We are pretty familiar with Employee Stock Option Plan (ESOP) and Employee Stock Purchase Scheme (ESPS) as an employee benefit plan and employee retention tool. They are attractive in listed companies, primarily because of easy trade-ability and established market price.

How about start-ups and unlisted companies? Are stock options attractive enough? Or is it shares vs. stock options? Let’s examine the different kinds of stock options, before trying to answer this question.

Incentive Stock Option (ISO) is issued to key employees like CEO. To illustrate, a CEO, to improve performance, is offered an option of buying 10,000 shares, two years later, at a price of Rs.200/- while the current market price is Rs.100/-. In an ISO, the exercise price (Rs. 200) must be equal to or greater than the current market price. If the price reaches Rs.200, then the CEO makes a cool Rs. 5 lakhs.

Employee Stock Purchase (ESP) is issued to all employees at a price that is atleast 85% of the current market price or more. Generally, 15% is left on the table for the employees.

Stock Appreciation Rights (SAR) also known as shadow / phantom option. In this case it is a notional transaction, as in, employee gets an amount equivalent to the appreciation in stocks granted under ESOP, without shares being exchanged. (Practised widely by multi-national companies in India)

Staggered options, available to employees over a period of time.

Stock Option is a right given by the company to its employees to obtain shares of the company, by exercising the Option. An Option is granted to an employee and over a period of time, ‘vesting period’, it is exercised for a share. It is only after the Option becomes a share, does the holder get ownership rights. Hence, it is a tool wherein, the employee has to ‘earn’ ownership over a time period.

With the new Fringe Benefit Tax (FBT) regulations, ESOPS are classified as fringe benefits and taxed not only at the time of sale but also at the time of allotment or transfer of shares. The company is liable to pay FBT on benefits arising from Stock Options at the time of allotment or transfer of shares, as against the earlier scenario where the tax liability was on the employee alone.

In early stage start-ups, I believe that shares are more attractive than Options. I agree that shares can be shared only with a select few. But please consider the below points:

Valuation at the time of exercising the Options is an issue. The valuation methodology, to many, seems like a black box. Also, added is the cost of the fees for valuation and then there is the FBT.

In Stock Options, an employee has to pay, ‘exercise price’, for exercising the option granted. Whereas, sweat equity can be issued for consideration other than cash (Example, for providing know-how, intellectual property …)

If the start-up falls apart, then a shareholder gets his revenue share of the assets sold. But an Option holder gets nothing L

If the start-up has received VC funding, then probably valuation might be a bit more transparent and Options might be a better choice. There would be dilution of the Promoter/s holding in either case of issuance of shares or Options.

The trade-ability factor, I guess, remains the same for both shareholder and the option-holder in an unlisted company.

My thoughts. Yours?

Please leave your questions in the comments section.

Sharda Balaji

Legal Counsel and Corporate Secretary.

Novojuris Services India Pvt. Ltd.

Email: sharda at novojuris.com

Disclaimer: This article is for informational purposes only and is intended but not promised or guaranteed to be correct, complete and up-to-date. This is not a legal advice or opinion.

ESOP means the option given to employees (Directors, permanent employees) which give the employees, the benefit to purchase or subscribe at a future date, the shares offered by the company at a pre-determined price.

ESPS means a scheme under which the company offers shares to employees as part of a public issue or otherwise.

FBT is a tax on benefits that employees receive from their employers as a result of their employment.

Employee (per SEBI guidelines) includes Director, permanent employee including part-time employee. Excludes promoter or relative of promoter.

Tags: Legal Advice to startups