CREATING AN ESOP POLICY
In our experience of having assisted several entrepreneurs with execution of ESOPs for their startups, we have observed that most entrepreneurs are under the impression that by just mentioning the number of ESOPs on their cap table, or in offer letters to their employees, the startup has fulfilled its obligation to grant ESOPs to its employees. This is actually incorrect.
Mentioning ESOP pool on your cap table actually just makes your investors happy. Why? Well when an investor invests in your startup, they want to ensure that they do not get diluted for any reason except in case of future rounds of fundraising by your startup (even for that they have the right to maintain valuation aka pre-emptive right). It is important for investors that their shareholding does not get diluted in order to give shares to your employees, mentors or all those well-wishers of yours, whose help and guidance you took in the initial days of starting up and promised equity to. Only you the founder should get diluted to give these promised equity shares to your mentors and advisors, not the investors. This is the reason why investors require a startup to create an ESOP pool/advisory stock option pool, as a condition precedent to their investment in a startup. This is also the reason why investors require you to convert all loans from friends and family, and conversion of convertible notes, if any.
Related reading: Understand how valuations work and how a founder’s shareholding gets diluted when an investor invests in a startup in our blog titled ” The Valuation Game.. What Does It Mean Exactly? , by our co-founder, Karthik Chandrasekar.
Therefore, all you have achieved by mentioning a “ESOP Pool” on your cap table and inserting a number against it is (a) carving out the maximum number / percentage up to which your investors won’t get diluted, and (b) demonstrating to your investors, your intention to give ESOPs some day to your employees.
At this stage, where your startup’s ESOPs are only on the cap table, your ESOPs are only a virtual pool. How do you convert the ESOPs in to reality? Well, that’s easy, you will just have to create an actual ESOP pool. In order to do that, you will have to take the following steps:
Draft an ESOP Policy in compliance with the Indian Companies Act, 2013. The ESOP Policy will have to set out in detail the terms of ESOPs, cliff period, vesting schedule, exercise price/strike price, exercise period, consequences of employee leaving the startup, consequences of the startup getting acquired, etc.
Once the draft ESOP policy has been finalized and if you have investors in your startup, then check your Shareholders’ Agreement and Articles of Association, to verify if the approval of investors for a ESOP policy will be required. Lost? Well, just look for a clause that is titled either as “reserved matter right” or “affirmative voting matter” or “affirmative voting right” or “investor protection matter”. Once you find this clause, then look through the several items and check if creating a stock option, ESOP etc is listed therein. If it is, then you would have to send an email to your investor alongwith copy of the ESOP policy for your startup, requesting the investor for its approval to the ESOP policy.
LexGyaan: Most VCs get their respective legal team to also review the ESOP policy. Therefore, be prepared for few iterations and discussions.
Where you don’t have any investors in your startup, you can skip step 2 and directly proceed with step 3, i.e., convene a Board Meeting for approval of the ESOP Policy. How to convene a board meeting properly under Companies Act, 2013?
Convene a meeting of Shareholders (aka EGM) of your startup, for approval of the ESOP Policy.
Now you have an ESOP policy and can formally start granting ESOPs. Click here to download a free template of a ESOP grant letter!
Click here to read FAQs on ESOPs.
Granting ESOPs to Promoters/Co-Founders
I often get asked this question – “Can I grant ESOPs to a Co-Founder who I recently brought on board my Startup?”. Well the answer is both yes and no!
The Companies Act, 2013 prohibits grant of ESOPs to the Promoter of a company. The term “Promoter” does not necessarily refer to only a person who is named as a Promoter at the time of incorporation of the company. A Promoter is defined broadly and includes, the following:
- Any person who has been named as such in a prospectus or is identified by the company in its annual return; or
- Any person who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or
- Any person in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act. Provided that such person is not someone who is acting merely in a professional capacity.
Therefore, typically a Co-Founder who you bring on board at a later stage, may not be a Promoter as stated in the Charter Documents (Memorandum and Articles of Association of your Startup) but still can be considered a “Promoter”, thus restricting him from receiving ESOPs in the company.
ESOPs to Promoters/Co-Founders of recognized Startups
The Companies Act, 2013 has made an exception to the above rule, by allowing Startups that are recognized by Govt. of India to grant ESOPs to founders, as long as the grant of such ESOPs is within 5 years from their incorporation. This means if your Startup has a Certificate of Recognition from DPIT, Govt. of India, then you can grant ESOPs to Promoters/Co-founders.
Related Readings : How to Get Startup India Registration
What is Differential Voting Rights?
Shares with Differential Voting Rights (DVRs) means shares that give the holder differential rights as to voting (either more or less voting right) as against the Ordinary shareholders of the company.
Types of DVR
- Shares that have superior voting rights
- Shares that have inferior voting rights
Eligibility/Condition for issue of shares with DVR*
- AOA of the Company should authorize issue of DVR;
- Consistent track record of distributable profits for the last three years;
- No default in filing annual return for last 3 Financial Years;
- No default in payment of declared dividend or repayment of deposit or loan borrowed;
- the shares with differential rights shall not exceed twenty-six percent of the total post-issue paid up equity share capital;
- No penalty by court or tribunal for any offense for the last 3 Financial Years; and
- The shares issued with DVR cannot be changed later.
*This provisions shall not apply to private companies in case MOA and AOA of the company provide otherwise.
Procedure for issue of shares with differential voting rights
- Check AOA of the Company;
- Obtain valuation certificate from registered valuer;
- Open a separate bank account;
- The terms of issue of shares should be finalized;
- Conduct board meeting for issue of shares with DVR;
- In case issue of DVR affects the rights of existing class of shares then obtain consent from 3/4th of the shareholders of that class;
- Filing form MGT-14 with ROC within 30 days of EGM;
- Circulate offer letter along with the share application form to the investors;
- Receive share application money along with the application form ;
- Conduct board meeting for allotment of shares;
- File form PAS-3 within 15 days of allotment of shares;
- Pay stamp duty and issue share certificates; and
- Make entry in register of members.
Difference between DVR shares and Ordinary Shares
- Provide few or higher voting right to shareholders.
- Rate of dividend is low or higher.
- DVR shares are ideal for small shareholders or promoters.
- Issued at a discount in comparison with ordinary shares.
- One share One Vote.
- Rate of dividend is fixed for class of shareholders.
- Ideal for large shareholders.
- Issue at FMV.
Advantages of Issuing shares with DVR
From Issuer Perspective
- To raise more capital without diluting its ownership structure.
- Get control in decision making process.
- A tool to avoid hostile take over.
- To fund large Project.
From Investor Perspective
- Benefit to investors since share are issued at discount & also for incremental dividend.
- Better for investors who are looking for good quick return rather than voting rights.
- Institutional Investors can invest in private companies without any limit and making it a subsidiary.
Dis-advantages of DVR
From companies Perspective
- Lack of investor awareness about such issue of shares.
- Issue shares at discount.
- Minority shareholders can lose faith in the Company.
From investor Perspective
- Lack of investor awareness about such issue of shares.
- Possible misuse of voting power
- by the promoters & hence act
- against the interest of the shareholders.
- Lack of liquidity may hamper return.
- Not beneficial for Institutional
- Investors as they are
- interested in voting rights and long term capital gains both.
Case of Tata Motors
- In 2008, issued DVR shares.
- It was the first company in India to issue DVR shares and amongst the very few in Asia.
- Issued at Rs 305 a share which was about 10% lower than the issue of normal rights at Rs.340.
- Will offer 5% of more dividends.
- Gives an additional 10.3% discount.
- But carry one-tenth the voting rights of ordinary shares. This means 10 DVR shares = 1 ordinary share as far as voting rights is concerned.
Amazon caps voting rights in Witzig Advisory Services at 17%
- Amazon has bought 17% stake in the company through Class A shares and the rest 32% through Class B shares having differential voting rights (DVR).
- Each Class A share shall have one vote, while the Class B shares shall not carry any voting rights. This effectively caps Amazon’s voting rights in Witzig at 17%.
- Amazon appears to have made use of DVR shares to comply with the new ecommerce FDI norms that came into force from February 1, and also to ensure that More can continue selling on its Indian marketplace.
- The new ecommerce FDI guidelines had forced Amazon to reduce its stake from 49% to 24% in Cloudtail and Appario, the two top sellers on its marketplace. The American etailer had also evaluated the idea of limiting its holding in Witzig to less than 26%, and not acquiring 49% in the company as was originally planned.
- By capping its voting rights in Witzig at less than 17%, Amazon will be able to continue with More as a seller. Samara Capital will hold 51% in Witzig, making the latter an Indian owned-and-controlled company.
- For an investor, who wants to be in the company’s decision processes, DVR shares is not an attractive proposition due to limited voting rights.
- But if an investor isn’t concerned much with voting rights, then investing in the DVR would certainly be an attractive option.
1. If it’s not to an employee or a director, then don’t call them ESOPs! Think of alternative structures.
ESOPs under Indian Companies Act, 2013 can be issued only to employees and directors. In case of a startup recognized by Department of Promotion for Industry and Internal Trade, you can even issue ESOPs to a promoter. Yes, you heard that right, ESOPs cannot be issued to promoters otherwise. Therefore, if you have promised ESOPs or sweat equity to a mentor or advisor or co-founder, think through and decide on alternative structures, unless you can actually issue ESOPs to them, under the law.
Related readings : Are you a recognized startup?
2. There is a statutorily mandated 1 year cliff on ESOPs
The Indian Companies Act, 2013 mandates a 1 year cliff period. This is compulsory and you cannot contractually exempt it.
Related Readings: Mandatory 1 year cliff on ESOPs
Planning for fundraising and considering a Convertible Note? Here is a cheat sheet for you:
- Check if Convertible Note is the right instrument for you. Click Here to do a quick check!
- Well, if you are convinced that Convertible Note is the right instrument for fundraising for your startup, continue reading:
- Register with Startup India from DPIT. Read more here
- Draft a Convertible Note Agreement. Purchase LexStart’s Convertible Note Primer to get a template. Purchase Now
- Draft a Convertible Note certificate.
- If the Articles of Association do not allow the Board to borrow money, amend the Articles of Association to give the Board the power to borrow by passing board and shareholders resolution.
- Draft a board resolution for approving Convertible Note.
- Draft a shareholders’ resolution for approving Convertible Note.
- Convene a Board Meeting for approving issuance of Convertible Note.
- Convene a Shareholders’ Meeting for approving issuance of Convertible Note.
- Stamp the Convertible Note Agreement.
- Procure signature of all Parties concerned on the Convertible Note Agreement.
- Upon receipt of investment amount, issue Convertible Note Certificate, duly stamped and executed.
- File Form MGT-14 within 30 days of Shareholders’ Meeting.
- File Form DPT-3 by 30th June of every year.
GST registration is the most fundamental requirement for identification of tax payers, ensuring tax compliance in the economy. GST Registration came into effect from July 01, 2017 under the Act. GST registration of any business entity under the GST law implies obtaining a unique number from the concerned tax authorities for the purpose of collecting tax on behalf of the government and to avail Input Tax Credit for the taxes on his inward supplies. Without GST registration, a person can neither collect tax from his customers nor claim any input Tax Credit of tax paid by him.
Documents Required for GST Registration:-
- PAN card of all the promoters/directors (Passport in case of foreign individual);
- PAN Number of the company;
- Aadhaar card of all the promoters/directors;
- Proof of business registration or Incorporation certificate;
- Identity and Address proof (i.e. PAN card and Aadhaar Card) of Promoters/Director with Photographs;
- Address proof of the place of business: (not older than two months)
- Own office – Copy of electricity bill/municipal khata copy/property tax receipt/ownership document;
- Rented office – Copy of electricity bill/municipal khata copy/property tax receipt/rent agreement/ownership document or No objection certificate (NOC) from the owner. (In case the owner is Body Corporate then a board resolution authorising use of such property by the applicant company is also required);
- Letter of Authorization/Board Resolution for Authorized Signatory for GST Application;
- Digital Signature (DSC) of any one authorised signatory; and
- Main objects with respect to business activities of the company.
Persons liable for registration:
- Every person shall be liable to be registered under GST Law if the total aggregate turnover (including exempt supplies*) crosses 20 Lakhs in a FY (40 Lakhs w.e.f. April 01, 2019). **
However, for Special Category States (i.e. Assam, Arunachal Pradesh, Himachal Pradesh, Uttarakhand, Manipur, Mizoram, Sikkim, Meghalaya, Nagaland and Tripura), the turnover limit is Rs. 10 Lakhs;
- Registered person under the Pre-GST law (i.e., Excise, VAT, Service Tax etc.) is required to get registered under GST;
- In case of transfer of business by registered person, transferee to get new registration;
- Transferee of business to get fresh registration in case of amalgamation or demerger;
- Casual taxable person / Non-Resident taxable person;
- Agents of a supplier and Input service distributor;
- Those paying tax under the reverse charge mechanism;
- Person who supplies via e-commerce aggregator;
- Every e-commerce aggregator; and
- Person supplying online information and database access or retrieval services from a place outside India to a person in India, other than a registered taxable person.
*Exempt supplies: Any Goods or Services or both which attract Nil rate of Tax or which may be wholly exempt from Tax.
**CBIC has notified the increase in threshold turnover from Rs 20 lakhs to Rs 40 lakhs. The notification will come into effect from 1st April 2019.
Multiple GST registration required in following matter:
If a business operates from more than one state, then a separate GST registration is required for each state. Further a business with multiple business verticals in a state have to obtain a separate GST registration for each business vertical.
Time frame for GST application:
Every person who is liable to be registered under GST law shall apply for GST registration in every such State or Union territory in which he is so liable within thirty days from the date on which he becomes liable to register.
However, a casual taxable person or a non-resident taxable person shall apply for GST registration at least five days prior to the commencement of business.
Time frame for GST registration process:
Once the GST registration process starts a TRN is generated and remains valid for 15 days within which the process needs to be completed.
GST registration usually takes between 2-6 working days.
A person, though not liable to be registered under GST law may get himself registered voluntarily, and all provisions of this Act, as are applicable to a registered person, shall apply to such person.
*Companies (Incorporation) Second Amendment Rules, 2019*
1) Shifting of Registered Office: (a) advertise in the Form No.INC.26 in the vernacular newspaper in the principal vernacular language in the district and in English language in an English newspaper with the ~widest circulation~ *With wide Circulation* in the State in which the registered office of the company is situated.
2) Incorporation of a Company: There will not be any ROC fees payable on eForm INC 32 (SPICE Form) for Incorporation of a Company with Authorised capital of less than or equal to rupees ~ten lakhs~ *Fifteen Lakhs* w.e.f. March 18, 2019.
The exercise price for a stock option will depend on the objective for which the ESOPs are being granted. ESOPs for employees can be granted based on different considerations by different companies. In fact, even with respect to different employees within the same company, the exercise price may be different, as the ESOPs may be granted to the different employees by the company with different objectives in mind. Let us elaborate on how it works.
Remuneration lower than the market level
If you are granting ESOP benefits to your employees in lieu of salary, with the objective of making up for the lost compensation for an employee who has taken a huge salary cut and joined a start-up, it is only fair that the ESOPs be granted to the employee at an exercise price which is as low as possible. Typically, that would be the par value (or the face value) of the shares. The typical face value is INR 10, though, it differs from company to company. It would be advisable to check the face value of your company’s equity shares before finalizing the exercise price.
Market level remuneration
If your employees are already drawing market level salaries and the stock options are granted to them in the form of added incentive or bonus, then the exercise price of the options should be higher.
For example, if you are granting ESOPs soon after a fundraising round, then you could use the valuation of shares assigned by the investors in such round as the benchmark. So, if you have issued shares at a price of INR 100 per share to the investors, you could fix the exercise price at INR 100 per share or maybe at a discount to the fair market value, for instance, INR 80 per share.
I often get asked, if INR 100 (i.e. issuing shares at the fair market value) to the employees would be an unfair exercise price. I honestly don’t think so, simply because the employee is not going to buy the shares immediately. The employee can only buy the shares depending on the vesting date as per the vesting schedule, which will be after a minimum period of 1 year in India (given the mandatory 1 year cliff period). By that time, hopefully the fair market value of the shares of your company would increase. Therefore, at the time of exercise date, the ESOP still benefits the employee as the exercise price would be a discount to the then fair market value of the shares of your startup.