Attracting and retaining good employees is a crucial task for the company. Therefore, the company comes up with different compensation plans to retain its employees. One of these compensation plans is the ESOP plan. While hiring employees, the company enters into an ESOP agreement with the employee.
In this article, we will discuss ESOPs, the procedure for issuing ESOPs, the documents required, and the essential clauses in the ESOP agreement.
What is ESOP?
Employee Stock Ownership Plan is a kind of benefit plan that encourages the employee to stay with the company and give a high-level performance. In this plan, the company provides a certain amount of shares to the key employees at less than fair market value until the vesting period. The employee can exercise his right to option after the vesting period. ESOPs are beneficial for both the employer as well as the employee.
Let us now discuss the procedure for issuing ESOPs
The procedure of issuing ESOP
There are three stages of an ESOP plan:
1) Grant Date: It is a date when the eligible employees are issued the share options.
2) Vesting Period: It is a date when the employee becomes eligible to exercise the option. This period is counted from the grant date till the time the option becomes vested. The employee is given the right to apply for the company’s shares according to the rules laid down in the ESOP plan. The vesting period depends on the target or milestone to be achieved, duration or performance of the employee.
3) Exercise of Option: After the vesting period or once the milestone is achieved, the option becomes vested, i.e., the employee has the right to exercise the option. When the employee exercises their option it is called exercise date. Once the employee exercises his option, the company allots the shares to the employee.
What are the documents required in an ESOP agreement?
- Employment Agreement
- ESOP Plan
- Trust Deed (if any)
- Letter of the grant of options
- Letter of acceptance by the employee
What are the essential clauses in an ESOP Agreement?
Before signing any agreement, one should thoroughly check the agreement to know their rights and liabilities, terms and conditions. We will now discuss the essential clauses in an ESOP agreement.
Following are the essential clauses under the ESOP agreement:
This clause gives the details about the ESOP plan, such as attracting and retaining the key employees, rewarding ownership to the employee in proportion to their contribution, encouraging employees to align their performance with the company’s objectives.
2) Quantum of Shares
This clause states the maximum number of shares subject to the option and how they will be authorized when the option can be exercised when it expires, and what happens if it expires.
3) Power of Administrator
The role of the administrator is crucial in the ESOP plan, as the administrator administers the ESOP plan in accordance with the ESOP plan. Therefore, the administrator’s power should be laid down, such as; determining the exercise price, vesting period, exercise period, and the number of shares subject to the option, prescribing, amending, and revoking any plan’s terms and conditions, etc.
This clause states the minimum and maximum vesting period of an option from the date of grant of an option. During the vesting period, the employee can exercise its option.
5) Exercise Period
The exercise period is when the employee can exercise his right to apply for shares against an option vested according to the agreement.
6) Bonus Share
All the vested but not exercised options plus the price per share included in such an outstanding option are counted as bonus shares.
7) Non- Transferability of options
The options that are granted to the eligible employees cannot be sold, assigned, hypothecated, pledged, disposed of, or transferred to another person except where the employee dies while in employment. The option shall vest in the legal heirs or nominees.
8) Right of First Refusal
This clause talks about how the shareholder can sell or transfer the shares to a third party. The shareholder should first offer their share to the company’s founders/existing shareholders as they have the right of first refusal. In case they refuse to purchase within a particular period, then the employee is free to sell the shares to any third party. However, such transfer of shares shall be restricted to certain conditions as the company may put forth.
9) Right of First Offer
This clause gives privilege to the eligible employee when the company wishes to sell its shares. So, whenever the company wants to sell its shares, it will first offer such shares to its key employees.
10) Drag along rights
This clause protects the shareholders from making their investment worthless. For example, suppose the company is not doing well and merges or get dissolved or liquidated. Then, when the company sells their shares to the other company, the majority shareholders can use their drag-along right and compel other investors and employees to sell their shares at the agreed price.
11) Intellectual Property Rights Ownership
Firstly, what constitutes “Intellectual Property” should be defined broadly. Next, this clause should mention that the company will have ownership over the work done or services rendered by the employee during the term of employment. And that the employee will disclose all the works, discoveries, designs, formulae, processes, technical information, know-how, and all other data related to the work or services rendered to the company. It should further state how all the materials furnished or used during the employment should be returned to the company before termination of this agreement.
This clause will lay down what constitutes “Confidential Information”, whether a computer program, inventions, designs, machines, methods, object code, source code, technical information, know-how, etc. This confidential information should not be disclosed by the employee to any other person, either directly or indirectly. This clause should also state what are the consequences of breach of confidentiality.
This clause restricts the employee from engaging in any business or activity that is similar or in competition with the company’s business for a particular number of years after termination.
14) Anti Dilution
When the company issues additional shares at a less than fair market value, the existing shareholders have a right to acquire shares at the price at which such share was infused. This clause state how the issue of additional shares shall be adjusted with the total paid-up equity capital of the company before the equity is infused.
15) Accelerated Vesting
Accelerated vesting means to shorten the period of vesting for the employees to gain access to their shares at an early period on fulfilment of certain conditions. This encourages the employee to give their high-level performance and remain with the company for a longer period. Accelerated vesting is exercised when the company is undergoing acquisition or IPO and the employee is terminated under such acquisition.
16) Tax Liability
ESOPs are not taxable until the employee exercises his right to option. This clause states that the employee shall pay tax when the employee purchases or disposes of the shares.
ESOP is the options given to the key employees to purchase the company’s shares at a predetermined price at the vesting period to fulfil certain conditions. The employee enters into the ESOP agreement at the time of joining the company. Before signing the ESOP agreement, one should look into the essential clauses of the agreement.