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Understanding ESOPs under Startup India Action Plan

Definition

A Stock Options Plan (SOP) is a legal document mandating a company to issue equity options to employees, board of directors, consultants and advisors. It is generally associated with big companies.

 

Purpose

Granting a SOP gives ownership as an incentive to top talent. It is a tool to attract, retain and motivate them to work for mutual benefit while adding value to the company.

 

Challenge

After release of the Startup India Action Plan, 2014 there has been an increase in discussion on whether start-ups should have the option to issue SOPs to incentivize their employees.

 

Solution

In response, the Ministry of Corporate Affairs (MCA) relaxed sweat equity issuance norms for start-ups in the following ways –

  • Amended Companies (Share Capital and Debentures) Third Amendment Rules, 2016 (Amendment Rules)
  • Amended Rule 8 (sweat equity shares issuance) and Rule 12 (issue shares under ESOP) of Companies (Share Capital and Debentures), Rules, 2014

These amendments allow startups to issue sweat equity under ESOP to their promoters and directors holding more than 10% for the first 5 years from the date of their incorporation. It is supposed to act as a valuable tool for promoters or founders who are incapable of contributing capital, but bring wisdom, dedication and determination to run a startup. To further facilitate these benefits, MCA set across a notification to exempt the startups from the application of Clause (i) and (ii) under the Explanation C of Section 62 (1)(b) of the Companies Act, 2013 that defines the term “Employee” (as shown below).

For the purposes of clause (b) of sub-section (1) of section 62 and this rule ‘Employee’ means-

(a)  a permanent employee of the company who has been working in India or outside India; OR

(b) a director of the company, whether a full time director or not, excluding an independent director;  OR

(c) an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company but does not include –

(i). an employee who is a promoter or a person belonging to the promoter group; OR

(ii). a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.

In reality, founders are rarely given ESOPs (atleast not in early stages of financing) as most of them hold a major chunk of equity in their company. They may get offered options in later stages.

 

As far as the employees go, the founder is always keen on hiring the best but that comes with a high cost attached. Granting ESOPs to top talent can help at this time if done correctly. The issuance of an ESOP gives the employee the same motivation as the founders but the terms and conditions should be drafted correctly as an employee has to wait for the vesting period before they can exercise their right to purchase the shares. During this period the ESOP will be considered according to the quality of the startup and the terms of the ESOP.

 

Case Studies

There are many examples of ventures that have issued ESOPs in their early stages –

  • Infosys – granted ESOPs to their employees, clerical staff, drivers, office assistants and secretaries to incentivize them and mange their direct costs.
  • Flipkart and Snapdeal opted for the same
  • Flipkart has recently done it again – post a massive fundraise of $1.4 Billion in April from Tencent, eBay and Microsoft. It is an attempt on Flipkart’s part to protect its employees from the price drop in share value post the round.

 

To conclude, it is again worth mentioning that the popularity of ESOPs is speedily growing with the emergence of a vibrant startup ecosystem in India. This option is valuable because it gives startup employees the right to buy the shares at a predetermined price so that they get to benefit from the upside. It is a great tool to build a talented team which is critical for success in business today. A high-performance employee should be given incentives other than mere salary – but please draft the terms correctly.

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