The ESOP Buyback - Things you should know
ESOPs are widely used to attract talent. Lately, several startups announced ESOP buybacks to reward their employees.
In startups, founders and CHROs are responsible for ESOP creation and administration. So they must be aware of the terms in the ESOP scheme. Not understanding the terms often leads to problems later.
In this post, you'll learn terms related to ESOP that you must be aware of.
ESOP:
Employee stock option plan refers to an employee benefit plan under which a company grants stock options to its employees. Companies use ESOPs to attract and retain talent by allowing their employees to purchase shares of the Company at a price fixed on the date of grant.
ESOP Scheme:
It contains all the rules and terms based on which ESOPs are granted and exercised by employees. Note that in Singapore, options can also be granted to non employees.
ESOP Pool:
The employee stock options pool is the total number of shares reserved for the company's employees. It's part of the ESOP scheme document and approved by the shareholders. Typically, companies set aside 10-25% of equity for the ESOP pool. Phantom stocks or SARs are the best choice, where a Company wishes to offer employees with rewards that are based on merit or some other discretionary basis – the benefit being since they are given in cash for the shares and no ownership control is given to the employees, handling of these options becomes easy for the owners.
When a company adds more shares to the ESOP pool, it is known as expanding the pool. Companies typically broaden the pool to give more stock options to the existing employees or to make critical hires.
Stock Options:
Stock Options give employees the right (but no obligation) to purchase the shares of a company. Keep in mind that stock options are different from actual company stocks/shares. A stock (or share) gives the shareholder fractional ownership in a company and certain rights which are available only for the stakeholders. A stock option is converted into shares only after the employees purchase them.
Vesting:
Employees can't just purchase the options right away after joining the company. There is a certain period they have to work in the company after which they earn the right to buy the stocks. This prevents the employees from joining a company, purchasing stocks at a discounted rate and leaving the company
Otherwise, it defeats the purpose of ESOP as a mechanism to retain employees. Vesting distributes the number of shares that employees can purchase at a time, which they have been granted. If all the stock options vest in one go, employees can purchase 100% of the stocks. It's called cliff vesting. When these options vest in parts, it's called graded vesting.
Vesting can be based on time, performance or a combination of both.
Time-based vesting schedule: This is used to retain employees. In time-based vesting, employees get the right to purchase shares based on the time for which they work in the company. Generally, companies make the vesting frequency as monthly, quarterly, or annually.
Performance-based vesting schedules: It's used to boost employee morale to perform and create value for the company ensuring that employees are rewarded only if value is created for the company. In performance-based vesting, employees get the right to purchase based on achieving a predefined target.
When a company allows employees to get their options vested quickly and before the scheduled vesting period, it is known as accelerated vesting. It often happens during the time of merger or acquisition.
Exercise:
Exercising means purchasing the vested options. Employees can purchase their vested stock options from the company at a predefined price which is decided at the time of grant, called exercise price.
Grant Letter or Grant:
The document issued by the company while allocating stock options to employees. It contains all the terms and conditions related to ESOP. You can download the grant letter format for free here.
The following terms must be present in every grant letter:
Apart from ESOPs, companies also give SARs or RSUs to their employees as compensation benefits.
Stock Appreciation Rights (SAR):
Stock appreciation rights provide similar monetary benefits to employees as ESOPs but work differently. Instead of giving the right to purchase specific shares in a company, employees are given an amount equal to the appreciation in the value of the company over a specific period (i.e. difference between the market price on the date of vesting and strike price). This appreciation in value is then either settled in cash or shares.
You can learn more about SARs here.
Phantom Shares:
They work similar to SARs but the appreciation is settled in cash.
Restricted Stock Unit (RSU):
RSUs are deep discounted options usually given at the face value.
Note there is a major difference in how RSUs work in India and the US. In India, though the strike price is very low compared with the market price, employees still have to exercise the option by paying the face value of the share.
On the other hand, in the USA, RSUs are stocks that employees own as they vest. Employees don't need to purchase them. Unlike in India, it's a one-step process in the US, as there is no concept of exercising in RSUs.
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