ESOPs and Startups – Indian Context

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In the current trend of booming industry of startups, competition has risen. Thus, in order to attract talents or to retain current employees, more and more startups are exercising the option of Employee Stock Options (used as ESOPs). Also, early stage startups who lack capital infusion also use ESOPs as a tool to hire employees on a lowed payroll when compared to the industry standards by giving them ESOP option.

Sec 2(37) and Sec 62(1)(b) of the Companies Act, 2013 governs the issuing of the ESOPs by private companies. Startups can opt the administration of ESOP by either its Board of Directors or by creation of an ESOP Trust (per Indian Trusts Act). Startup should opt for administration of ESOPs through it’s Board of Directors as forming a trust first is a more complex procedure and in early seed startup with less number of employees, ESOPs through board of directors is a far simpler process.

 

Exercising ESOPs by a Startup

Through Board of Directors Route-

A startup cannot just grant employee stock options by issuing a simple letter. Often early-stage startups do this and then have to eventually handle disgruntled employees because they suddenly wish to exercise their options which, strictly under Indian law, were never really granted to them. Certain measures need to be taken before issuing ESOPs to the employees

Get an ESOP scheme drafted and approve it in a shareholders’ meeting. Till June 2015, this scheme had to be approved by a ‘special resolution’ and filed with the Registrar of Companies (ROC). With effect from June 05, 2015, vide notification G.S.R. 464(E), private limited companies do not have to comply with Section 62(1)(b) of the Companies Act, 2013 which originally mandated ESOP schemes to be approved through a ‘special resolution’ and file its key terms with the ROC, making all this information available publically. Once an ESOP scheme is approved by the shareholder, a Letter of Grant must be issued to the employee informing him how many options are being granted to him and what the vesting period would be. Also, he should be informed about exercise price will be determined, if he choose to exercise the vested options. In the event an employee wishes to exercise any of his vested options, he should make an Exercise Application to his employer company pursuant to which his options would be converted into equity.

 

Under the Trust Route-

A Trust is formed under the Indian Trusts Act, and the Trust Deed is registered with the jurisdictional Sub-Registrar. The ESOP Trust receives stock either from company by way of fresh allotment or by purchasing from existing shareholders in open market or the owner of the company may sell shares of his holding to the ESOP Trust. The ESOP Trust usually obtains its funds through a loan either from a financial institution or from the seller or a combination of institutions and seller. A company can extend loan to the Trust for purchasing the Shares. There is a specific provision in the Companies Act, which permits such loan under Sec. 77(2) (b) and (c). Then, the ESOP Trust allots shares to employees on exercise of their right in exchange of cash and repays its loans.

 

Key Points to be considered while drafting an ESOP

Most employees have employment contracts that allow termination upon giving some notice.

A startup would definitely not want an ex-employee to hold equity in its venture when such employee could very well be working for, say, a competitor. Accordingly, terms of an ESOP scheme have to be carefully thought out and discussed. Proper exit mechanism for employees and vesting options should be outlined in order to fulfill the objective of retaining talent.

 

Author: Yash Maheshwari

2nd Year, BA LLB, WBNUJS

India