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.

Sign up here to request a free Demo

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

 

Issue of Shares with Differential Voting Rights

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

DVR 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.
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.

Conclusion

  • 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.

Convertible Note – Cheat Sheet !

Planning for fundraising and considering a Convertible Note? Here is a cheat sheet for you:

  1. Check if Convertible Note is the right instrument for you. Click Here to do a quick check!
  2. Well, if you are convinced that Convertible Note is the right instrument for fundraising for your startup, continue reading:
  3. Register with Startup India from DPIT.  Read more here
  4. Draft a Convertible Note Agreement. Purchase LexStart’s Convertible Note Primer to get a template. Purchase Now
  5. Draft a Convertible Note certificate.
  6. 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.
  7. Draft a board resolution for approving Convertible Note.
  8. Draft a shareholders’ resolution for approving Convertible Note.
  9. Convene a Board Meeting for approving issuance of Convertible Note.
  10. Convene a Shareholders’ Meeting for approving issuance of Convertible Note.
  11. Stamp the Convertible Note Agreement.
  12. Procure signature of all Parties concerned on the Convertible Note Agreement.
  13. Upon receipt of investment amount, issue Convertible Note Certificate, duly stamped and executed.
  14. File Form MGT-14 within 30 days of Shareholders’ Meeting.
  15. File Form DPT-3 by 30th June of every year.

Disclosure of Significant Beneficial Ownership

The Ministry of Corporate Affairs (MCA) on June 13, 2018 notified Section 90 of the Companies Act, 2013 (Act); and notified Companies (Significant Beneficial Owners) Rules 2013. This rule came into effect on June 14, 2018. These provisions require certain compliances to be followed by a Significant Beneficial Owner and a company.

Who is a “Significant Beneficial Owner”?

“Significant Beneficial Owner” means an individual who acting alone or together, or through one or more persons or trust, including a trust and persons resident outside India, holds ultimate beneficial interest of not less than 10% in shares of a company or the right to exercise, or the actual exercising of significant influence or control in a company.

This applies to the (i) individual who is acting alone or together with one or more persons (includes partnerships) (ii) includes a trust (iii) person resident in India or outside India.

 Sr. No. Where Shareholder of a company is a Who is Significant Beneficial Owner?
A. Company Significant Beneficial Owner is the natural person, who, whether acting alone or together with other natural persons, or through one or more other persons or trust holds atleast 10% of share capital of the Company or exercise significant influence or control in the company.
B. Partnership Firm Significant Beneficial Owner is the natural person, who, whether acting alone or together with other natural persons, or through one or more other persons or trust holds atleast 10% of capital or is entitled of not less than 10% of profits of the partnership firm.
C. Trust The Significant Beneficial Owner shall be- the author of the trust, and the trustee and the beneficiaries with not less than 10% interest in the trust and any other natural person exercising ultimate effective control over the trust through a chain of control or ownership.

Where no natural person is identified in point no. A and B in the table above, the Significant Beneficial Owner is the relevant natural person who holds the position of senior managing official.

What is the obligation of Significant Beneficial Owner?

  • Every existing Significant Beneficial Owner is obligated to file a declaration in Form No. BEN-1 with the respective company. This declaration is to be made by September 10, 2018.
  • Every Significant Beneficial Owner shall file any change in his significant beneficial ownership within 30 days to the company.
  • Every individual, who acquires significant beneficial ownership in a Company, shall file a declaration in Form No.BEN-1 to the Company within 30 days of acquiring such significant beneficial ownership.

What are the obligations of the Company?

  • The company receiving the declaration has to maintain a register of Significant Beneficial Owners.
  • The company has to file a return in Form No. BEN-2of significant beneficial owners of the company and changes therein with the Registrar within 30 days from the date of receipt of the declaration.
  • Maintain a register of significant beneficial owner in Form No. BEN – 3.
  • Also, if the Company knows or has reason to believe that someone is s Significant Beneficial Owner (or has been a Significant Beneficial Owner in last 3 years) and is not registered with the company as a Significant Beneficial Owner then, the company is required to give notice to such person seeking information in Form No.BEN-4.

Consequences of non-disclosure by Significant Beneficial Owner

  • Shares may be made subject to the restriction on transfer.
  • All rights in shares held by such Significant Beneficial Owner shall be suspended, including, voting rights, dividend etc.
  • The MCA may impose penalty of up to INR 1,00,000/- and INR 1,000 per day the default continues.
  • Such Significant Beneficial Owner can be charged with fraud under Section 447 of Companies Act, 2013.

Consequences of non-compliance by a company?

Fine ranging from INR 10,00,000/- to INR 50,00,000/- for company and INR 1,000 per day the default continues.

Who is exempted from definition of Significant Beneficial Owner?

  • Mutual Funds;
  • Alterative Investment Funds (AIFs); and
  • Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (lnvlTs).

New requirement for Foreign Direct Investment

The Reserve Bank of India (RBI) has announced that with a view to integrating the reporting structures of various types of foreign investments in India, it will introduce a single master form (SMF) which is to be filed online.  

The SMF will provide for reporting to the Reserve Bank of India (RBI) of (i) total foreign investment in an Indian entity, and (ii) investment by a person resident outside India in an investment vehicle in India. As a pre-requisite to implementing the SMF and to receive foreign investments in India, Indian entities will be required to provide data on total foreign investments received by them in a format specified by Reserve Bank of India (RBI). The format for providing information on foreign investment is yet to be issued by the Reserve Bank of India (RBI) and will be made available on the website of Reserve Bank of India (RBI) between June 28, 2018 to July 12, 2018.  

What happens if you skip filing the information with the Reserve Bank of India (RBI) within the timeline prescribed by the Reserve Bank of India (RBI)? Indian entities not complying with this pre-requisite will be considered non-compliant with Foreign Exchange Management Act, 1999 and regulations made thereunder and will not be able to receive foreign investment (including indirect foreign investment) in India.

In order to enable Indian entities to start collating the information in advance, the Reserve Bank of India (RBI) has provided the list of information that will be required to be filled in the form. These details can be found in Annex 1.  The format of the SMF currently contemplated by the Reserve Bank of India (RBI) is Annex 2.  The final forms will be available in the Master Direction on Reporting under the Foreign Exchange Management Act, 1999 to be issued by the Reserve Bank of India (RBI).

Fundraised from Foreign Investors? Ensure You Don’t miss this Filing with RBI!

Which companies are eligible to file the Form FLA?

Every Indian company and Limited Liability Partnership (LLP) which have received Foreign Direct Investment (FDI) and/or made Overseas Direct Investments (ODI) in the previous year(s), including the current year are required to file Annual Return on Foreign Liabilities and Assets (“Form FLA”) with RBI on or before July 15th every year.

The Form FLA has to be also filed in a case where a company/LLP has not received any fresh FDI and/or ODI in the current year but has outstanding FDI and/or ODI from previous years.

In case where the company/LLPs financial statements are unaudited before the due date of submission of Form FLA, the return is required to be submitted on the basis of such unaudited (provisional) financial statements. Once the accounts get audited and there are revisions from the provisional information submitted, the company/LLP’s will be required to submit a revised return by September 30th.

The following companies are excluded from submitting FLA return:

  1. Where Indian company/LLP does not have any outstanding investment in respect of inward and outward FDI as on the end of March of the reporting year, the company/LLP is not required to submit the Form FLA.
  2. If a company/LLP has received only share application money and does not have any foreign direct investment or overseas direct investment outstanding as on the end of March of the reporting year, the company/LLP is not required to submit the Form FLA.
  3. If all non-resident shareholders of a company/LLP has transferred their shares to the residents during the reporting period and the company/LLP does not have any outstanding investment in respect of inward and outward FDI as on the end of March of reporting year, the company/LLP is not required to submit the Form FLA.
  4. If shares are issued by reporting company to non-resident on Non-Repatriable basis, then it should not be considered as a foreign investment; therefore, companies which have issued the shares to non-resident only on Non-Repatriable basis, are not required to submit the Form FLA.

How does one submit the Form FLA?

The format of Form FLA can be found here. The filled form along with any attachment has to be mailed to [email protected] by the due date. The email has to be sent from the official email id of any authorized person in the company/LLP, such as CFO, Director, Company Secretary, etc.  Acknowledgment will be received from RBI on the same email id from which the form is sent.

P2P Lending Regulations – Important Provisions You Should Know

The Reserve Bank of India, in its recent notification, has brought in platforms carrying out the business of P2P lending under the purview of NBFC. Below are the key provisions:  

  1. Any business proposing to carry out business of Peer to Peer (“P2P”) Lending will be required to register with the Reserve Bank of India (“RBI”).
  2. Existing entities carrying out the P2P business will have to register within 3 months of the notification
  3. Dos and Don’ts
    1. What can a registered P2P entity do?
      • Act as an intermediary providing an online marketplace or platform for P2P lending.
      • Ensure adherence to legal requirements applicable to the participants.
      • Store and process all data relating to its activities and participants on hardware located within India.
      • Undertake due diligence on the participants and undertake credit assessment and risk profiling of the borrowers and disclose the same to their prospective lenders.
    2. What are the restrictions on a registered P2P entity?
      • Cannot raise deposits.
      • Cannot lend on its own.
      • Cannot provide or arrange any credit enhancement/credit guarantee.
      • Cannot facilitate or permit any secured lending linked to its platform.
      • Cannot hold, on its own balance sheet, funds received from lenders for lending, or funds received from borrowers for servicing loans.
      • Cannot cross sell any product except for loan specific insurance products.
      • Cannot permit international flow of funds.
  4. Prudential Norms
    • A P2P entity shall maintain a Leverage Ratio not exceeding 2.
    • The aggregate exposure of a lender to all borrowers at any point of time, across all P2Ps, shall be subject to a cap of INR 10,00,000/-.
    • The aggregate loans taken by a borrower at any point of time, across all P2Ps, shall be subject to a cap of INR 10,00,000/-.
    • The exposure of a single lender to the same borrower, across all P2Ps, shall not exceed INR 50,000/-.
    • The maturity of the loans shall not exceed 36 months.
    • P2Ps shall obtain a certificate from the borrower or lender, as applicable, that the limits prescribed above are being adhered to.
  5. Mode of Transfer of Funds
    • Fund transfer between the participants on the P2P lending platform shall be through escrow account mechanism, which will be operated by a trustee.
    • The P2P entity needs to set up at least 2 escrow accounts – 1 for funds received from lenders and pending disbursal, and the other for collections from borrowers.
    • The trustee shall mandatorily be promoted by the bank maintaining the escrow accounts.
  6. Prior written permission of the Bank shall be required for:
    • Any allotment of shares which will take the aggregate holding of an individual or group to equivalent of 26% and more of the paid up capital of the P2P entity.
    • Any takeover or acquisition of control of a P2P entity, which may or may not result in change of management.
    • Any change in the shareholding of a P2P entity, including progressive increases over time, which would result in acquisition by/ transfer of shareholding to, any entity, of 26% or more of the paid up equity capital of the P2P entity.
    • Any change in the management of the P2P entity which would result in change in more than 30% of the Directors, excluding Independent Directors.
    • Any change in shareholding that will give the acquirer a right to nominate a Director.
  7. Public Notice about Change in Control/ Management
    • A public notice of at least 30 days shall be given before effecting the sale of, or transfer of the ownership by sale of shares, or transfer of control, whether with or without sale of shares. Such public notice shall be given by the P2P entity and also by the other party or jointly by the parties concerned, after obtaining the prior permission of the Bank.
  8. Intimation Requirements – Change of address, directors, auditors, etc. RBI needs to be intimated about any of the following changes, within 30 days from the change:
    • The complete postal address, telephone number/s and fax number/s of the registered / corporate office.
    • The residential addresses of the Directors of the company.
    • The names and office address of the auditors of the company.
    • The specimen signatures of the officers authorised to sign on behalf of the NBFC-P2P to the Regional Office of the Department of Non-Banking Supervision of the Bank within whose jurisdiction the Registered Office of the P2P entity is located.
  9. Reporting Requirements 

The following quarterly statements are required to be submitted to the RBI within 15 days of the end of each quarter:

  • A statement, showing the number and amount in respect of loans (quarterly).
  • The amount of funds held in the Escrow Account.
  • Number of complaints outstanding at beginning and at end of quarter, and disposed of during the quarter.
  • The Leverage Ratio, with details of its numerator and denominator.