Stock option plans are a suitable way for start-ups to conserve cash as well as attract top tier talent without having to pay large salaries upfront. It also promotes a sense of ownership in employees with a promise of a sizeable payout in the future.
In this article, we examine multiple stock option plans that entrepreneurs can take advantage of while structuring remunerations.
What is a stock option plan?
Stock options or an Employee Stock Option Plan (“ESOP”) is an employee benefit plan which involves providing an option to the employees, either to buy the stocks at a rate below the prevailing market value or a certain percentage of the employee’s remuneration being provided as stocks of the company or both (as the case may be). Companies offer ESOPs to employees to retain them for the long-term, and also to make them the stakeholders in the company.
The five different types of stock option plans are:
1. Employee Stock Option Scheme (“ESOS”)
- Company grants an option to its employees to acquire shares at a future date at a pre-determined price
- Eligible employees are free to acquire shares on vesting within the exercise period
- Employees are free to sell the shares subject to lock-in period, if any
2. Employee Stock Purchase Plans (“ESPP”)
- Employees are given the right to acquire shares of the company immediately at a price lower than the market price
- Shares issued under ESPP may be subject to lock-in period
- Company may prescribe other restrictive conditions on transfer of dividend and voting rights on such shares
3. Restricted Stock Units (“RSUs”)
- Compensation issued by an employer to an employee in the form of company stock
- Issued through a vesting plan after achieving required performance milestones or upon completing required time in company
- Issued at Fair Market Value (“FMV”) when they vest
- Upon vesting, RSU are considered income and a portion of the shares is withheld to pay income taxes. The employee receives the remaining shares and can sell them at his or her discretion
4. Stock Appreciation Rights (“SARs”)
- SARs are a type of employee compensation linked to the company’s stock price during a present period
- It is a right to increment in value of the company’s stock over a specified period of time
- No payment is made by the employee for purchase of rights unlike in ESOP
- SARs are beneficial to employers since they do not have to dilute share price by issuing additional shares.
- Settlement of the appreciation right is either done through equity shares of the company or cash payment
5. Phantom Stock Options
- Those units of SARs which are settled by way of cash settlement
- No actual shares are allotted to the employees
- The value of settlement is linked to the value of the share price
- Phantom Stock Options are of 2 types
- Appreciation only – Employee is given appreciation in the value of shares between two specified dates (difference between the value the phantom stock was worth when it was granted and the current value of the stock) as an incentive or performance bonus
- Full value – Full value phantom stock pays out exactly what the stock is worth at the time of cash settlement of the stock.
- Cash settlement paid to employees is treated as perquisite in hands of employee and employer needs to deduct tax at the time of payment
- Company needs to make provision for payment on FMV at the end of every financial year
How does an ESOP work for an employee?
ESOPs are generally offered as an option to employees, officers and directors of the company. This option gives the right to directors, officers and employees of the company to subscribe to the company share at a future date at a predetermined rate. Employees may receive stock options of the company or in some cases even of the parent / holding company. Based on the type of stock options, the same may or may not be coupled with vesting conditions (such as Initial Public offer or Liquidation) and lock-in period requirements.
Best practices startups should keep in mind while creating their ESOP plans:
Before rolling out an ESOP plan, a company should undertake a detailed feasibility study. Based on the study and keeping in mind the financial position of the company, the next steps under this process include –
- Draft an appropriate ESOP scheme based on stage of the company and propose the same in a shareholders’ meeting.
- Once approved, employees to be granted the stock options in a ‘Letter of Grant’. This will have all the written information about the options like several granted options, exercise period, vesting exercise period, etc.
- After the vesting period is over, the employees can translate this option to shares and thereby become the shareholders of the company.
Start-ups play a very vital role in our innovative eco-system. The innovation also extends to hiring, retaining and managing the talent pool. Stock options / ESOPs are the best way start-ups can establish a bond with their employees and manage to pay high salaries to attract the best talent. In the last year, government had also announced tweaks to taxation rules that will defer the tax burden and potentially make ESOPs more attractive for start-up employees.
Simply put, in order to have a successful start-up story, ESOPs can act as a strategic tool to achieve and implement the strategy and also create wealth simultaneously. This mechanism can develop accountability on both sides — create a sense of belonging to the employees, while founders ensure equitable compensation within the organization.
Authored by Smita Goel, Partner – Tax, Barkha Tahiliani, Principal Associate – Tax
For any ESOP related query or assistance in structuring, implementing or managing your ESOP plans, reach out to us at: email@example.com
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