One of the pillars of the government’s Make in India endeavors is the Startup India initiative. This gave rise to a slew of start-ups, which are said to be multiplying at a rate of 10 to 12% every year. This new surge neatly matches the government’s goal of creating a digital economy based on India stack-based inventions like UPI and BHIM.
With so many new firms sprouting up every day, onboarding and retaining talented employees is a real challenge. Employee stock option plans also known as ESOPs in Indian startups can be a great method to retain talented employees and reward them for their contributions.
Numerous unicorns have been established on the strength of a well-planned ESOP policy. If you’re a founder who wants to learn everything there is to know about ESOPs and how to use them to create a healthy work environment, contact CoffeeMug today.
Understanding ESOPs in Indian startups
ESOPs allow employees to purchase corporate shares at a reduced price. Startups implement this method for a chosen group of employees, based on their position and capacity to influence the organization.
It is usually included in retirement and employee benefit plans where employees own their interests. Ownership is determined through the issuance of company shares, which are acquired upon meeting certain conditions. Most often, however, ESOPs are offered as part of the compensation package for start-ups to motivate employees to perform well.
How much ESOP to give away?
It may be tough for founders to determine how much ESOP to give at what point.
To offer ESOPs, founders must dilute a portion of their own equity and form an ESOP pool. Employee stock ownership plans (ESOPs) are distributed from this pool to employees. In subsequent fundraising rounds, more dilution may be required to replenish the pool.
As a result, the size of the ESOP pool is inversely related to the firm’s stage of growth; as the company grows, the size of the ESOP pool shrinks.
ESOPs as early-stage compensation
An ESOP share should be higher for early-stage employees. Joining an unproven business venture entails higher risks that need to be compensated adequately through ESOPs. In addition, an early-stage company is quite volatile. The problem of attracting key executives without huge cash compensation can be alleviated by giving more ESOPs as part of compensation.
ESOPs as an incentive at the growth stage
During the expansion stage, the focus is on retaining important talent, which is what propels the company forward. So, if you’re a founder wondering how much ESOP to give during your company’s growth stage, keep in mind that as the ESOP pool shrinks, it makes sense to set away ESOPs for key employees and award performance-based ESOPs. Furthermore, as the firm grows and cash flows improve, it is easier to reward new employees with higher cash compensation rather than diluting ownership further.
Balanced ESOP at maturity stage
Startups reach maturity after raising a Series B round. At this point, both the cash component and the ESOP pool are likely to be balanced. For the founders, now is an ideal time to boost their ESOP awards based on performance. In light of the high cash component of ESOPs, they should not be offered until absolutely necessary. Further, note that later on in the process, the company’s valuation would be very high, leading to a high Fair Market Value (FMV) for each ESOP. Thus, founders ought to view the rewards for employee performance equitably.
How to structure ESOP?
Stock option schemes typically have a vesting term of 4 to 6 years, with the majority of grants being granted on a yearly basis. Here’s a rundown of how to structure ESOP:
Step 1: Establish an Employee Stock Ownership Plan (ESOP)
At this stage discuss the vesting period, cliff, ESOP pool and other ESOP features with your legal advisors.
Consider the following factors while developing an ESOP plan:
- Vesting: A standard vesting timeframe is 3 or 4 years. You have the option of distributing the stocks evenly or in a progressive manner.
- Establish an ESOP pool: It is usually part of a shareholder agreement when obtaining financing. You can start with an ESOP pool size of 5-10% to begin with. You can extend the ESOP pool while raising the next round of capital, according to your recruiting needs.
- Cliff period: It’s the time it takes for an employee’s first set of stock options to become fully vested. According to Indian rules, a cliff time of at least 12 months is required.
Step 2: Request a certificate of valuation
When creating an ESOP plan, you must additionally specify the striking price. A valuation report is also required for accounting and auditing purposes.
Step 3: Get your board of directors’ approval
After you’ve designed the ESOP scheme, you’ll need to get board approval before implementing it. You should begin preparing your ESOP strategy as soon as possible. Otherwise, you may not be able to provide ESOPs to early employees at the price you promised since investors prefer to buy when the strike price is close to the market price.
Step 4: Obtain the consent of the shareholders
This is done in India by a special resolution passed at an extraordinary general meeting (EGM). (Section 62 (1) (B) of the Indian Companies Act, 2013). At least twenty-one days before the meeting, provide notice of the general meeting to all of the company’s directors, auditors, shareholders and secretarial auditors and pass a resolution authorizing the issuing of ESOP shares to the company’s employees, directors and officers. Finally, within 30 days of the board and shareholder resolutions being passed, you or your company secretary must file them with the Registrar of Companies (RoC). eForm MGT-14 can be used to submit the resolution electronically.
Step 5: Initiate distribution of ESOPs
You can start awarding ESOPs to your employees through a grant letter once you have completed all of the preceding stages.
Making ESOP a part of employee benefits is the most effective approach to get the team to work harder and longer. When you make employees a part of your business’s success, they will experience a subtle sense of pride. It is also a terrific strategy to keep good employees by giving them a bigger stake.
Join CoffeeMug to connect with specialists who can assist entrepreneurs and founders build their ESOP pool, create their ESOP policy and more.
Q. How does compensation work in the tech industry?
A. The following elements make up a tech company’s compensation:
- Additional benefits
Q. In today’s tech companies, how is equity distributed?
A. Equity is distributed in two ways:
1. As stock options – Allow employees to purchase a set number of shares of the company’s stock at a discounted price at a later date.
2. As stock grants – As part of their remuneration, employees are given shares of stock. The shares are simply received as a source of revenue in an employee account on a regular basis.
Q. What are the different kinds of equity options?
- ISO – Incentive Stock Options
- NSO – Non-Statutory Stock Options
- RSU – Restricted Stock Units
- SAR – Stock Appreciation Rights
Q. How does ESOP benefit employees?
- Increases employee personal wealth through equity ownership.
- As major contributors, you will advance professionally.
- Improved job security and job satisfaction
- Employee can participate actively in the decision-making process
Q. When should ESOPs be accepted by employees?
A. After thoroughly reading the following details you can go ahead and accept ESOPs.
- Terms and conditions,
- The startup’s scope
- The startup’s idea’s originality
- Implications of taxes
- Employment conditions