A Founder’s Guide to ESOPs
In this brief session, Kashish & Sahil will answer some questions about ESOPs and the profound impact ESOPs are having on the startup ecosystem- the process behind ESOP Management.
Founded by Kashish & Sahil, Equitylist is a full-stack equity management platform for startups to help manage ESOP (Employee Stock Options), and Cap table related operations. According to the current trends, ESOPs have been quite instrumental in providing value-driven incentives to employees while keeping them motivated in the longer run.
What are the different types of Equity incentives?
Equity compensation can be facilitated in multiple ways.
Employee Stock Options (ESOPs)
Employee Stock Purchase Plan (ESPP)
Stock Appreciation Rights (SAR)
Restricted Stock Unit (RSU)
Why should you look at ESOPs as a startup?
If you are a growing startup, ESOPs can be quite helpful in retaining your employees and compensating them for their long-term association with the company.
What is the typical lifecycle of an ESOP?
Framing ESOP Policy Document
Granting of ESOPs through a Grant Letter
Vesting of ESOPs as per the schedule
Exercising ESOPs at a predetermined discounted price
Is there any liability of TDS for employees?
For permanent employees, there isn’t any liability as such. It is mainly incorporated within Income Tax. The TDS liability can be there for contractual employees provided they are issued SAR units.
Can we provide ESOPs to consultants?
ESOPs, being Employee Stock options, can only be issued to permanent, full-time employees. For consultants or contractual employees, equity incentives can be provided as phantom stock plans like SARs or RSUs in exchange for cash.
How do you decide when is the best time to set up an ESOP scheme?
Right from the beginning! For any startup, bootstrapped or not, you should have an ESOP scheme in place to incentivise your employees and motivate them.
How do you determine the price for issuing equity for bootstrapped startups?
There are multiple ways to go about it. Most companies allow their employees to have exercise prices equal to the face value of the equity share while some can base their exercise prices on the valuation exercises done every year. It is advisable to go for an option valuation, which basically helps you determine a lesser share value that you can allot shares at for your employees and give them a discounted exercise price.
If we don’t want to decide on a price right now, can we skip mentioning the exercise price in the ESOP policy document?
It’s possible. You can just specify that the exercise price in terms of every grant will be decided by the company founders and the Board at the time of the grant and will be mentioned in the grant letter.
What are some of the important terms to be mentioned in the Grant Agreement?
A Grant Agreement is a direct agreement between the company and the employee. It must contain:
Number of units you are issuing to them;
Requirements and period of vesting;
Exercise price; etc.
Wouldn’t issuing equity with an exercised price similar to FMV increase the tax liability?
Of course, it would be a higher tax liability but there are many ways to minimise it. Most big companies go for this structure as they have confidence in their buyback programs and ensure that the tax never goes out of an employee’s pocket.
What are some liquidity events other than fundraising for Private limited companies? (In the context of employees)
Buyback programs
Private Secondary Transactions with Investors
When does the indexation benefit come into play?
The indexation benefit comes only into effect when ESOPs are exercised and held for a period longer than 2 years. If the exercise event and liquidity event happen at the same time as in most buyback scenarios, short-term capital gains come into effect instead of indexation benefits.
What percentage of the overall stock pool of a startup would be considered an ideal ESOP pool?
This primarily depends on the share structure and can vary from one company to another. In most early-stage startups, the range is between 5-15% and can grow over time as your company's strength increases.
Can we create an ESOP pool prior to the VC round or funding round? Does the valuation get set there?
You can always create an ESOP pool with the face value prior to the VC round or funding. No, there isn’t any valuation generated for the same.
Will the phantom stock options issued to contractual employees be reflected in the PNL as a cost item?
Yes, they do. But the same applies to ESOPs as well. The expenses that you are incurring by giving a notional shareholding to your employees are also calculated and accounted for.
Can we increase our ESOP pool limit on a need basis?
Yes, any entity in the cap table can increase its shareholding, provided your board allows it. It is advisable to go for sizeable increments as each time you decide to increase your company’s ESOP pool, there are several compliances & regulatory steps to be followed.
If the face value of a share is Rs. 1 and the fair market value comes up to Rs. 500 in the latest valuation report, can we issue the ESOPs at the face value instead of FMV? Are there any tax implications on the date of issue?
It is possible as long as you haven’t mentioned anything significant about the exercised price and have the Board's consent for the same.
There are no tax implications on the date of the issue and liabilities only occur during the exercising or selling of the shares.
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