Key things to consider before issuing shares via ESOP

‘ESOP’ [Employees Stock Option Plan] is a scheme or plan set up by a company for its employees. It helps you explore options under which a company gives the right to its employees to purchase its shares at a discounted price. ESOP is a type of employee benefit plan which offers its employees, ownership interest in the shares of the company on the fulfillment of certain conditions

Companies issue shares via ESOP to obtain certain benefits like:

• Boosting employees’ financial well-being and motivational level, thereby urging them to serve the company in a better way; 
  
• Reducing the cases of employees leaving jobs in a few months;  
  
• Incentivizing employees to help in the company’s growth and success.
  

The employees get an opportunity to become shareholders of the company and they work for the company’s growth as they know they can share the profits of the company.

But there are a few practical aspects that need to be kept in mind before the issue of shares via ESOP. 

Some major things to keep in mind for the issue of shares via ESOP are discussed below:

Financial and non-financial matters

The issue of shares via ESOP involves complexities concerning financial, legal, operational and HR matters. These matters need to be properly addressed either by the company or can be outsourced to third parties.

Accounting of ESOPs-

The reporting of accounts prepared by the company should be either as per Guidance Note on Share-based payments (2005) issued by the Institute of Chartered Accountants of India, or Ind AS, depending on the eligibility criteria. According to the Guidance Note, companies have the option to choose between accounting for ESOPs on ‘intrinsic value basis’ or ‘fair value basis”.

• Value, in the case of a listed company, is the amount by which the quoted market price of the underlying share exceeds the exercise price of an option while, in the case of a non-listed company, since the shares are not quoted on a stock exchange, the value of its shares is determined based on a valuation report from an independent valuer.
  
• The enterprise should measure the fair value of shares or stock options granted at the grant date, based on market prices if available, taking into account the terms and conditions upon which those shares or stock options were granted. If market prices are not available, the enterprise should estimate the fair value of the instruments granted using a valuation technique to estimate what the price of those instruments would have been on the grant date in an arm’s length transaction between knowledgeable, willing parties.
  
• On the other hand, IndAS 102, “Share-Based Payment” mandatorily requires an accounting of ESOPs on a ‘fair value basis’.
  

Unvested options in case of acquisition or change of control

This is an important aspect that should be made clear in the terms and conditions of the ESOP agreement. This happened in the case of the acquisition of RedBus by the Ibibo group. 

Generally, startups having private limited company registration launch ESOP scheme to reward those who had been with the Company since the beginning and also incentivize the new members, who have been just hired. It may happen that just in a time frame of 1-2 years, the company gets acquired and the control over management changes without the options being vested, i.e., the Unvested ESOP remain with either no “Acceleration of vesting” clause or “Complete acceleration of unvested options”. Both these clauses may be unfair to the employees of the company. It also impacts the Earnings per share (EPS) of the company. So, it becomes very important to review the duration of the existence of the company before issuing shares via ESOP, the purpose of issuance of ESOP, the impact of changing the vesting terms and the acceptable level of drop-in return of the investors.

Vested options of ex-employees

Some companies have a clause in ESOP agreement that at the time of leaving the company, employees would exercise their vested options within a given time frame, even if no liquidity event is planned shortly. But this clause can lead to cash strain on the employees because of the tax implications at the time of exercise of the option. The taxable value is the difference between the fair market value of the shares (on the date of exercise of the option) and the amount recovered from employees for such shares (exercise price). Therefore, employees who leave choose not to exercise the options. So, the companies now change the clause to allow the leaving employees to hold the vested options even after leaving the company and exercise them when the liquidity event arises.

In this way, they get the privilege of exercising the options the same as the existing employees of the company. This acts as a fair means for the ex-employees who served the company for a long period. Still, the issue like the proportion of options that can be exercised by the ex-employees and the existing employees at the time of liquidity event needs to be taken into consideration and the clause should be added accordingly in the agreement.

Some companies have a clause in ESOP agreement that at the time of leaving the company, employees would exercise their vested options within a given time frame, even if no liquidity event is planned shortly. But this clause can lead to cash strain on the employees because of the tax implications at the time of exercise of the option. The taxable value is the difference between the fair market value of the shares (on the date of exercise of the option) and the amount recovered from employees for such shares (exercise price). Therefore, employees who leave choose not to exercise the options. So, the companies now change the clause to allow the leaving employees to hold the vested options even after leaving the company and exercise them when the liquidity event arises. In this way, they get the privilege of exercising the options the same as the existing employees of the company. This acts as a fair means for the ex-employees who served the company for a long period. Still, the issue like the proportion of options that can be exercised by the ex-employees and the existing employees at the time of liquidity event needs to be taken into consideration and the clause should be added accordingly in the agreement.

Conclusion

ESOPs are offered by companies to the key employees to achieve the long term goals and objectives of the company. ESOPs involves complexities and therefore, should be administered by a proper team. The management of the company should be aware of the costs involved in the process of issuing shares via ESOP, which may be legal cost, administration cost, valuation cost, etc.