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Decoding ESOP Process

ESOPs or Employee Stock Ownership Plans have an interesting history dating back to 1956 when a San Francisco lawyer Louis Kelso created the first ever SOP to solve a business succession problem. Since then, ESOPs have been used for a variety of reasons, the most fascinating being the need to enable wider participation in the capital of the company, especially by the people who helped build it. Historically, most employee wealth creation has taken place when companies have either gone public or been acquired by a public company.These events have provided economic security for thousands of people employed in these organizations. 

One of the most famous examples is that of Bonnie Brown, an in-house masseuse at Google, who was given stock options as part of her compensation package. These options landed her millions of dollars, completely changing her life. ESOPs have the potential to unlock similar opportunities for employees and can be a powerful tool for companies to attract and retain talent. 

In this blog post, we will delve into the intricacies of the ESOP process, specifically focusing on the four critical stages: Granting, Vesting, Exercise, and Disposal. Additionally, we will discuss essential factors to keep in mind while creating your ESOP plan.

1. Granting

When a company decides to award stock options to its employees as part of their compensation, it’s known as a ‘grant’. Essentially, a grant gives employees the right to purchase a specific number of shares at a predetermined price, known as the exercise price. Granting is the first stage in the ESOP process. When deciding the grant, ask yourself the following questions: 

  • What kind of ESOPs should I grant – do individuals only have a right to acquire shares or simply a right to participate in the company’s growth?
  • Should there be any pre-conditions attached to ESOPs – eg. time based, performance based or based on listing / strategic investments?
  • Which individuals should be granted ESOPs – all employees or just a handful?
  • What should be the quantum of ESOPs to be granted to these individuals?

Once you have determined the details of the ESOP grant, the next step is to document and execute the ESOP agreements with each of the grantees. These agreements outline the terms and conditions of the ESOP in detail, including the vesting schedule and any pre-conditions attached to the grant. When employees receive the grant, it creates a sense of ownership and belonging to the company, which can lead to improved morale and higher performance levels.

2. Vesting

To have the opportunity to participate in the growth of a startup, individuals must satisfy the criteria established in the ESOP agreements. The right to acquire shares in the company is not automatic and is instead determined by vesting, which is the process of gaining the right to do so.

Vesting of ESOPs usually involves certain conditions, with time being the most common one. Typically, ESOP plans have a four-year vesting period with a one-year cliff, and the grant vests equally each year. After the first year, the vesting schedule can be monthly, quarterly or annual, with quarterly being the most common. Another condition for vesting can be linked to performance, such as reaching a sales target or effective client engagement. Finally, options can also be linked to event-based conditions, such as the company achieving revenue or profitability targets.

3. Exercise

During exercise, option holders whose options have been vested communicate their intention to acquire the company’s stock. They pay the strike price and become the shareholders of the company. The request to exercise has to be made with the exercise window, otherwise the ESOPs lapse.  

Exercise of shares is considered as a taxable event in India. The gains made on exercise are taxed as employment income for the grantee.

An important point to note is that the option holders have a right to exercise the grants or stock options; there is no obligation or compulsion to exercise the right.

Your ESOP policy is put to the real test in this stage. It involves a substantial cash outflow for the individuals. If they believe in the potential of the company to give an upside, they would go an extra mile to acquire shares of the company, despite the heavy cash outflow.

4. Disposal

Once an individual acquires shares under the company’s ESOP policy, the ownership of the shares is transferred to the grantee. The grantee has the option to retain the shares and enjoy the privileges of being a shareholder or sell them at any time in the future. However, when the shares are disposed of, it is considered a taxable event, and the gains made on the sale of shares are subject to taxation.

In conclusion, ESOPs can be a powerful tool for both employers and employees. For employers, ESOPs provide a way to incentivize and retain top talent while also giving employees a stake in the company’s success. By understanding the different stages of ESOPs and the benefits they offer, both employers and employees can make informed decisions and maximize the value of this powerful compensation tool. 

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