ESOPs are converted into equity shares, causing current shareholders’ stakes to be diluted. In this context, deciding how much esop equity the Promoters should set away is a critical issue when executing any ESOP Plan. The choice must be reviewed in light of the perspectives of both parties, namely promoters (existing shareholders) and employees. The third stakeholder, the Regulator, remains deafeningly mute on the topic, leaving it up to the existing shareholders to decide on the ESOP pool.
From the perspective of the shareholders, the first decision is whether to embrace employees as co-owners and participants in sharing the wealth produced. If the answer is no, the other option is to consider Cash settled Options (also known as Shadow or Phantom options). However, if the answer is affirmative, the degree of dilution is determined by:
- A number of workers to be covered by the Plan; more employees would necessitate more shares, resulting in more dilution.
- The Plan’s Objectives If the goal is to make ESOPs a component of the remuneration (performance incentive), the Plan must operate for a longer length of time, necessitating a larger esop equity pool. If the goal is to keep the core personnel, the pool must be large enough to act as a disincentive. ESOPs often provide potential income that is multiples of the set Cash payout over time. If the goal is to foster a broader employee ownership plan, the Plan would require a greater distribution of stock.
- The Plan’s Duration. If the intention is to make it a one-time event (e.g., new investor entry, IPO of the firm, silver jubilee of the company), the stock pool required will be substantially lower.
- Existing esop equity foundation. This, in turn, is determined by the type of business. For example, an infrastructure firm or an NBFC need a significant capital base from the outset and would require a lower pool (in terms of per cent) than a software or internet startup, which would require a lesser percentage of equity given their greater values in the early stages.
- The cost of exercise. When options are offered at a discount to their fair market value, fewer shares are required to provide the same amount of benefit, resulting in less dilution.
Does a smaller pool imply that you should or can provide less to employees? No, not always. By adjusting the terms, kind of instrument, and so on, it is possible to provide more benefit with fewer shares. That is a topic within itself.
Because an employee ownership plan is a long-term incentive, any employee ownership plan that is profitable and beneficial must be maintained for a longer length of time. The pool size should be sufficient for allocation over a period of 4-5 years. In the case of publicly traded corporations, dilution is computed based on the number of outstanding options. Exercised options that are converted into shares are not included as dilution. At the risk of generalising, the thumb rule is that dilutions in large established public businesses vary between 2% and 5%, but in unlisted early stage companies, the range is between 10% and 12%.
Is it important to select beforehand whether Stock Appreciation Rights will be cash settled or equity-settled in the case of Stock Appreciation Rights?
To guarantee compliance with the different legal requirements, the Company must select whether the scheme will be Equity Settled or Cash Settled at the outset. However, under an Equity settled plan, a mechanism for the Company to purchase back vested rights may be inserted to ease the settlement of rights in cash rather than esop equity if necessary.
What is the distinction between SAR and Phantom Stock?
SAR is an abbreviation for Shares Appreciation Rights, which are a type of incentive or delayed pay connected to the success of the Company’s stock. SAR grants the right to the monetary equivalent of the increase in the value of the company’s shares. The appreciation is calculated on a certain number of shares over a predetermined period of time and is settled in the future either through equity allotment or cash as chosen by the corporation.
A cash-settled SAR is sometimes referred to as Phantom Stock. While SAR is an equity-settled scheme, Phantom Stocks are exclusively settled in cash.
Can cash-settled SAR be exercised during the shutdown period?
Employees might have their SAR vested during the shutdown period since they are regarded to be in continuous service at that time, and then exercise the vested rights within the exercise period.
What is the distinction between an ESOP and a Sweat Equity?
An employee has the right under an employee ownership plan to exercise the Option to obtain allotment of shares of the Company by paying the exercise price upon vesting of an Option, which cannot occur sooner than one year from the date of issuance of the options. Sweat Equity provides employees with instant issuance of shares with no vesting period.
Unlike ESOPs, which give deferred pay, Sweat Equity shares provide the instant right to the benefit extended.
Is there a limit on the amount of employee stock option plan and the number of employees for ESOP issuance?
There is no minimum or maximum amount of ESOP or number of employees participating in ESOP. Furthermore, workers granted shares through an ESOP are not considered in the maximum number of shareholders (200) in the event of a Private Company under the Companies Act’s definition of a Private Company.
Can a director’s total ownership, following the issuance of shares under ESOPs, exceed 10% of the Company’s paid-up capital?
- A director is ineligible for ESOPs if he owns more than 10% of the Company’s outstanding esop equity shares, either personally or indirectly through a relative or through a corporation.
- As a result, if a Director a’s holding does not exceed this limit, he can be given ESOPs. However, it must be assured that his holding on the issuance of shares pursuant to ESOPs does not exceed 10% of the Company’s paid up capital.
- At the moment, certain qualifying Startups have been granted a reprieve in terms of granting ESOPs to its Promoters and Directors, where the Startup Company can award ESOPs to its Promoters and Directors.
Can an ESOP’s exercise price be less than its face value?
No, the Company may set the Exercise Price below the current market price or at any other reduced price, but it may not be lower than the face value of the shares.
Is it possible for the exercise fee to be different for each employee on the same exercise date?
Yes. On a discretionary basis, awards may be issued to each employee or class of workers at a different exercise price.
Is there any recourse if the employee lacks the means to exercise the vested stock options?
- Employees may be granted loans by the company in order to exercise their vested stock options.
- If the firm does not have adequate financial reserves or for any other reason decides not to offer such financing, an employee stock option plan finance arrangement can be formed through several agencies.
- These agencies provide cash to employees in order for them to exercise their stock options, and the employee repays the ESOP financing to the agency.
Should the exercise price, even for a private company, be predetermined? Is there a way for calculating the exercise price if this is the case?
Yes, a company, whether public or private, must set the exercise price, which must be determined at the time the options are granted. The Company is free to decide the exercise price, which may be a discount/premium to the prevailing market price at the time of award.
MUDS’ experienced personnel specialise in all elements of Employee Stock Ownership Plans for both private and public enterprises in India and throughout the world. Our distinct approach focuses on the financial aspects of ESOPs while organising the many various pieces required to effectively create an ESOP. Because any equity-based tool is an expensive instrument for the employer, it must be used wisely. This must be considered while allocating the esop equity pool.