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The ESOP Process

The idea of earning a share in the profit has always been romanticized, whether you are in employment or in business. Rewarding employees through employee stock options plans (ESOPs), restricted stock units or stock appreciation rights (SARs) is one such way in which corporates share their profits with crème de la crème or with the entire workforce. 

If you are also contemplating an ESOP plan, you must understand the nuances first. Understanding the ESOP process is one of them.  Any kind of stock options (including ESOPs) broadly involve the four stages – Granting, Vesting, Exercise and Disposal.

1. Granting

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 arrive at the answers to these questions, the ESOP documentation is executed with each of the grantees. These agreements lay down the terms of ESOPs in detail.

Employees receiving the grant feel elated to have received a right to participate in the ESOPs. This itself creates a feeling of belonging to your company and reflects in their performance.

2. Vesting

The right to participate in the growth of the startup is not automatic. Individuals must meet the criteria set forth in the ESOP agreements. Vesting is the right of the individual to acquire shares in your company.

The most common conditions for vesting are pure time-linked grants. The plans generally provide for a four-year vesting (with the grant vesting equally each year) with a one-year cliff. After the first year, the practice is varied. Vesting may be monthly, quarterly or annual, with quarterly vesting being the most common practice. 

In some cases, you may wish to introduce performance-based criteria before the ESOPs vest.

3. Exercise

During exercise, an individual communicates their intention to acquire the stock, pays the strike price and becomes a shareholder of the company. The exercise window is for a limited period and hence it is important to act within the timelines; lest 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 individual has 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

Shares acquired under the ESOP policy of the company now belong to the individual. The grantee is free to hold them and enjoy the rights as a shareholder of the company. Or simply dispose them either immediately or at a later date. Disposal is a taxable event and attracts tax on gains made on disposal of shares.

Adequate documentation and transparency tend to make the ESOP process smooth for the company and its employees. For more information, refer to: 

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