How is an ESOP share price determined?

Employee stock ownership plans, or ESOPs, are slowly gaining traction in the Indian startup environment as a way to reward, retain, and recruit employees. When team members become stakeholders, they get several benefits as trust is built and the company's focus on value creation and wealth-building benefits them in the long run. It also allows firms to hire and retain people without depleting their financial reserves, as well as take advantage of tax benefits.

Understanding the foundations of the employee stock/share ownership plan, is critical for any entrepreneur or company interested in launching an ESOP programme. It is the most important legal document since it contains all of the regulations that govern an ESOPs activities.

Although there is no standard framework for creating an ESOP, businesses can specify their own set of regulations in this important document. They must, however, follow SEBI's statutory requirements as well as the Companies Act of 2013. Let's take a look at the elements to consider when creating an ESOP.

Pool Dimensions

This is generally defined in the shareholding agreement for financed businesses (SHA). Again, there is no set formula or guideline, although in the early stages, a pool size of 10-15% should suffice. In future financing rounds, it is extremely usual to increase the pool size.

Employee Eligibility Criteria

Based on employment duration, performance, seniority, future potential, and other factors, these determine whether an employee is qualified for a grant or vested option.

READ MORE: Why shouldn't you be misled by startup ESOP options

ESOP Distribution

It can be done in a variety of ways. In India, however, most entrepreneurs choose the straight way and manage the process themselves. This method is considerably more straightforward. The grants are approved by the board of directors, or a small committee is created to do so. The other option is to distribute via an ESOP trust. This is a time-consuming approach that necessitates additional accounting tasks. As a result, just a few businesses choose it.

Vesting and Lock-In Period

Even when employees are given stock options, they do not become owners of the shares straight once. Simply explained, vesting is the process of applying for and purchasing a company's stock after a set length of time has elapsed and specific criteria have been satisfied according to the company's regulations.

The vesting time must be at least a year between when the stock option is granted and when it is exercised. The vesting time after which an employee can apply for the shares given must be specified in the ESOP. It should also allow the administration committee to set a lock-in period during which an employee is unable to redeem or sell his/her shares.

Former Employees' Exercising Period

Because ESOP shares are often equity shares, even a former employee may be able to keep them. In its ESOS, a business can define how long it wants its workers to exercise their stock options after they leave the company.

Exercise Process and Plan

The exercise duration and the exercise cost are both included in an exercise plan. The exercise period is the time after the vesting period during which an interested employee must exercise his/her right to apply for and pay for the company's shares. It's crucial to stress that acquiring these shares is a choice, not a requirement, for employees.

If all criteria are met and an employee agrees to purchase the shares, the exercise price, which is less than the fair market value (FMV), might be paid. Employees must be able to exercise their ESOP options in some form or another, and the firm must have a framework in place to allow them to do so.

Buybacks of ESOPs

Even in the midst of the Covid-19 epidemic, several Indian businesses launched ESOP buyback programmes, letting employees to cash in their stock options. An ESOP buyback occurs when an employee surrenders or forfeits his/her ESOP grant, and the business rewards the employee with a bonus equal to the amount surrendered.

ESOS Amendment/Termination

The ESOS of a firm must answer the following questions: Who has the authority to change the ESOP and under what conditions? Is it possible to cancel the plan before it expires? If that's the case, who would have the authority to terminate the ESOP and under what conditions? Covering these questions are considered essential while drafting an ESOP.

ESOPs are a company's option or right, but not a requirement, to acquire its shares at a predetermined price in the future. Employee stock ownership plans connect employees' interests with the long-term interests of firms and play a critical role in retaining employees during a company's growth stage. Hence, considering the above factors helps in understanding and determining the correct ESOP for an employee as well as the employer.