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Guide to ESOP in India
Guide to ESOP in India

Introduction

A dedicated team is essential for any business, large or small. An ESOP pool is made up of equity shares earmarked for workers of a private firm. It is a method of enticing bright individuals to a startup; if the employees assist the firm in becoming profitable enough to go public, they will be paid with shares. Those that join the firm early typically have a larger pool of options than employees who join later.

Founders use ESOPs to bring employees closer to the company goal and develop a sense of ownership and trust across the ranks.

Employees contribute years of experience to early-stage firms, take a risk by joining the company at a time where it has not achieved product-market fit, and help it realise its near-term goals and long-term vision. Growth-stage firms may still be able to match regular market wages, but early-stage firms cannot. Thus they provide ‘delayed profit-sharing instead of ESOPs.

These equity shares are given to employees when they join or during their employment (depending on how important the person is to the organization’s success). However, implementing ESOPs is not so straightforward. It requires founders to dilute a portion of their ownership in order to contribute to the ESOP pool (at an early stage). Employees receive their ESOP shares from this pool. 

As a result, you cannot give ESOPs to new workers unless you have an ESOP pool. If you exhaust the ESOP pool and still have unmet recruiting needs, as a founder, you can dilute your ownership further or ask your investors to do so.

Significance of an ESOP Pool 

  • Putting together the core team: A solo founder is like a lone wolf at first. Even the lone wolf appears to be forming a herd as time passes. Businesses nowadays are based on the performance of several teams working together. To make this happen, a business needs leaders – people who believe in and work toward the founder’s goal. Founders can use ESOPs to recruit or retain personnel who can add value. These employees will have more faith in the firm since they will share in the profits.
  • Recognize, motivate, and encourage high performance in your organisation by providing employee stock option programmes. Top performers must understand that their efforts are appreciated. These incentives raise their morale, allow them to build their fortune, and motivate them to remain loyal.
  • Instilling in employees a sense of ownership: The sooner you have a dedicated and committed crew, the sooner you will achieve your objectives. However, in order to form such a team, employees must regard the firm as their own. ESOPs can help founders promote this culture. Employees in ESOPs share earnings with owners, encouraging them to remain dedicated to growth.

Having said that, some entrepreneurs construct enterprises from the ground up with a 5% pool, while others assign a 25% ESOP pool from the start. There is no specific baseline against which startups should establish their ESOP pool. The allocation might be anything depending on the company’s market position, investment stage, and other considerations.

How To Establish A ESOP Pool?

It is critical to recognise that the size of the ESOP pool and the number of ESOP grants are inversely related to the company’s worth. The pool is generally roughly 15% of the total equity at the seed stage. Founders and other shareholders can partially replenish the pool by diluting additional ownership in subsequent investment rounds.

The company’s worth rises as it matures, and startups may meet employees’ compensation expectations. As a result, they may reward staff with smaller grants. A decent combination of take-home pay and ESOPs would be sufficient to recruit, motivate, and retain the necessary personnel. When the firm gets Series B money, an ESOP pool that was 15% in the seed round may be reduced to 4%.

A critical question arises here: ‘When is the optimal moment for founders to establish the ESOP pool?’ In a webinar, Satheesh KV, former HR Director at Flipkart and co-founder of Spottabl, states,

Create the ESOP pool as soon as possible. I believe the ESOP pool and related governance mechanisms should begin on Day 1.

“The ESOP pool should be established as soon as feasible.” When the firm approaches Series A, the ESOP pool size on a fully diluted basis should be about 10%.”

-TN Hari, BigBasket’s Head

“A 10% pool is excellent to have at the start.” Anything less is inadequate. In subsequent phases (say, Series C or Series D), the pool may fall to 3 or 4 per cent as the company’s valuation rises,” explains Deepak Abbot, a former VP at Paytm and now the founder of a stealth startup, during a webinar with trica equity on the relevance of ESOPs.

These words make it clear that entrepreneurs should aim toward developing an ESOP pool from the start. But why is an ESOP pool so important? Why should a founder give up some of their stock before making any revenue?

How does the ESOP Plan Promotes Growth?

Employee ownership and shared capitalism are relatively new notions in India, yet they significantly influence the startup environment. Because of the advantages ESOP shares provide, they have become a permanent strand in the DNA of every business. 

While founders use ESOPs to retain employees, employees perceive these stock choices as a wealth multiplier. An employee stock option plan is essentially a long-term incentive given to workers to purchase or subscribe to the company’s shares at a specified price. Grantees are therefore granted equity compensation in lieu of or in addition to their income. The advantage of ESOPs is that they provide recipients a stake in the firm, leading to increased loyalty and drive.

However, entrepreneurs must understand ESOPs and play their cards carefully since the dilution of both founder and investor stock occurs at every level. With a few bad plays, the house of cards might fall!

To provide ESOPs, founders must dilute a portion of their stock and carve out the ESOP pool. Employees are given ESOPs or stock options from this pool. If the pool is depleted, founders and investors may dilute further ownership in subsequent fundraising rounds to replace it. The size of the ESOP pool is inversely related to the firm’s growth; as the company matures, the size of the ESOP pool decreases. As a result, employee ESOP awards are decreasing.

Know These Before Rolling Out ESOPs

  •  Understand the law: The ESOP policy should be written following the laws and regulations of the nation where the company is registered. A lack of knowledge of local tax regulations may prove to be a barrier. when it comes to diluting and liquidating stock.
  • Align the ESOP design with your goals: Founders should issue ESOPs to employees who are mission-critical to the organization’s success. This strategy would also bring employees closer to the company’s vision.
  • Personalize the ESOP policy: Create it from the ground up. The strategy should be adaptable, employee-friendly, and aligned with your roadmap.
  • Employee connectivity: “While distributing ESOPs, have a one-on-one meeting with each team member and explain the business to the degree you have visibility” (next round of funding, exit plans, anticipated dilution, etc.). Maintain total transparency in the plan. “Be receptive to feedback and provide realistic statistics when employees inquire about the possible profit on the transaction,” Hari advises. It’s a good idea to weigh the predicted riches against the company’s growth trajectory and valuation. Allow the employee to have a bird’s-eye view of the endeavour and the potential for wealth generation.
  • Offer ESOPs in units rather than dollars: Employees who joined you at an early stage should be given more ESOPs than those who join later. “Suppose you issue 5000 USD of options to an employee today, and your firm raises a fund after that,” Satheesh explains. If you give the identical 5000 USD options to someone else a week later, the number of units they each possess will be drastically different. To ensure equity, ESOPs must be offered in units rather than dollars.”
  • ESOPs should be self-contained: ESOPs do not have to be a proportion of the cash component. “Do not include ESOPs in the CTC.” “It’s OK to offer someone a lesser cash component if you’re offering them more ESOPs,” Satheesh argues.

Startups should be used as a business model by founders. The ESOP policy should be structured to develop quickly. Every stage of the startup lifecycle is a growth stage, and ESOPs may be effective development accelerators at each level. According to Hari, as the firm expands, the size of the ESOP pool should decline. Early-stage ESOPs should be provided more than late-stage ESOPs.

Planning the Growth Stages

  • Early Stage – Aggressive ESOP Participation: Companies are often less liquid in the early stages (seed and angel rounds). They may not have enough resources to hire C-suite executives and other key staff for business growth. In such instances, entrepreneurs should be aggressive in offering ESOPs because they will have a reduced cash component. ESOP funds can be substantial, and policies should be flexible. At this point, the primary goal is to attract personnel.
  • Stage of development – competitive cash play: “By the time a startup obtains a Series A or B financing, the firm has developed,” adds Satheesh. Founders should aim to match employees’ monetary expectations and limit ESOPs to the most valuable employees.” 

Employees should be rewarded with ESOPs. During this stage, the retention of high-performing personnel becomes critical to growth. 

Offer ESOPs only when absolutely necessary. Founders in the growth stage should use ESOPs to address business difficulties – they must make the proper employees! Furthermore, entrepreneurs should exercise caution with ESOPs at this point since values are quite high.

  • Maturity Level – A well-balanced ESOP and cash play Startups reach a mature stage after raising a Series B financing. Both the cash component and the ESOP pool are most likely balanced at this point. At this point, Satheesh recommends that founders raise performance-based ESOP awards. Because the monetary component is significant, ESOPs should only be issued when absolutely essential.

It is also vital to understand that when the firm progresses, its valuation rises, implying that each ESOP’s Fair Market Value (FMV) rises as well. As a result, entrepreneurs should take a balanced approach to the awards awarded to staff for performance. Deepak responds,

Many unicorns have been established on the strength and strategy of an ESOP policy. To develop great work culture, founders should completely grasp ESOPs and adopt them. It’s also vital to recognise that stock options mix the founder’s profit and private ownership goals with employees’ desire to share in the riches they help generate. A well-planned ESOP plan might act as a quiet navigator in the startup’s success narrative.

What Is the Procedure for Granting ESOPs From the ESOP Pool?

As a company founder, you begin giving ESOPs to key personnel on day one. However, many entrepreneurs are unsure of how to implement ESOPs in their businesses. Let me guide you through all the processes necessary to register your company in India. The stages are essentially the same for startups incorporated in other countries, with a few small differences.

Step 1: 

  • Establish an ESOP programme with the help of a professional. 
  • This plan document contains several legal terms that regulate ESOP administration, pool size, awards, vesting, employee quitting, exercise time, and other topics. 
  • If you have raised any round of funding, the SHA from that round most likely already includes a provision for an ESOP pool, and the amount of the pool is also stated in the SHA. 
  • Now, the lawyer will ask you various questions in order to add/modify terms in the ESOP plan paperwork to your specifications. 
  • It is critical to ensure that the plan is designed in a fair and useful manner for the employees; otherwise, the entire objective of the ESOP as a vehicle to recruit and retain talent may be lost. 
  • The trica equity ESOP Scheme Generator may assist you in customising your ESOP scheme and designing an ESOP policy that is strongly linked to the organisational roadmap.
  •  Schedule a demonstration right away!

Step 2: Obtain board permission before implementing this ESOP plan.

Step 3: 

  • A special resolution must also authorise the ESOP programme at the annual shareholder meeting (EGM). 
  • You must first put out an EGM notice, convene the EGM, and pass the shareholder resolution. 
  • It should be noted that this must be a special resolution (more votes in support of the resolution than votes against) rather than an ordinary resolution (simple majority).

Step 4: 

  • Board and EGM decisions must be filed on the Registrar of Companies (RoC) website using form MGT14. 
  • This is something your business secretary can accomplish. There is no need to file anything further with the RoC.

Step 5: 

  • Because ESOPs are just options and not shares, there is no requirement to increase the company’s authorised share capital at the time of ESOP issuance. 
  • It is only necessary when an employee goes for a workout, normally considerably later.

Step 6: 

  • You are now prepared to issue ESOPs to your workers via a grant letter formally. trica equities streamline end-to-end equity management.

Conclusion

We frequently see founders attempting to provide grant letters to workers backdated to an earlier date because the employee was promised them long before the ESOP scheme was authorised by shareholders. This is illegal. Bear this in mind! The grant date must be later than the date of the ESOP shareholder decision.

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