?

The term "employee" within the context of Rule 12(1) under clause (b) of sub-section (1) of the Companies Act 2013 is explicitly defined to provide clarity and delineate the scope of eligibility for ESOPs. The definition is exhaustive and includes the following categories:

1. A permanent employee of the company working in India.

2. A permanent employee of the company working outside India.

3. A permanent employee of the subsidiary company of the company working in India.

4. A permanent employee of the subsidiary company of the company working outside India.

5. A permanent employee of the holding company of the company.

6. A director (other than an independent director) of the company, whether in a whole-time capacity or not.

7. A director (other than an independent director) of the subsidiary of the company, whether in a whole-time capacity or not, and whether in India or outside India.

8. A director (other than an independent director) of the holding company of the company, whether in a whole-time capacity or not, and whether in India or outside India.

Cited comprehensive list ensures that a diverse range of individuals, including employees and directors associated with the company and its subsidiaries or holding company, are covered under the ambit of ESOP eligibility, fostering a strategic and inclusive approach to ESOP Compliance in India.