By Law, What Is The Minimum Percentage Of Assets That An Esop Must Invest In Its Company'S Stock?

By Law, What Is The Minimum Percentage Of Assets That An Esop Must Invest In Its Company’S Stock?

By Law, What Is The Minimum Percentage Of Assets That An Esop Must Invest In Its Company
ESOPs require companies to invest 51 percent in the company’s own stocks.

What is an ESOP limit?

ESOP Contribution Limits – For 2022, the limit on contributions to defined contribution plans, including contributions to the ESOP on the employee’s behalf, are limited to the lesser of $61,000 or 100% of compensation. For 2021, this limit was $58,000.

How is stock allocated in an ESOP?

How Are ESOP Shares Allocated to Participants? – Shares are typically allocated to participants based on compensation. So, an employee who makes $200,000 a year will get a higher percentage of that stock than an employee who makes $20,000 a year. Participants receive an annual statement showing the number of shares allocated to them that year as well as the value of their entire account balance—just like they would in a profit-sharing plan.

Graded vesting, where a defined percentage is vested every year for a set time period. For example, it might be 20% per year with participants fully vested after six years. Cliff vesting, which occurs when employees have no vested interest in their account until they’ve been employed for a defined amount of time, for example three years, after which they’re 100% vested.

Participants receive the vested portion of their ESOP accounts after job termination, retirement, or death. Benefit distribution practices can vary, but they’re generally paid in equal installments over five years. However, other options, such as lump sum payments or a delay in distributions, are permitted depending on the design of the plan.

What is a 100% ESOP?

Employee Stock Ownership Plans (ESOPs) – The most common structure for broad-based employee ownership in the U.S. is the employee stock ownership plan (ESOP). Approximately 6,500 U.S. companies have an ESOP, and approximately 14 million U.S. workers are ESOP participants, (see Employee Ownership by the Numbers ).

An ESOP is a type of retirement plan, similar to a 401(k) plan, that invests primarily in company stock and holds its assets in a trust for employees. An ESOP may own 100% of a company’s stock, or it may own only a small percentage. ESOP participants (employees) accrue shares in the plan over time, and are paid out by having their shares bought back, typically after they leave the company.

ESOPs are often created in the process of selling a business, as an ESOP can buy a departing owner’s shares in pre-tax dollars on terms that are highly favorable to the owner, the employees, and the business itself. Selling owners can sell any portion of their stock to the ESOP, and they can defer tax on the gain from the sale if certain requirements are met.

Congress created incentives for ESOP to borrow money (“leveraged ESOPs”), allowing them to purchase more shares than they otherwise would be able to.
Nonleveraged ESOP transactions tend to be smaller and have lower transaction costs.
Companies also can use ESOPs simply as a way to reward and engage employees even if there is not a selling owner.

To learn more about how to use an ESOP for business transition, see Using an ESOP for Business Transition,

What are the basic ESOP structures?

The basic structure of an ESOP – ESOP is an acronym that stands for “employee stock ownership plan,” though we can all admit that it’s way more fun to say “ESOP.” Ranging in size from companies with 10 or 20 employees to some with tens of thousands, the purpose of any ESOP is to give employees ownership stake in their company without having to invest any of their own money.

In an ESOP, employees become shareholders in the company through a trust that acquires stock and pays out dividends when employees retire or leave the company. It’s a lot like a 401(K), though contributions are made entirely by the company through gifted shares. Put simply, all or part of a company’s shares are placed in a retirement fund and administered on behalf of employees.

Then they get paid when they leave. The process looks like this:

A company establishes a legal entity that holds stock on behalf of the employees and starts contributing to it through existing or borrowed money.
Typically, employees become eligible to participate in the ESOP by working for a certain period of time and becoming vested in the company.
The company allocates a certain number of shares to each eligible employee. This might be based on pay scale or another form of distribution, but legal regulations require it to be equitable.
Each employee’s shares are held in the company’s ESOP trust until they leave or retire. When that happens, employees can sell their shares on the market or back to the company — and they pay no taxes until the sale.

The process can be a bit more involved depending on the circumstances. For example, an independent appraiser is needed for an ESOP to buy company shares from the selling owners, and “leveraged” ESOPs need to follow additional regulations in order to borrow money from banks.

What percentage is ESOP?

The options strategy and grant size will depend upon the stage of funding – Let’s first start with a Series-A funded startup and from there go back (seed/angel) and forward (Series B/C). The options pool post Series A is typically 15 percent of the overall equity pool on a fully diluted basis.

Typically, a Series A investor would ask the founders to make the provision.
This has serious implications for the founders.
Let’s assume that the pre-money value of the startup is $5 million and the founders own 100 percent.
The Series A investor would come in and agree to put in, say, $5 million for a 50-percent stake with the proviso that after the investment, the founders would own 35 percent and the balance 15% would comprise the options pool.

Obviously, the investor is getting you, the founder, to create the options pool from your equity. So, be wise. If you do not need a 15 percent pool now, just go with, say, a 10-percent pool size. If you need to increase the pool size later on you can jointly dilute with the investor and create the additional five percent.

What should be the quantum of grant? The standard and well-tested practice is to consider anything between one and two percent for a CXO, and between 0.25 and one percent for a key hire one level below a CXO.
A professional CEO may need four-eight percent.
The bigger the valuation at the time of Series A, the lower the end of the range could be the size of the grant.

Now, you can go back to the seed round. Based upon the extent of dilution expected after Series A, you need to work backwards. If you expect a 50 percent dilution, then the seed round grants need to be double of what they are after Series A. What should be the strike price? The best approach is to use the current market value.

This is a clean design and ensures that those that come in at an early stage see a greater upside even if the grant size is the same as it is for someone who comes on board later. So, the risk takers that came in early have the dual advantage of a greater upside (on account of a lower strike price) as well as early vesting.

Some startups tend to use the par value of a share as the strike price. This is not a common practice though. We believe the reason these startups have resorted to this approach is to assign and communicate the dollar value of the options at the time of grant.

This makes it easy for someone who has no idea how to value options. Let us assume that a startup offers a salary of $125,000 plus stock options (with a four-year vesting) whose value is $300,000 at the time of grant. The value of $300,000 is arrived at by multiplying the number of options and the differential between the current market price and the par value.

What is an ESOP?

If the grant size is 30,000 options, the current market price is $11 and the par value is $1, then the current value of the options is 30,000*(11-1), which is $300,000. Therefore, the equivalent cash compensation of this offer is $200,000 per annum (which is $125,000+25 percent of $300,000).

The obvious error with this approach is that if the share price appreciates (and it is certainly expected to appreciate – and appreciate significantly), this calculation is totally flawed. If the share price quadruples in four years, then the terminal value of the options is actually $1,200,000 and the total compensation per annum is actually $425,000 and not $200,000.

The other problem with the exercise price being at par is that irrespective of when a person comes on board, the upside tends to be the same. This is a deviation from the fundamental design principle of an ESOP plan, which is that everyone gets an upside depending upon the value creation that they have enabled during their tenure.

What are ESOP rules?

ESOP Rules – An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan.

Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. The 2017 tax bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, at which point the limit decreases to 30% of EBIT (not EBITDA).

In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments. New leveraged ESOPs where the company borrows an amount that is large relative to its EBITDA may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change.

This change will not affect 100%-ESOP owned S corporations because they don’t pay tax. Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula.

As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares).
Private companies must have an annual outside valuation to determine the price of their shares.
In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues.

In public companies, employees must be able to vote all issues.

How is the fair value of ESOP determined?

The fair value of an ESOP is estimated using an option-pricing model like, the Black-Scholes or a binomial model. For undertaking fair valuation of ESOPs, the Black-Scholes model is mostly preferred as it takes into account the various other factors like Time Value, Interest Rate, Volatility, Dividend yield etc.

How do you determine ESOP value?

Methods of Valuation of ESOP – Under Guidance Note 18 on Accounting for Employee Share-Based Payment, ESOP accounting is required in India (2005 edn.) released by ICAI ESOP valuation can be carried out using the Fair Value approach or the Intrinsic Value method ( ESOP Valuation Methods ) using the Income, Asset, or Market Approach (like Business Valuation) (through Option Pricing valuation including Black Scholes or Binomial method).

Who owns an ESOP company?

Governance structure – ESOPs are overseen by a trustee who becomes the shareholder of record for the company stock held by the ESOP. In addition to the trustee, a plan administrator will have certain oversight and administrative roles with respect to the ESOP.

The plan administrator may be the company, a third party designated as the plan administrator, or a committee or individual within the company,that is either appointed in writing by the plan sponsor or specifically named in the ESOP plan document.
Under ERISA, the plan administrator’s general responsibilities include ensuring the ESOP is operated in accordance with the plan document and required information is reported to the IRS and participants.

This operation covers many of the annual accounting tasks, including tracking accounts and allocations, managing plan distributions and determining eligibility. Often, the company will hire a third party to provide many of these recordkeeping services, but someone at the company must provide the third party the applicable data on employee status, compensation, and other information needed to properly administer the plan.

Even when a third party is used, the plan administrator retains ultimate responsibility for these duties and is generally also a named fiduciary to the ESOP, which means they are the party primarily responsible for the plan. As is true with any trust, the trustee has a fiduciary responsibility to protect the assets of the trust for the beneficiaries, including the stock that represents a retirement benefit for employees.

The trustee also has a number of duties to carry out on behalf of the trust, including negotiating the ESOP’s corporate stock purchase and engaging an independent third party to appraise the corporate stock each year. The corporation’s board of directors (board) appoints the ESOP trustee.

The party selected as the trustee may be a bank or outside institution that provides professional trustee services, or it may be someone who already has a relationship with the corporation (e.g., the chief financial officer).
In choosing whether to use an external or internal trustee, the corporation needs to weigh the cost of an outside trustee with the benefit of receiving additional independence, and perhaps ESOP expertise, to manage the fiduciary responsibilities.

In some cases, the corporation may appoint an external trustee who is directed by an internal ESOP committee with respect to certain corporate actions in which the external trustee does not have proper knowledge. A directed trustee must still act to protect employees’ retirement benefits when taking direction, but the internal committee can provide guidance.

Even if the committee is not charged with directing the trustee, an internal ESOP committee is often formed within the board or management to undertake the corporate responsibilities with respect to the ESOP, including employee communication and plan administrative oversight.
Depending on whether the committee makes decisions that affect the plan or directs the trustee, the committee may become a fiduciary to the plan.

As the legal shareholder, the trustee participates with any other corporate shareholders in electing the board. While this election creates a circular relationship for the trustee when carrying on its primary responsibilities with the business, who was appointed by the board, it rarely creates a problem.

While the board is not held to the same fiduciary standards as the trustee, the board is generally required to act in the best interests of the corporation and shareholders, and thus, the parties’ interests are often aligned.
The board retains the same duties after an ESOP owns corporate shares, including appointing officers, approving budgets, accounting to shareholders, and governing broad corporate policies and objectives.

The officers appointed by the board hire management, and management runs the day-to-day operations of the company. Again, these responsibilities are not altered after an ESOP acquires shares. Not only do the duties of management and the board stay relatively the same after an ESOP owns shares, but the individuals in management and on the board also usually stay mostly the same, maybe with the exception of adding an independent board member or members that the trustee believes will act as a neutral party when participating in board decisions.

With this structure, selling shareholders may be able to exit ownership while retaining essentially the same decision-making power over the company operations as when they held shares directly. While the trustee relationship is new, the trustee only has duties with respect to the share of the company stock it holds.

Therefore, any shares still held outside of the ESOP still have the same rights as before the ESOP sale. Even in cases in which the ESOP holds all of the corporate shares, the management team and the board retain corporate decision-making responsibilities, with an added layer of oversight from the ESOP trustee to ensure those decisions are in the best interest of long-term share value.

What is the average ESOP contribution?

How Much Is Enough? – Employers often ask not “how much can we contribute,” but “how much should we contribute to make plans meaningful to employees.” The average corporate contribution to all retirement-oriented plans combined is only about 4% of pay (this does not count employee contributions).

The average ESOP contribution, according to various surveys, is about 6%-10% of pay.
More than 80% of all ESOP participants also are in another company-sponsored plan, often a 401(k) plan.
How much is enough to make employees fell like owners, unfortunately, cannot be answered, but research does show the higher the contribution, the more employees feel like owners.

Whether calculating legal limits or practical guidelines, it is important to get qualified, ongoing advice. The penalties for violating the limits are both severe and, with planning, easily avoided. : ESOP Tax Incentives and Contribution Limits

What is the average ESOP payout?

ESOPs and Retirement Wealth Inequality Employee Stock Ownership Plans (ESOPs), the most common form of employee ownership in America, excel at helping bridge the gap in retirement wealth inequality. Most ESOPs require no out-of-pocket contribution from employees.

This frees employees to pay for necessary items, save, or invest in other retirement vehicles.
ESOPs are fairly unique in this regard.
According to a Vanguard report, “In a typical DC plan, employees are the main source of funding, while employer contributions play a secondary role.” The average employee in an ESOP company has accumulated $134,000 from his or her stake in the business, according to a 2018 Rutgers University study.

This is 29 percent more than the average 401(k) balance of $103,866 reported by Vanguard the same year. Among ESOP companies responding to a 2018 ESOP Association survey, 54.7 percent contributed 11 percent or more of pay to employees’ ESOP accounts. (Among Vanguard defined contribution retirement plans, 70 percent offer a maximum employer match of three percent.) Many businesses offer their employees no retirement plan at all.

By contrast, among ESOP companies responding to an ESOP Association survey, 93.6 percent offer their employees two retirement plans—a 401(k) plan in addition to the ESOP; 2.6 percent of responding ESOP companies offer a pension in addition to the ESOP. Americans need retirement options—like ESOPs—that require no out-of-pocket contribution from employees.

A Northwestern Mutual report found that 21 percent of Americans have no retirement savings at all. And 25 percent of employees who participate in a 401(k) fail to contribute enough to earn the full match from their employers—thereby losing $1,336 dollars per employee each year—according to a 2015 report from Financial Engines.

What is the largest ESOP company?

October 2022

Rank	Company	Plan
1	Publix Super Markets	ESOP & Stock Purchase
2	WinCo Foods*	ESOP
3	Brookshire Grocery Company*	ESOP
4	Houchens Industries*	ESOP

What happens to my ESOP if I leave the company?

What is ESOP? – An Employee Stock Ownership Plan (ESOP) is a type of retirement plan that invests primarily in company stock and holds its assets in a trust for employees. The shares within the ESOP may represent 100% of the company stock, or may represent a portion of the company stock.

ESOP participants (employees) accrue shares in the plan over time. Participants are paid out by having their shares bought back, typically when they leave the company. Many ESOP participants utilize their shares as part of their retirement investments. Keep in mind that an ESOP is more than a retirement plan.

An ESOP brings benefits to multiple stakeholders within the company and aligns their interests together. Let’s explore a bit more.

How much ESOP can a company issue?

Employee Stock Option Plans (ESOP) – Frequently Asked Questions Corporate Professionals has been in ESOP advisory for over 15 years and we have witnessed the popularity which the Employee Stocks Options and Employee Stock Plans has been gaining over the years.

While Information technology companies started the trend of offering share options to employees in India, companies in several other sectors including Financial Services, Diversified Manufacturing, Health, Real Estate & Construction, Life Sciences, Retail sectors followed suit with a view to creating entrepreneurial spirit and retaining and rewarding employees.

ESOPs have drawn a lot of attention of the employers who are curious to demystify the ESOP machinery to the core. As an ESOP consultant with extensive client interaction and while addressing industry participants in our webinars, we have observed some commonly asked queries related to key attributes of Employee Stock Plans.

1. ESOPs can be granted to Permanent Employees only. Who is a Permanent Employee? The term Permanent Employee has not been explained in the enabling legal provisions of ESOP nor has it been defined under the Companies Act per se. Considering the practical aspects, in case of both Listed and Unlisted Companies, an employee who has satisfactorily completed the probation period can be considered to be a Permanent Employee.2. Companies Act restricts promoters and directors holding more than 10% of capital of the company from participation in an Employee Stock Plan. Is there any relaxation for Startups? A Startup Company, as recognized by the Department for Promotion of Industry and Internal Trade (DPIIT), is exempted from the restriction of participation in an Employee Stock Plan of the promoters (founders) and directors, holding more than 10% of the capital, for a period ten (10) years from the date of its incorporation or registration with the DPIIT.3. Can a Private Company, that is not a recognized Startup, issue ESOPs to a person who is an employee and also a shareholder of the Company? Yes. A Private Company can grant ESOPs to its permanent employee, who is also a shareholder of the Company Further, a Director cannot be made allotment of shares pursuant to ESOPs if he is holding (directly or indirectly along with his relatives) beyond 10% of the paid up capital of the Company.4. Can ESOP scheme include future employees also? Yes. The scheme can cover both existing and future employees of the company who join after the approval of the scheme.5. Can a Company listed in India issue shares through ESOPS to an employee of step down subsidiary which is a foreign Company? Yes. A Step down subsidiary is also a subsidiary to the extent permissible by law and an Indian Company can grant ESOPs to employees of its Subsidiary Company, in India or outside India.6. Nowadays, people opt to work as full time professionals as against an employee contract. Are these people eligible for ESOP? ESOPs can be granted only to permanent employees who are on the payroll of the company. Since a consultant a full time Professionals is not on the pay rolls of the company, they are not eligible for ESOPs.

Vesting Period

7. Is there any minimum vesting period under ESOP scheme for an unlisted Company? Can it be as slow as three months or has to be the same as the minimum period as per the regulatory framework? The minimum vesting period of ESOPs granted under a scheme is minimum of one (1) year, whether Listed or Unlisted Company. In case of graded vesting, post one (1) year from grant date, vesting can be made systematically on a monthly/quarterly/semi- annual/annual basis.

Exercise Price

8. Can the Exercise Price of ESOP be less than face value? No. The Company can set Exercise Price below the prevailing market price or at any such discounted price but it cannot be below the face value of the shares.9. Can the exercise price be different for each employee for the same exercise date? Yes. The grants may be made to each employee or class of employees at a different exercise price on a discretionary basis.10. Is there a remedy if the employee does not have enough funds to exercise the vested stock options?

The Company can give loan to employees for exercising the vested stock options.In case the company does not have sufficient cash reserves or for any other reason decides not to extend such loan, an arrangement of ESOP funding through various agencies can be made.These agencies extend funds to employees to exercise the stocks and repayment of such ESOP funding is made by the employee to agency.

11. Can a Company give loan to directors and employees to subscribe to ESOP in accordance with the law? A Company can extend loan to its employees to subscribe ESOP in accordance with Section 67 of the Companies Act, 2013. In accordance with Section 186 of the Companies Act 2013, a Company is prohibited from extending loan to its director or director of holding Company. However, Loans and advances made by the companies to their employees, other than the managing or whole-time directors, are not governed by the requirements of Section 186.Thus the company can freely extend loan to its employees to subscribe ESOPs.12. Should the exercise price be pre-determined even for a private Company? If so, is there any method to arrive at the exercise price? Yes, a Company, whether public or private, has to set the exercise price which has to be determined at the date of grant of the options. The Company can freely set exercise price which may be at a discount/premium at the prevailing market price at grant date.13. Can two differential exercise price offered to employees be incorporated in one scheme? Yes.

Quantum

14. Is there any threshold on the quantum of ESOP and the number of employees for issue of ESOP? There is no minimum or maximum threshold on the quantum of ESOP or the number of employees participating in ESOP. Also, the employees issued shares under ESOP are not counted in the maximum limit of shareholder (200) in case of Private Company in terms of the definition of Private Company under the Companies Act.15. Can the total shareholding of a director, after allotment of shares under ESOPs, exceed 10% of the paid up capital of the Company? A director shall not be eligible for ESOPs who either himself or through his relative or through anybody corporate, directly or indirectly, holds more than 10% of the outstanding Equity shares of the Company. Thus, a Director a can be granted ESOPs if his holding does not exceed this limit. However, it has to be ensured that his holding on allotment of shares pursuant to ESOPs, does not exceed10% of the paid up capital of the Company. At present, certain eligible Startups have been extended relaxation regarding grant of ESOPs to its Promoters and Directors where under the Startup Company can make grants to Directors holding more than 10% of the capital of the Company.

Type of Shares

16. Can shares having Differential Voting Rights be issued as ESOP? Yes. Any form of shares may be issued under ESOP which may be Preference Shares, Equity Shares or Shares with Differential Voting Rights.17. Can we issue ESOP shares to employees without giving voting rights? No. A share must always carry a voting right which may be same as the existing shareholders or differential.

Stock Appreciation Rights (SAR)

18. In the case of Stock Appreciation Rights, is it necessary to decide upfront, whether it will be cash settled or Equity settled? The Company has to decide upfront whether the scheme will be Equity Settled or Cash Settled to ensure compliance with the various legal requirements. However, in an Equity settled scheme, provision of buyback of vested rights by the Company may be added to facilitate settlement of rights in cash instead of Equity if required.19. What is the difference between SAR and Phantom Stock? SAR stands for Stock Appreciation Rights which is a form of incentive or deferred compensation that is linked with the performance of the Company’s stock. Under SAR, a right to the monetary equivalent of the appreciation in the value of the shares of the company is given. The appreciation is measured on a specified number of shares over a specified period of time that is settled in the future either by way of Equity allotment or Cash as pre-determined by the company. A SAR that’s settled in cash is popularly known as Phantom Stock. While SAR may be considered as Equity Settled Scheme, Phantom Stocks are settled in cash only.20. Can SAR to be settled in Cash be exercised during shut down period? Employees can get their SAR Vested during shut down period as they are considered to be in continuous service during such period and subsequently exercise the vested rights within the exercise period.

Sweat Equity Shares

21. What is difference between ESOP and Sweat Equity? Under ESOP an employee has the right to exercise the Option to receive allotment of shares of the Company by paying exercise price upon vesting of an Option which cannot take place earlier than one year from the date of grant of the options. Under Sweat Equity the employee receives immediate allotment of shares without any vesting requirement. While ESOP is a deferred form of compensation, Sweat Equity shares provide immediate entitlement of the benefit extended.

Restricted Stock Units (RSU)

22. What are the different forms of Restricted Stock Units (RSU)? Based on vesting conditions RSUs can be broadly categorized as:

a) Loyalty Based RSU’s are granted with an objective to retain an employee in an organization for a specific number of years. b) Performance Based RSU’s are granted with an objective to motivate an employee for achieving a pre-determined performance target. Here the performance targets can be linked with individual performance or organizational performance or combination of both.

23. Can all three types of share based plans i.e. RSU, ESPS and ESOP be implemented in the same scheme? Yes, a comprehensive scheme can be drafted incorporating different plans, clearly specifying the number of shares attributable to each plan and providing specific provisions for each plan providing common administrative powers with a Compensation Committee.

Impact of Phantom Stocks on Financials

24. What is the impact of issuing phantom stocks on the financials of the company? How are phantom stocks recognized in books of accounts? Phantom stocks create a financial liability which has to be settled in cash, resulting in impact on the profits and the cash flows of the Company. A provision of the same is recognized with the vesting of the units and such provision needs to be re-measured & revised each year till they are settled.

Trust Related

25. What is the objective of implementing ESOP Scheme through Trust? A Company is restricted to buy its own shares; however, it may do so by extending finance to a Trust to acquire its shares for the benefit of the employees. Also in case of listed companies, it is mandatory to implement the scheme through Trust as per the applicable SEBI Regulations.26. Apart from avoiding dilution, are there any other benefits in the Trust model? Trust is a highly lucrative mechanism through which the Company can extend funding to the Trust to acquire shares of the Company in pursuance of its employee share based benefit scheme. The shares held by the Trust are transferred to the employee upon exercise of their vested rights. Companies further use trust to create funding arrangement for exercise of options by employees, whereby the employee can pay the exercise price to the trust in installments and to also restrict transferability of shares during such period. Trust provides another useful feature that is of cashless exercise of options by the employee and facilitating the sale of shares of the employees in both listed and unlisted companies.27. Can a Company extend interest free loan to the EOSP Trust to acquire shares for the purpose of the Scheme? Yes, a Company can freely extend loan without interest to the ESOP Trust to acquire shares for extending the share based benefit to employees who are beneficiary of the Trust in accordance with the scheme under Section 67 of the Companies Act, 2013.28. Is In-Principle Approval from Stock Exchange required for acquisition of shares through Trust? Where Shares are acquired from secondary market through Trust for transferring shares to employees pursuant to ESOP exercise there is no requirement of In-Principle approval as there is no fresh allotment of shares.29. Can Company transfer shares to foreign employees using Trust Route? Yes. The FEMA Regulations allow the issue of shares to foreign employees is in accordance with the SEBI Regulations which per se allow the Trust mechanism.

Price Unattractive

30. How a Company can compensate its employees, in case of the options become unattractive due to fall in market price of the shares? The Company can re-price the Options, which are not exercised, whether or not they have been vested if the Schemes were rendered unattractive due to fall in the price of the Shares in the stock market. Any change in terms of options and such re-pricing must be in the interest of the grantees and approval of shareholders needs to be taken in this regard.

Corporate action

31. Bonus Issue involves allotment of additional shares to shareholders without payment of any subscription money. Pursuant to Bonus issue how will the adjustment be done, as the ESOPs exercise requires payment of exercise price? Pursuant to Bonus Issue, the number and price of Options shall be adjusted in a manner such that total value of the options to the employees remains the same after the corporate action and the vesting period and the life of the options shall be left unaltered as far as possible to protect the rights of the employees who are granted options.

Compliance

32. Is MGT-14 required to be filed at the time of approval of scheme by Board of Directors? Yes. MGT 14 is required to be filed both at the time of passing the Board Resolution and upon passing shareholders resolution.33. Is it necessary to pass a board resolution when the Stock Option lapses or for cancelling the options? The unvested options that lapse due to non-fulfillment of the vesting conditions, in accordance with the terms of grant, do not require passing of a Board Resolution.

Tax

34. What is the taxation of ESOP in India on an employee? ESOPs in India are taxed in the hands of the employee at two instances. First, at the time of exercise as Perquisite that is the difference between the Fair Market Value of the Shares at that time and the exercise price paid for it. Secondly, the capital gain arising of the sale of shares received on exercise of the options is taxable as per the period of holding of the shares.35. At what time does liability to deduct TDS arise on perquisite income arising from ESOP exercise? The Company has a liability to deduct TDS from the salary of the employee earned during the month in which allotment/transfer of shares is made to the employee, at the applicable rate of tax on which TDS under the head salary is deducted.36. ESOPs do not require any cash outlay; will such non-cash compensation cost allowed as tax deductible expenditure? Yes. The ESOP Discount that is recognized as Compensation Cost by the Company is an ascertained expense and is tax deductible expenditure u/s 37 of the Income Tax Act, 1961. The meaning of the term expenditure u/s 37 does includes not only paying out but also incurring the expense and could also encompass loss, even though no amount is actually paid.37. What is the timing and quantum of deduction of ESOP expense available under Income Tax? The Liability towards ESOP expense is incurred during vesting period; hence it is deductible over the vesting period on straight line basis. However, the actual amount of ESOP cost is determined only at the time of exercise of Option; such options may also be unvested or unexercised or lapsed, accordingly a suitable upward or downward adjustment of cost in relation to actual fair market value of shares need to be made at such time.

Insider Trading Law

38. Which price is to be considered for seeing the requirement of 10 lakhs disclosure under SEBI (PIT) Regulations- Is it ‘the market price of the Equity share as on the date of exercise’ or ‘exercise price’? The market price at the time of exercise is considered for making requisite disclosure of trade under the SEBI (PIT) Regulations.

Valuation & Accounting

39. What is the timing for seeking valuation- is it at grant or at exercise? For the purpose of accounting, -valuation is required to determine the intrinsic value/ fair value (as the case may be) of the Stock Options at the date of grant of the options. So, the Company must seek a valuation on the grant date to record the cost of the stock options in its books of accounts. Further, for the purpose of determining income and taxes in accordance with the requirement of the tax laws, an Unlisted Company needs to determine the fair market value of the shares at the time of exercise so it needs to seek a valuation of its shares on the exercise date. The price of shares of a Listed Company is known from the price quoted on the Stock Exchange, so the valuation of shares for taxation purpose is not required by it. Thus, an Unlisted Company must get valuation both at the time of grant of the options and the exercise of the options. However, a Listed Company needs valuation only for accounting purpose at the time of grant of the options.40. When does the compensation cost need to be booked for ESOP accounting- at grant date or vesting date? The value of the Stock Options granted is a compensation cost of the employees that needs to be booked for ESOP accounting. Since this cost is incurred by the company over the vesting period, the estimated cost is measured on grant date and is booked systematically over the vesting period.41. Whether valuation is also needed at the end of every financial year for the purpose of ESOP accounting? In case of equity settled grant, the compensation cost is determined by measuring the value of stock options at the grant date which is recognized systematically over the vesting period. There is no requirement to re-measure and revise the value at the end of each financial year; hence, there is no need to get annual valuation done.42. Whether valuation of ESOP needs to be done by a Merchant Banker or can it be done by a Registered Valuer or Chartered Accountant? For the purpose of recognizing compensation cost in the books of Accounts, the valuation may be procured from a Registered Valuer or Chartered Accountant but for the purpose of Income Tax the valuation report of a Merchant Banker is required.

: Employee Stock Option Plans (ESOP) – Frequently Asked Questions

Is 1% equity in a startup good?

Attorney Mary Russell counsels individuals on startup equity, including:

Compensation Counsel on Job Offers Legal Counsel on Job Offers Legal Counsel on Other Equity Choices

You are welcome to contact her at (650) 326-3412 or at [email protected], Originally published February 12, 2014. Updated April 6, 2017, August 7, 2019 and November 7, 2022. “Hey baby, what’s your employee number?” A low employee number at a famous startup is a sign of great riches.

But you can’t start today and be Employee #1 at Stripe, SpaceX, or one of the other most valuable startups on Earth, Instead you’ll have to join an early-stage startup, negotiate a great equity package and hope for the company’s success. This post walks through the negotiation issues in joining a pre-Series A / seed-funded / very-early-stage startup.

Q: Isn’t it a sure thing? They have funding! No. Raising small amounts from seed stage investors or friends and family is not the same sign of success and value as a multi-million dollar Series A funding by venture capitalists. Here’s an illustration from Dustin Moskovitz’s presentation, Why to Start a Startup from Y Combinator’s Startup School on the chances so “making it” for a startup that has already raised seed funding,

Q: How many shares should I get? Don’t think in terms of number of shares or the valuation of shares when you join an early-stage startup. Think of yourself as a late-stage founder and negotiate for a specific percentage ownership in the company. You should base this percentage on your anticipated contribution to the company’s growth in value.

Early-stage companies expect to dramatically increase in value between founding and Series A. For example, a common pre-money valuation at a VC financing is $8 million. And no company can become an $8 million company without a great team. Imagine, for instance, that the company tries to sell you on the offer by insisting that they will someday be worth $1B and, therefore, your equity worth, say, $1M.

The obvious question would be: Does it feel fair to you to make a significant contribution to the creation of $1B in value in exchange for $1M? For most people, the answer would be “no.” Or, consider that the company is insisting that an offer of 1% is “worth” $1M because the company expects to raise a Series A – based in part on your efforts – at a $100M pre-money valuation.

Leaving aside the wisdom (or lack thereof) of evaluating the offer based on its future value, you would want to ask yourself: Does it feel fair to you to make a significant contribution to the creation of $100M in value in exchange for $1M in equity (which would presumably be only partially vested as of the Series A)? That would depend, of course, on how significant your contribution would be.

And it would depend on the salary component of the offer. If the cash compensation is already close to market level, that might seem more than fair. If the cash offer is a fraction of your opportunity cost, you would be investing that opportunity cost to earn the equity. The potential upside would need to be great enough to balance the risk of that investment,

Q: How should early-stage startups calculate my percentage ownership? You’ll be negotiating your equity as a percentage of the company’s “Fully Diluted Capital.” Fully Diluted Capital = the number of shares issued to founders (“Founder Stock”) + the number of shares reserved for employees (“Employee Pool”) + the number of shares issued to other investors (“preferred shares”).

There may also be warrants outstanding, which should also be included. Your Number of Shares / Fully Diluted Capital = Your Percentage Ownership. Careful, though, because most startups do not issue preferred stock when they take their seed investment funds from their seed investors. Instead, they issue convertible notes or SAFEs.

These convert into shares of preferred stock in the next round of funding. So if you negotiate for 1% of a seed stage startup funded with notes or SAFEs, the fully diluted capital number used as the denominator of that calculation does not include the shares to be issued for those seed funds.

How can you address this? First, make sure you know what’s included.
You can ask: How many shares are outstanding on a fully diluted basis? Does this include the full option pool? Are there any shares yet to be issued for investments in the company, such as on SAFEs or convertible notes? How many shares do you expect to issue upon their conversion? If you are comparing your offer to other seed stage offers or to market data for seed stage offers, you would want to take that into consideration.

The number the company provides is only an estimate, of course, but it’s a way to address this in your evaluation. Q: Is 1% the standard equity offer? 1% may make sense for a key employee joining after a Series A financing, but do not make the mistake of thinking that an early-stage employee is the same as a post-Series A employee.

First, your ownership percentage will be significantly diluted at the Series A financing.
When the Series A VC buys approximately 20% of the company, you will own approximately 20% less of the company.
Second, there is a huge risk that the company will never raise a VC financing or survive past the seed stage.

According to CB Insights, about 39.4% of companies with legitimate seed funding go on to raise follow-on financing. And the number is far lower for seed deals in which big name VCs are not participating. Don’t be fooled by promises that the company is “raising money” or “about to close a financing.” Founders are notoriously delusional about these matters.

If they haven’t closed the deal and put millions of dollars in the bank, the risk is high that the company will run out of money and no longer be able to pay you a salary. Since your risk is higher than a post-Series A employee, your equity percentage should be higher as well. Q: Is there anything tricky I should look out for in my stock documents? Yes.

Look for repurchase rights for vested shares, If so, you may forfeit your vested shares if you leave the company for any reason prior to an acquisition or IPO. In other words, you have infinite vesting as you don’t really own the shares even after they vest.

This can be called “vested share repurchase rights,” “clawbacks,” “non-competition restrictions on equity,” or even ” evil ” or ” vampire capitalism,” Most employees who will be subject to this don’t know about it until they are leaving the company (either willingly or after being fired) or waiting to get paid out in a merger that is never going to pay them out.

That means they have been working to earn equity that does not have the value they think it does while they could have been working somewhere else for real equity. According to equity expert Bruce Brumberg, “You must read your whole grant agreement and understand all of its terms, even if you have little ability to negotiate changes.

In addition, do not ignore new grant agreements on the assumption that these are always going to be the same.” When you are exchanging some form of cash compensation or making some other investment such as time for the equity, it makes sense to have an attorney review the documents before committing to the investment,

Q: What is fair for vesting? The standard vesting is monthly vesting over four years with a one year cliff. This means that you earn 1/4 of the shares after one year and 1/48 of the shares every month thereafter. But vesting should make sense. If your role at the company is not expected to extend for four years, consider negotiating for a vesting schedule that matches that expectation.

Q: Should I agree to milestone or performance metrics for my vesting schedule? No.
This is a double risk.
Not only is there a high risk that the company will not be successful (and the equity worthless), there is a high risk that the milestones will not be met.
This is very often outside the control of the employee or even the founders.

More on this issue here, The standard is four-year vesting with a one-year cliff. Anything else is off-market and is a sign that the founders are trying to be too creative and reinvent the wheel. Q: Should I have protection for my unvested shares in the event of an acquisition? Yes.

When you negotiate for an equity package in anticipation of a valuable exit, you would hope that you would have the opportunity to earn the full number of shares in the offer so long as you are willing to stay through the vesting schedule.
If you do not have protection for your unvested shares in the stock documents, unvested shares may be cancelled at the time of an acquisition,

I call this a “Cancellation Plan.” Executives and key hires negotiate for “double trigger acceleration upon change of control.” This protects the right to earn the full block of shares, as the shares would immediately become vested if both of the following are met: (1st trigger) an acquisition occurs before the award is fully vested; and (2nd trigger) the employee is terminated after closing before they are fully vested.

There’s plenty of variation in the fine print of double trigger clauses, though. Learn more here, Q: The company says they will decide the exercise price of my stock options. Can I negotiate that? A well-advised company will set the exercise price at the fair market value (“FMV”) on the date the board grants the options to you.

This price is not negotiable, but to protect your interests you want to be sure that they grant you the options ASAP. Let the company know that this is important to you and follow up on it after you start. If they delay granting you the options until after a financing or other important event, the FMV and the exercise price will go up.

This would reduce the value of your stock options.
Early-stage startups very commonly delay making grants.
They shrug this off as due to “bandwidth” or other nonsense.
But it is really just carelessness about giving their employees what they have been promised.
The timing and, therefore, price of grants does not matter much if the company is a failure.

But if the company has great success within its first years, it is a huge problem for individual employees. I have seen individuals stuck with exercise prices in the hundreds of thousands of dollars when they were promised exercise prices in the hundreds of dollars.

Q: What salary can I negotiate as an early-stage employee? When you join an early-stage startup, you may have to accept a below market salary.
But a startup is not a non-profit.
You should be up to market salary as soon as the company raises real money.
And you should be rewarded for any loss of salary (and the risk that you will be earning $0 salary in a few months if the company does not raise money) in a significant equity award when you join the company.

When you join the company, you may want to come to agreement on your market rate and agree that you will receive a raise to that amount at the time of the financing. I sometimes see people ask at hire to receive a bonus at the time of the financing to make up for working at below-market rates in the early stages.

This is a gamble, of course, because only a small percent of seed-stage startups would ever make it to Series A and be able to pay that bonus. Therefore, it makes far more sense to negotiate for a substantial equity offer instead. Q: What form of equity should I receive? What are the tax consequences of the form? These are the most tax advantaged forms of equity compensation for an early-stage employee in order of best to worst: 1.

Restricted Stock. You buy the shares for their fair market value at the date of grant and file an 83(b) election with the IRS within 30 days. Since you own the shares, your capital gains holding period begins immediately. You avoid being taxed when you receive the stock and avoid ordinary income tax rates at sale of stock.

But you take the risk that the stock will become worthless or will be worth less than the price you paid to buy it.1. Non-Qualified Stock Options (Immediately Early Exercised). You early exercise the stock options immediately and file an 83(b) election with the IRS within 30 days. There is no spread between the fair market value of the stock and the exercise price of the options, so you avoid any taxes (even AMT) at exercise.

You immediately own the shares (subject to vesting), so you avoid ordinary income tax rates at sale of stock and your capital gains holding period begins immediately. But you take the investment risk that the stock will become worthless or will be worth less than the price you paid to exercise it.3.

Incentive Stock Options (“ISOs”): You will not be taxed when the options are granted, and you will not have ordinary income when you exercise your options. However, you may have to pay Alternative Minimum Tax (“AMT”) when you exercise your options on the spread between the fair market value (“FMV”) on the date of exercise and the exercise price.

You will also get capital gains treatment when you sell the stock so long as you sell your stock at least (1) one year after exercise AND (2) two years after the ISOs are granted. Q: Who will guide me if I have more questions? Attorney Mary Russell counsels individuals on startup equity, including:

Compensation Counsel on Job Offers Legal Counsel on Job Offers Legal Counsel on Other Equity Choices

You are welcome to contact her at (650) 326-3412 or at [email protected],

What should be the ESOP pool?

Step by Step Guide to ESOP in India – Muds Management A dedicated team is essential for any business, large or small. An ESOP pool is made up of equity shares earmarked for workers of a private firm. It is a method of enticing bright individuals to a startup; if the employees assist the firm in becoming profitable enough to go public, they will be paid with shares.

Those that join the firm early typically have a larger pool of options than employees who join later.
Founders use ESOPs to bring employees closer to the company goal and develop a sense of ownership and trust across the ranks.
Employees contribute years of experience to early-stage firms, take a risk by joining the company at a time where it has not achieved product-market fit, and help it realise its near-term goals and long-term vision.

Growth-stage firms may still be able to match regular market wages, but early-stage firms cannot. Thus they provide ‘delayed profit-sharing instead of, These equity shares are given to employees when they join or during their employment (depending on how important the person is to the organization’s success).

What is the ESOP 5 year distribution threshold?

ESOP 5-Year Distribution Threshold – $1,230,000. ESOP Additional Year Threshold – $245,000.

What are my rights as an ESOP employee?

Voting Rights –

Employees maintain their voting rights in an ESOP merger. In both private and public companies, employees retain the ability to direct the trustee regarding the voting of all allocated shares in a merger. This means that the employees have a say regarding the shares which have been allocated to them by the plan. If their shares will be affected by the merger, the employees retain the ability to vote in favor of or against the proposed action. Employees do not have the ability to vote in actions regarding non-allocated shares, or shares that have not been given out in the ESOP.

How long is ESOP vesting period?

There is no ‘standard’ ESOP vesting period. It varies from as little as 12 months to 3 years and even beyond that.

Is ESOP really worth it?

It’s only been five months into this year, but Indian startup employees have made more than $159 Million in ESOP buybacks. That’s nearly ₹1200 Cr. – around ₹1.2 Cr. per employee on average if we assume as many as 1000 employees participated in the buyback.

This is the kind of number that can make anyone looking from outside get tempted and immediately want to jump the startup bandwagon for one of its best-fabled perks – wealth creation through equity.
But is it that easy? You join a startup, get ESOPs, and basically want to get rich quickly? Not really.

Most people find ESOPs complicated with all their legalese, clauses, and documentation, and many professionals prefer not to take ESOPs at all in favour of a higher cash component in their salaries because they aren’t entirely convinced of the long-term value of the company’s shares.

What is the difference between an ESOP and a 401k?

ESOP vs.401k: As a Qualified Retirement Plan – It is important for business owners to consider the value of the ESOP vs, 401k plans as a qualified retirement plan. While the ESOP and the 401k are both qualified retirement plans, the 401k is funded by the employee and sometimes matched by the employer, whereas ESOPs are funded exclusively with contributions of company stock.

This unique difference is what makes ESOPs a great option for employees.
Why? Because many younger or lower wage and income employees cannot afford to make regular payroll deferrals to a 401k.
What’s more, many others simply choose not to.
In fact, only two-thirds to three-quarters of eligible employees elect to defer a portion of their salary to their 401k.

This makes the ESOP both a powerful recruiting tool for employers and a meaningful retirement benefit for the employees—one that the employees pay nothing for!

What does ESOP mean to employees?

An employee stock ownership plan (ESOP) is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan.