ESOP’s Fables: Getting the story right

At 70, when Ashok Soota decided to start over again as an entrepreneur, having worked in fabled wealth creation companies like Wipro Limited and Mindtree Limited, he had some ideas. Specifically around granting stock options to employees. With Happiest Minds Technologies (started in 2011), an IT consulting and services company, he envisioned a venture where employees were committed to building it up right until the Initial Public Offering (IPO).

What are the Employee Stock Options Plans?

“In the previous company (Mindtree) we realized that you issue Employee Stock Options Plans (ESOPs) to employees and they walk away. That way you lose both the shares and the talent. You might not have enough stocks to allocate to a new hire who will replace this person,” says Raja Shanmugam, chief people officer at Happiest Minds who worked with Soota in Mindtree. From being the chief executive officer at the non-profit arm, Mindtree Foundation, Happiest Minds is Shanmugam’s first stint as a CPO.

He says that the company made it clear to its employees from day one that it will go public in the next seven years. In case an employee wants to walk away before that, she has to sell her vested shares back to the company and can benefit from the appreciation in share price during her employment. The grant letter also says that failing an IPO in seven years, employees can retain vested shares in the company until it goes public, as a reward for contributing to the growth of the organization.

This is just one of the ways in which a grant letter for ESOP can be framed with necessary details to safeguard the interests of the company.

ESOP structures in the Indian startup ecosystem are often an afterthought as founders are focused on making the core product market-ready. Structured plans for employee stock options are brought to the table usually by institutional investors when they come onboard. With Happiest Minds, which raised $45 million from external investors within months of inception, the funding set the pace.

Private companies in India, however, can go on till Series B round without a clear ESOP structure in place. In that period, which could be anywhere from two to five years since the inception of the company, founders end up overlooking key issues in ESOP distribution.

Different strokes of ESOP

According to tax and law experts, the stringent laws under the Companies Act make the Indian ESOP structure far more complicated than those in the US or Singapore, and so, these countries are preferred by large companies for registration. For example, rewarding founders and promoters with ESOPs is common in these countries but Indian laws forbid issuing ESOPs to promoters or anyone holding more than 10% equity in the company.

This can be circumvented easily by companies registered outside India. According to Paper.vc data, Kavin Mittal, founder of messaging app Hike, was issued differentiated Class A ESOP shares which carry 10 weighted voting rights per share in 2016. Other employees in the company were issued Class B ESOPs which carry weighted voting rights of 1 per share.

A long-term view of the company’s exit strategy and attention to the optional clause in the grant letters is all it takes for founders to create a structure beneficial to both the company and its employees in the long run.

The following checklist is recommended by tax and legal experts as well as the founders we spoke to:

  • Pledging 10-15% shares of the company as part of the ESOP pool. Too less would mean investors get diluted for subsequent rounds of funding
  • Ensuring that employee share options are protected in case of an acquisition
  • Visibility to the number of vested shares on request or openly in case of very large companies
  • Keeping a track of employees who have bought their vested shares and may or may not be a part of the company anymore. This ensures ease of bringing people together for a liquidity event such as an IPO or acquisition by a larger company or share buyback by the parent company
  • All this amounts to an empty exercise if there is no significant employee pool. An effective ESOP plan needs key hires and employee strength of close to 20
  • Failing these checks and balances, the company can expect zero commitment and often a bad reputation in the startup ecosystem.

 

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