Can we delay the exercising of ESOPs?

Has the lure of stock options been at a huge cost for employees? All that glitters is certainly not gold and there is no better example than the potential realisation on employee equity. Some of us may know the story of Raghu Varma that YourStory published last year. Raghu worked for a startup for a few years at a CXO role, saw the company through a few rounds of funding and then moved out. He had a large chunk of ‘vested stock options’. He held on to these as he thought the valuation of the company would only go up and he wanted to take advantage of this at that time. He went to his old startup a couple of years after he quit and a few months before his options were to expire. The company lawyer met him and told him that he should have “exercised” his option when he quit as, according to the fine print in the contract, all stock options would expire after three months from the date of termination of employment.

The options, had Mr. Varma consulted his lawyer at the time of resignation, would have been to either pay an exorbitant rate to purchase the shares or lose his vested options. Further, had he purchased the shares, he may have had to pay a tax on the capital gains made from such purchase. This would have been a heavy price in the garb of salaries. What then could have been ideal alternatives for Raghu? Let’s explore the possibilities to exercise options when an employee resigns from a startup, typically a private unlisted company.

This article will not delve into the details of the basics of ESOPs as these have been well documented.

However, there are three basic terms to be acquainted with while dealing with the concept of employee stock options: granting, vesting and exercising. Vesting is the employee’s right to the options granted to him/her. Exercising refers to the actual conversion of the employee’s rights to owning the stock.

The law

The law to issue stock options for private limited companies is governed by Section 62 (1)(b) if the new Companies Act and by Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Only those shares that have vested may be exercised within the time period specified in the employee stock option scheme upon an employee’s resignation (or under any other circumstance). All options not vested in the event of a resignation or termination shall expire unless the board or the compensation committee provides that the options may be vested in an accelerated manner.

The scheme

The new Companies Act states that the exercising of vested stock options shall be subject to terms and conditions provided in the employee stock option scheme. The employee stock option scheme is the bible that is approved through an ordinary or special resolution (in the case of a private limited or public company respectively). This provides the detailed terms and conditions relating to the stock options, like the eligibility for stock options, general conditions upon which they terminate, the conditions relating to granting, vesting and exercising, and lays out the exercise period in pre-funding and post funding or pre-listing and post-listing scenarios.

Typical stock option schemes provide an average of three months upon an employee’s exit to exercise options that are vested in the employee else they risk losing the vested options. As a result, the employee would have to pay an ‘exercise price’ or a pre-determined price for the share, if he is interested in procuring the shares with the hope of seeing an upside some day in the future. That’s a huge risk.

Is it possible, therefore, for the ‘deserving’ employees to benefit at a later period of time?

Silicon Valley seems to be moving in the direction of offering flexible options to the employee who resigns. Some companies are providing an option to the ex-employee to sell a certain percentage of his stock each year (for liquidity) or by offering a lengthy period of 10 years to exercise the vested options, as in the case of Pinterest.

This trend is yet to emerge in India. Some of my industry colleagues would affirm this and quote the availability of a clean (read: hassle free) shareholding structure. So what is typical for a start-up is that the exiting employees convert and sell their shares to existing shareholders at an average of 20-25% discount. This way, neither does the exiting employee lose out nor does the investor as he gets his clean “cap table” (aka shareholding structure).

There are no laws in India that prohibit a lengthy exercising option and therefore solely based on the commercials. How and when Indian startups begin following the trail that their cousins in Silicon Valley have begun blazing is anybody’s guess.

This article first appeared on Yourstory.com and was authored by Harini Subramani.

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