LexGyaan Series on ESOPs – Part 1: How do Employee Stock Options Plan (ESOPs) work?

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:

Step 1

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.

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Step 2

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.

 Step 3

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?

Step 4

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.

LexStart makes ESOP creation a breeze. Click here to learn more. Request a Demo.

 

LexStart’s LexGyaan Series: Can I grant ESOPs to a Co-Founder?

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

FAQs on ESOPs

 

LexStart’s LexGyaan Series : Thinking of issuing ESOPs? 2 Things you need to know!

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?

Do you qualify to be a 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 ReadingsMandatory 1 year cliff on ESOPs

Is your ESOP grant just an offer?

What happens if an employee leaves the company before the shares have vested?

This depends on the ESOP policy of the company. The norm is for the unvested ESOPs to lapse upon cessation of employment. This means that the employee will not be able to exercise and avail ESOP benefits from those ESOPs any more.

However, in case an employee suffers a permanent incapacity while in employment, all the ESOPs granted to him as on the date of permanent incapacitation, shall vest in him on that day and in the event of the death of an employee while in employment, all the ESOPs granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.

Below are the typical scenarios:

Company Friendly
Event Vested Unvested
Termination with Cause Lapse Lapse
Termination without Cause Exercise within the notice period Lapse
Resignation Exercise within the notice period Lapse
Death or Disability Exercise within 3 months of the event Exercise within 3 months of the event
Retirement Exercise on or before the last working day Lapse

 

Employee Friendly
Event Vested Unvested
Termination with Cause Exercise immediately Lapse
Termination without Cause Exercise immediately Lapse
Resignation Exercise immediately Lapse
Death or Disability Exercise within 6 months of the event Exercise within 6 months of the event
Retirement Exercise within 6 months of the event Exercise within 6 months of the event

What does Cause in the above scenario mean?

 If your employment agreement has a definition of cause, you could consider including that. If not, then we would recommend the following definition:

“Cause” shall include:

  • Wilful insubordination or disobedience, whether or not in combination with another, of any lawful and reasonable order of a superior.
  • Theft, fraud, misappropriation, embezzlement, moral turpitude or dishonesty in connection with the employer’s business or property.
  • Habitual absence without leave, overstaying the sanctioned leave without sufficient grounds, or proper and satisfactory explanation, or habitual late attendance.
  • Commission of any act subversive of discipline or good behavior on the premises of the Company, such as, drunkenness, riotous, disorderly or indecent behavior, gambling or taking or giving bribes or any illegal gratification whatsoever.
  • Disregard of the rules of the Company.
  • Disclosing to any unauthorized person any confidential information with respect to the Company and/or its business and/or its operation, including but not limited to trade secrets, intellectual property etc.
  • Commission or attempt to commit any cyber-crime.
  • Proven instance of sexual harassment.
  • Any other grounds that results in the Board of Directors of the Company to conclude that the act or omission by the concerned person may result in loss, damage or injury to the Company.