An Employee Stock Option Scheme, in general, is an embodiment of aims, principles, and rules. It is worth noting that an employee stock option plan is a regulated instrument regardless of whether it is a listed or unlisted company at any stage of business.
When identifying the important components of an Employee Stock Option Scheme, the first thing to examine is the applicable laws governing what is permissible and what is not, which become the four corners of the employee stock option plan. Any articulation on ESOP Scheme design is subject to these legal requirements. The articulation is all about the structure of the employee stock option plan, which specifies the details of essential components and is mostly dependent on commercial understandings of “why” and “how” an ESOP Scheme should be implemented.
The following elements are critical components of an Employee Stock Option Scheme or any of its derivatives, such as a Stock Appreciation Rights Scheme (“SAR Scheme”), a Restricted Stock Unit Scheme (“RSU Scheme”), or even a Phantom Scheme:
- Primary goal(s): Identifying objectives such as reward/motivation for retention, performance, and so on.
- Mode of payment: cash, equity shares, or a combination of the two;
- Source of shares: In the case of equity shares, whether primary or secondary;
- Implementation strategy: Directly or through a trusted intermediary;
- Coverage/selection criteria: Employee levels/bands who may be eligible for funding;
- Individual allocation is critical for retaining and motivating talent.
- Identifying the administrator: The administrator serves as the central decision-making forum for the scheme.
- Vesting parameters include the minimum and maximum vesting periods, as well as the vesting schedule and vesting requirements.
- Exercise criteria include the exercise price that an employee must pay as well as the time frame in which ESOPs must be exercised.
- Employee separation: How ESOPs are treated in the event of a separation for any reason;
- Other essential topics include ESOP taxation, clarification of an employee’s rights as an employee stock option plan holder, a plan of action in the event of a corporate action such as a bonus issue, rights issue, merger, or other corporate action, data privacy protection, and jurisdiction.
Last, not the least
In addition to the foregoing, monetization (or what is commonly referred to as “exit” or “liquidity”) of ESOPs or ESOP shares is a critical and complex component of an Employee Stock Option Scheme for an unlisted firm. The ESOP regulation for unlisted firms is silent on this, allowing for the best possible structuring of when, how, and to what degree ESOPs or ESOP shares can be sold. Furthermore, if shares are issued in a tightly held firm, what safeguards may be taken to mitigate or prevent any hazards arising from shares owned by an employee, an ex-employee, or a group of such employees?
Fine-tuning of these essential components in precise terms often necessitates an examination with reference to a company’s business strategy in order to determine whether these (i) are conducive to the ESOP Employee Stock Option Scheme objectives and (ii) generate a win-win situation for all stakeholders. As a result, while these essential components are the same for all businesses, their specifics frequently change and may range dramatically in some circumstances even within a sector.
Why should you have an ESOP scheme?
Now that we know what an employee stock option plan (ESOP) is, let’s look at the benefits of issuing an ESOP:
- A ready market for the stock of the firm’s owners: The owners of a privately held company can use an ESOP to establish a ready market for their shares among workers and directors.
- Owners of ESOPs can borrow money at a cheaper after-tax rate.
- It also has a number of tax advantages. These are some of the advantages:
- Stock contributions are tax-deductible, thus corporations can benefit from a present cash flow advantage by issuing new shares through an ESOP.
- Cash contributions are tax deductible: This implies that a corporation can contribute funds to the ESOP on a year-by-year basis and receive a tax credit in order to build up a cash reserve for future usage.
- The ESOP Scheme serves as a retainership tool, which is critical for small enterprises. This is due to the fact that workers might exercise their entitlement to acquire shares during a lock-in period under this arrangement. If an employee chooses this option, he or she must serve the firm for the duration of the lock-in period and cannot leave. This enables the company to keep its staff.
- Employee stock ownership plans (ESOPs) provide employees a sense of ownership. They believe they are not just employees, but also owners of the company. They are more motivated and encouraged to achieve the organization’s goals since they share in the profits (in the form of dividends).
- It serves as a non-cash incentive that allows the organisation to compete for the top employees.
- It also serves as a means for the owners to get liquidity without having to sell the company to a rival or other third party.
Now that you know why having an Employee Stock Option Plan is so important, let’s look at the main provisions that an ESOP plan must include.
Objectives of the Employee Stock Option Scheme
The clause outlining the plan’s objectives is the first and most important clause in an ESOP. The objectives may include: providing an incentive to attract, recruit, and retain employees; motivating employees with reward opportunities; creating a sense of ownership and providing wealth creation opportunities for employees; achieving sustained growth of the company and aligning the interests of employees and the company, and so on.
Term of the Employee Stock Option Scheme
This provision specifies when and for how long the ESOP scheme will be in force. It might also include information on if and how this ESOP plan can be expanded.
Equity shares subject to the Employee Stock Option Scheme
This clause will indicate the quantity as well as the price of the equity share in great detail.
The maximum proportion of total shares that can be issued under the ESOP programme must be provided. It may also state that the board of directors has the authority to adjust the maximum amount through the proper method (like a resolution).
The provision must also specify the face value of each equity share issued under the programme. It may also state that the board of directors has the authority to set further terms and conditions for these equity shares.
This provision explains how an employee might be eligible for a grant or vested option in detail. The criteria might be based on the number of years of continuous service or the achievement of certain performance objectives, among other things. It can contain seniority, length of service, the employee’s merit and performance record, as well as the employee’s future prospective performance.
Grant of options
The procedure through which the corporation issues shares, options, or other benefits under the employee stock option plan is referred to as a grant. The compensation committee or any other equivalent body authorises the grant on the grant date.
This section outlines how workers who meet the requirements will be identified and enrolled. It would also specify the price at which the grant would be given and the manner by which the grant’s price would be determined. For example, it may state that the ESOP’s grant price will be determined by the board of directors.
The maximum length of time an employee has to accept the award should also be specified in this condition. It may also state that until the employee converts his or her option into a share, he or she has no rights to the option, including the right to a dividend and/or a vote in this regard.
Vesting of options
Vesting is the procedure through which an employee can apply for business shares in exchange for the rights that have been given to him or her. The vesting period is the term during which an employee can exercise his or her option to purchase the company’s stock.
The vesting term must be as long as possible under this condition. The lock-in time may also be specified by the board of directors, the pay committee, or any other entity recognised for this purpose.
Let’s look at an example to better comprehend this clause: The maximum vesting time would be one year from the day the option was granted. The board of directors will have the discretion to determine the maximum vesting duration for the equity shares granted under this ESOP, subject to this maximum period.
Option exercising plan and consideration
The exercise price and time would be specified under this clause. The commission paid by an employee who intends to exercise his right to hold business shares is referred to as the exercise price. The exercise period refers to the time period following vesting during which the employee must exercise his right to apply for business shares and make the necessary payments.
For example, this clause could state that the exercise period will be two years from the date of vesting and that the exercise price and payment method will be determined by the board of directors/compensation committee, etc.
This provision should also state if the corporation wishes to offer employees any form of bridge money for this reason.