Draft ESOP Scheme for Private Companies and startups

Designing a good ESOP scheme is emerging as a powerful tool to reward the employees in the companies/startups and reduce attrition rates and retain the most valuable staff. Many start-ups as well as established companies issue the ESOP shares to their employees for their long-term retention in the companies/startups. But along with issuing ESOP shares, it is equally important to ensure that ESOP schemes are designed in an effective manner. Ensuring effectiveness in designing the ESOP scheme is beneficial for the employer as well as the employee otherwise, the ESOP share may turn out to favour only one party of the agreement and hence may not provide the expected benefits. This may result in the employee leaving the companies/startups and the company incurring expenses without any long term benefits.

Designing criteria of ESOP Scheme

Designing of the ESOP scheme is not an easy process. It is a complex process which requires consideration of many attributes. These attributes are crucial in making the ESOP scheme effective and help the company to make informed decisions about the grant of ESOP shares to employees and also assists in future planning of ownership structure. Let us have a look at the attributes associated with designing the ESOP scheme.

1. Number of Employees/Equity dilution: The very first decision which the company has to make is to decide the number of employees to whom ESOP shares should be granted. This is an important consideration because it is directly linked with the ownership structure of the company. More the number of employees granted ESOP shares, more will be the equity dilution of the company. Thus, the company needs to carefully decide the number of employees who are to be granted the ESOP shares.
2. Eligibility of Employees: Eligibility of employees is yet another criterion when it comes to grant of ESOP scheme. Every company has a different policy about the eligibility of employees who will be granted ESOP scheme. ESOP are generally granted to key-performing employees of the organization. However, ESOP shares can be granted to the permanent employees or directors of the company.
3. Vesting Condition: The vesting condition means the condition which the employee has to fulfil in order to receive the ESOP stock. This vesting condition can be time based or performance based or milestone based. Time based conditions require the employee to work with the company for a given minimum period of time. Performance based condition means that the employee has to achieve a certain target in order to exercise the ESOP shares. Milestone based conditions means that the ESOP will be granted if the company achieves the given milestone. A company can use time based, performance based, milestone based or even a combination of all 3.
4. Exercise Price: The exercise price means the price which will be paid by the employee to acquire the equity shares once the vesting condition is fulfilled. The company sets its exercise price based on the face value of the share or a fixed percentage of the current market value (such as 25% of the market value as at the date of grant)
5. Exit Condition: The exit condition means the condition under which an employee can sell the shares they have acquired by exercising their ESOP shares i.e. exit the stock position. The company needs to define the terms and conditions under which an employee can sell the shares or the company can buy back the stocks granted under ESOP from the employees. Companies have different exit conditions based on their policies and performance.

General market trends

There are several options available to the companies for deciding the factors discussed above; however over the years ,based on the ESOP scheme issued by the startups and big giants, some general market trends have emerged for these factors. These patterns have been observed through the research and are discussed below:

• Number of Employees: The number of employees depends upon how many employees are performing effectively in the organisation. A general market trend observed is that the ESOP shares are usually granted to the 8-10 top performing employees or CXO.

• Eligibility of Employees: ESOP are usually granted to the key managerial personnel of the organization. These key managerial personnel are responsible for the growth of the organization, bringing in the business or leading the efforts in increasing the sales or responsible for effective delivery, thus, ESOP schemes are granted to them with the purpose of motivating them and retaining them in the organization. (However in certain cases, ESOPs were granted to middle level employees as well as the new joinees in the organization).

• Vesting Condition: The vesting condition is usually set in terms of time period or performance based. It is usually rare to see the vesting condition based on a company milestone since the milestone depends on a lot of other factors and hence might not be considered fair by the employees. This time period varies between 3-5 years means the employee has to work in the company for at least 3 or 5 years. Performance based vesting conditions may be based on bringing in a certain amount of business or reaching a certain amount of sales. 

• Exercise Price: Following the motive of wealth creation, the exercise price set by the start-ups is usually equal to the face value of the shares. Companies like Zomato offered ESOPs at the face value to accelerate wealth creation among its employees. Some large listed companies have been known to issue ESOPs not at the face value or some %age of the current share price.

• Exit Condition: The exit conditions are mainly based on resignation or termination of employment which means that the company can buy back its shares from the employees once the employee is terminated or leaves the company. However, in certain cases employees were allowed to sell their shares in the open market or at the time of acquisition or buy back announced by the company. In some cases, the ESOPs are issued as a means of retirement planning and can keep the shares with them till the retirement 

General market trends

There are several options available to the companies for deciding the factors discussed above; however over the years ,based on the ESOP scheme issued by the startups and big giants, some general market trends have emerged for these factors. These patterns have been observed through the research and are discussed below:

• Number of Employees: The number of employees depends upon how many employees are performing effectively in the organisation. A general market trend observed is that the ESOP shares are usually granted to the 8-10 top performing employees or CXO.

• Eligibility of Employees: ESOP are usually granted to the key managerial personnel of the organization. These key managerial personnel are responsible for the growth of the organization, bringing in the business or leading the efforts in increasing the sales or responsible for effective delivery, thus, ESOP schemes are granted to them with the purpose of motivating them and retaining them in the organization. (However in certain cases, ESOPs were granted to middle level employees as well as the new joinees in the organization).

• Vesting Condition: The vesting condition is usually set in terms of time period or performance based. It is usually rare to see the vesting condition based on a company milestone since the milestone depends on a lot of other factors and hence might not be considered fair by the employees. This time period varies between 3-5 years means the employee has to work in the company for at least 3 or 5 years. Performance based vesting conditions may be based on bringing in a certain amount of business or reaching a certain amount of sales. 

• Exercise Price: Following the motive of wealth creation, the exercise price set by the start-ups is usually equal to the face value of the shares. Companies like Zomato offered ESOPs at the face value to accelerate wealth creation among its employees. Some large listed companies have been known to issue ESOPs not at the face value or some %age of the current share price.

• Exit Condition: The exit conditions are mainly based on resignation or termination of employment which means that the company can buy back its shares from the employees once the employee is terminated or leaves the company. However, in certain cases employees were allowed to sell their shares in the open market or at the time of acquisition or buy back announced by the company. In some cases, the ESOPs are issued as a means of retirement planning and can keep the shares with them till the retirement 

Making ESOP effective

• Number of employees: There is no set criteria on the number of employees who should be granted ESOP shares. However, more ESOP shares are granted during the initial phase of a start-up in order to attract and retain the employees involved in setting up the venture or employees who are key to taking the ventures to the next phase or are key to get fundings. Comparatively less ESOP shares are granted as the company grows. ESOP schemes are also granted to fresh joiners in some of the organization and in some only to the directors or key executive directors. Thus, it is totally dependent on the company’s policy to decide the number of employees to whom ESOP shares should be granted. A key factor to consider is the dilution of the equity i.e. how much of the equity can be diluted through ESOP shares. Usually only 2-5% dilution is done through ESOP scheme.

• Eligibility of Employees: Grant of ESOP stocks should not only be restricted to key managerial personnel or top level management, instead they should be offered to middle level workers because this will serve as a great and powerful tool of motivation and retention. Middle level workers will also feel a sense of belongingness with the organization if they own some shares of the company. (Meesho grants ESOP stocks to all the employees irrespective of the hierarchical position)

• Vesting Condition: The vesting condition should be set in such a way which is fruitful for the employee as well as the employer. Companies set the vesting condition in terms of performance if they want the employee to achieve a certain target or in terms of time period if the companies want the employee to work atleast for a specific period. However, the terms should be reasonable and fair enough for the employee to work upon. (For eg- the vesting period should not be set for 5-6 years else the employee can leave the company and in the similar manner achievable milestones like increasing sales by 15% should be given). 

• Exercise Price: The exercise price should be decided in such a way that the employee is able to get maximum benefit and opportunities of wealth creation. For instance, a company sets the exercise price equal to face value of the shares, then, the benefit arising with the increase in the ESOP valuation of the share over the vesting period accrues to the employee when ESOP stocks are exercised.The company will also be at the advantage of paying less tax because of the increase in the employee compensation expense. Another way to set exercise price is a fixed percentage of the current trading price (for eg- 25% of the current trading price as at the day of grant).

• Exit Condition: Exit conditions should be fair enough for the employees to make informed financial decisions. Some companies allow the employees to sell their stocks only to the company i.e. the company will buy-back the shares from the employee and the employee is not at the discretion to sell the share as per her choice. Some employees may not like this clause and hence may not be able to get the benefits of the ESOPs granted to them. Employees should be provided open exit conditions such as sale of shares in the open market or if the employee leaves the organization, then the company should buy back the shares from the employee.

Why BizFoc: ESOP Consulting firm

Bizfoc is a leading ESOP consulting firm which has expertise in ESOP or RSU design for the companies and startups. BizFoc team will guide on the every step on the rationale followed by the ESOP designing. It will help the company to recognise the expense in the financials and recognise liability in the balance sheet. It will assist the company in determining how much ESOP company can issue in the future and make ESOP attractive for employees.

Conclusion

ESOP schemes offer benefits to employees as well as the employer. However, it is essential to ensure the effective designing of the ESOP scheme leading to both employees and the employer reaping the benefits. Employees should feel satisfied with the ESOP scheme offered to them which in turn will benefit the employer with long-run retention of the employee in the organization. Thus, effective designing is the key for successful implementation of the ESOP shares.

FAQs related to ESOP Design