Employee Stock Option Plans (ESOPs) offer a unique approach to employee compensation, particularly advantageous for startups aiming to preserve cash while still providing substantial rewards to their workforce. 

A lot goes into the structure and operations of an ESOP. Therefore, a founder must know basic ESOP terminology to plan and execute ESOPs smoothly.  

In startups, it falls upon the founders and Chief Human Resources Officers (CHROs) to oversee the development and management of Employee Stock Ownership Plans (ESOPs). Consequently, they must possess a clear understanding of the ESOP scheme's terms, as a lack of comprehension can potentially give rise to issues in the future. We have simplified this task for you by creating this write-up for ESOP terms, which you can peruse at any point.  

Source: fastercapital


Common ESOP terms that you must be aware of  

Before diving into the terms, let's establish a foundational understanding of an ESOP. An ESOP is a perfect plan that allows employees to buy organization shares at a fixed price within a stipulated timeframe. This incentivizes people to contribute to the organization's growth and success, as they directly benefit from the increase in the company's stock value. Let's explore!  

1. ESOP pool 

The ESOP pool designates the portion of the company's shares allocated for the Employee Stock Ownership Plan. Usually, it can be 10-15%, but the percentage of early-stage startups can be below. Hence, it is essential for businesses to exercise caution when segregating their capital. 

2. ESOP Scheme

The ESOP Scheme is a plan that delineates the guidelines and regulations governing the allocation of shares to employees. It outlines the qualifying requirements, the allotted share quantity, and the duration of the vesting period.

3. Stock Options

Stock Options have the privilege, without any obligation, to buy shares of a company. It's important to note the distinction between stock options and actual company stocks or shares. Unlike stocks, which grant shareholders fractional ownership and exclusive rights in a company, stock options only convert into shares when employees choose to purchase them. 

4. Scheme Document  

The Scheme Document encompasses the comprehensive details of the ESOP, specifically covering eligibility criteria, the percentage exercisable at each stage, and the designated strike price. 

5. Vesting Period 

Vesting refers to the period an employee must work for a company before gaining the right to exercise their stock options. Vesting is typically gradual, with employees earning a percentage of their stock options over time. For instance, if an employee has a four-year vesting schedule with a one-year cliff, they would need to work for one year before gaining any vested rights and then vesting in equal increments over the remaining three years.  

6. Cliff Vesting 

Cliff vesting is a specific vesting structure where employees do not earn any vested rights until they have completed a certain period, known as the cliff period. Once this period is completed, the employee becomes fully vested, often at a predetermined percentage. 

7. Accelerated Vesting  

Sometimes, a company may choose to accelerate the vesting of stock options. This can occur due to specific events such as a merger, acquisition, or the company going public. Accelerated vesting ensures that employees do not lose their vested rights in the event of a significant change in the company's structure.  

8. Exercise Period

The exercise period, also known as the exercise window, is when employees can purchase stock options. This period is defined in the ESOP agreement and is crucial for employees to be aware of to avoid forfeiting their possibilities. Typically, the exercise begins after the vesting period is complete and can extend for several years

9. Fair Market Value (FMV)  

The Fair market value at which a company's stock would be traded on the open market. This is used to determine the value of the company's stock to grant ESOPs.  

10. Grant 

The initial phase involves the issuance of options to the employee. Important terms associated with Employee Stock Ownership Plan (ESOP) during this stage include:
  • Grant Date: The date on which an organization allows ESOPs to employees.
  • Exercise Price: Commonly referred to as the strike or grant price, this represents the reduced price at which employees have the option to purchase the company's shares following the completion of the vesting period.
  • Expiry Date: Employees must exercise their options before the specified deadline, beyond which they will expire. 
The specifics must be clearly defined within the grant letter.

11. Stock Valuation Rights (SVR)  

Stock Valuation Rights provide employees with the same economic benefits as ESOP but with different functions. Instead of the right to purchase a particular share of the company, the employee is granted an amount equal to the increase in the company's value over a specific period (that is, the difference between the strike price and the market price on the vesting date). Either cash or stock offsets this increase in value.  

12. Restricted Stock Unit (RSU)

A Restricted Stock Unit (RSU) is a form of equity-based compensation commonly used by companies to reward employees. RSUs comes with a promise by the employer to grant the employee a certain number of shares of company stock, typically as part of an incentive or compensation package. However, unlike stock options, RSUs do not involve the immediate transfer of shares.

Are ESOP Terms & Conditions Equal for All Organizations?  

The ESOP operates without a rigid set of rules, allowing each organization to adopt varying terms and conditions. There is flexibility in how the policy is implemented and executed. Nonetheless, regulatory bodies such as the Securities and Exchange Board of India (SEBI) establish a framework of rules to ensure fair trade practices. It's worth noting that SEBI primarily oversees companies listed on Indian stock exchanges, while unlisted startups and other small to medium-sized businesses adhere to the guidelines outlined in the Companies (Share Capital and Debenture) Rules, 2014. 

Final Thoughts  

Therefore, ESOP terminology can be confusing and overwhelming. Vega Equity is here to ease your work, streamline your policy and relentlessly execute the transactions on time. Book a demo to know how we can assist.