It is common for a new founder to start thinking about different avenues to attract and retain talent in the start-up environment. The management often considers issuing employee stock options (ESOPs) as the most prevalent and popular way to create value in an employee’s interest in the company. In the context of issuing ESOPs, founders often need to look more holistically/ many aspects.
There are certain key elements to be considered and kept in mind by a founder before issuing ESOPs to employees, which are detailed as below:
- Block an ESOP pool on your Cap-table to indicate fully diluted holding: A company should always try to depict the cap-table on a fully diluted basis. This will consider all possible dilutions in the shareholding like future conversion of securities such as convertible preference shares, warrants, options, etc., and various notional pools such as the employees’ stock option pool. This will give the founders an idea of how many employee options can be allocated and the dilution that will happen once these options are exercised in the future.
- Avoid making impulsive commitments: Most founders make this mistake of making impulsive and sporadic commitments of giving options to the company at an early stage. Such commitments are to be avoided unless it is backed by proper legal documentation and a well-structured ESOP arrangement in place. Any kind of oral or email commitment can come back to bite.
- Understanding the difference between Advisors option and Employees option: Under the Indian laws, ESOP’s cannot be provided to advisors/ consultants as they are not employees on the rolls of the company. If the founders are indeed interested in issuing options to advisors, then it must be from a pool separately earmarked for advisors and strictly outside the purview of the ESOP administration.
- ESOP pool instead of ESOP trust route: Founders proposing to issue ESOPs in the future should prefer to set aside the agreed number of options to be granted to the employees of the company, in the form of ESOP pool rather than creating an ESOP trust, which can be used for allotting options to the employees on a timely basis. On the contrary, if ESOP trust is created, shares are required to be allotted to the trust immediately (but tax-efficient).The ESOP pool in the cap-table will depict the number of shares and the % that it constitutes in the whole shareholding pattern on a fully diluted basis of a company that is reserved for granting under the ESOP scheme without any actual allotment of shares.Investors would want the company to create an ESOP pool prior to the investment so to avoid any dilution impact to them on account of creation or increase of pool size after the investment is made.Also, this will be a more tax-efficient approach for the employees as they need to pay the applicable taxes based on the tenure of holding of securities.
- Importance of having an ESOP plan: ESOP’s can be issued to employees only once the company has adopted and implemented an ESOP plan by following the legal process as required under the law.
- Understanding the advantages of having a start-up registration: One of the major drawbacks for employees of start-ups is that they are liable to pay tax at the time when ESOPs are exercised which means taxability event arises before the ESOPs are liquidated. However, the Finance Act 2020 provided some relief in the form of deferring the taxation of ESOPs. Accordingly, the prerequisite tax on ESOP for employees of start-ups having DPIIT registration is required to be paid after the expiry of 5 years from the end of the relevant financial year in which shares are allotted; or from the date of the sale of such shares by the employee; or from the date on which the employee ceases to be the employee of the start-up, whichever is the earliest.
- Having a good understanding of the tax implication on ESOP issuance and future exercise: ESOPs are taxable twice in the hands of the employees. Initially at the time of exercise of options (tax on perquisite) and later when employee sells those shares (tax on capital gain). Also, the company needs to deduct withholding tax on the prerequisite amount of the employee. There are many other factors to be considered from tax angle such as residential status, short-term and long-term capital gain, valuation of the company etc for which it is important to consult a tax expert.
- Understanding various legal concepts in an ESOP plan: A fair understanding of basic concepts like grant, vesting period, exercise events, treatment of options at the time of exit of employees gives the required clarity to a founder to have a more structured and informed approach before implementing an ESOP plan.
- Time of exercise of stock options: While planning to grant stock options to employees one should also consider the timing for the exercise period to be committed. Future exercise and subsequent allotment of the shares only in liquidity or exit events can help to avoid the situation where a large number of employees having a small portion of shareholding is part of the cap-table which creates unnecessary chaos in the shareholding. However, the company also should keep in mind that the investors may feel wary if they are forced to buy a small number of shares from a large number of employees unless commercially discussed already.
- Investors’ preference to have less minority shareholders: While designing ESOPs it is important for a founder to keep in mind the impact it can have on the immediate or a future round of funding. New potential investors are usually very wary of a cap table filled with lots of small, often employees turned shareholders. It may also mean difficulties in the future, as dealing with say multiple minor shareholders who are usually more troublesome than working with a few larger and more experienced investors. Many top-tier investors will not join around if it has too many small shareholders already on the cap table.
A logical and clear approach before issuing ESOPs will make it easier for the founders to ensure a smooth implementation of ESOP and as a result, avoiding any chances of potential litigation issues in the future. Additionally, it makes the process more tax-efficient for the employees, and hence more rewarding in nature.
Authored by Rahul Roy, Principal Associate-CS
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