ESOP Terms 101: The MUST Know Terms for Every Founder

Employee Stock Option Plans (ESOPs) are a novel way of compensating employees. They are highly suitable for a startup that prefers to conserve cash but rewards its employees well.

That being said, there is a lot that goes into the structure and operations of an ESOP. Therefore, a founder must be aware of basic ESOP terminology to plan and execute ESOPs smoothly.

We have simplified this task for you by creating this cheat sheet of ESOP terms, which you can peruse at any point.

ESOP Terminology that Founders Must Know

In India, ESOPs are regulated by the Companies Act, 2013 and Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. Companies can set up an ESOP either directly or through a trust.

According to the Companies Act 2013, an ESOP is defined as the option given to the directors, employees, or officers of the company or of its holding or subsidiary company, the right to purchase or benefit or subscribe for the shares of the company at a predetermined price on a future date. 

Basic ESOP terminology

These are ESOP terminologies you must be aware of:

1. Stock Option

A stock option gives the buyer a right, without an obligation, to purchase the shares of a company at a later date at a preset price.

As a result, employees can enjoy significant discounts on purchasing their employer’s shares via an Employee Stock Option Plan.

2. Scheme Document

The document outlining all the terms and conditions of the ESOP, particularly the eligibility, the percentage which can be exercised at each stage, and the strike price, is called the Scheme Document.

3. ESOP pool

The portion of a company’s equity allocated for ESOPs is called the ESOP pool.

Typically, it may lie between 10% and 15%, although early-stage startups may have a lower percentage. Therefore, a company must be careful while demarcating the equity.

Unsure of creating an ESOP policy? Click here to read the success story and suggestions of Guru On Tap Consulting for guidance and inspiration. 

ESOP Terminologies of Three Stages

ESOP terminology is categorized into three segments based on the different stages of an ESOP, as discussed below:

1. Grant

The first stage is a grant when the employee receives the options. Key ESOP terms in this stage are:

Grant Date: The date on which a company allows ESOPs to employees.

Exercise Price: Also known as strike price or grant price, this is the discounted price at which employees can purchase the company’s shares after the vesting period.

Expiry Date: The last date for employees to exercise their options, after which they will lapse.

These details have to be outlined in the grant letter. Here is a sample letter from trica equity.

2. Vesting

Vesting is the gestation period between the joining date of an employee and the date when s/he becomes eligible to purchase ESOPs.

A vesting period protects the employer by ensuring that employees who receive ESOPs are committed to the company.

In India, the minimum vesting period as per law is one year. This initial period is also called the cliff period, after which employees can begin to vest.

Once the cliff period is over, vesting does not happen in one go; it is distributed in a structured manner based on the types of vesting, as discussed below.

Time-based vesting 

After the initial cliff period, an employee can vest a fixed percentage of the total options s/he is eligible for annually. Sometimes this is further broken down into quarters or months as time progresses.

Project-based vesting 

Instead of time as the deciding factor for eligibility, the completion of specific projects is taken as the milestone based on which the eligibility for an employee to vest the options comes into place.

Hybrid vesting

This combines time and project-based vesting, bringing the best of both worlds together.

Accelerated vesting

It is known as accelerated vesting when a company permits its employees to vest their options before the agreed-upon vesting schedule (based on the three types discussed above). Typically, this happens during a merger or acquisition.

The number of vested options is that which employees can purchase, and the number of unvested options is that which are yet to become eligible. In case the employee leaves the organization, they get added back to the ESOP pool.

3. Exercise

Exercising is when employees purchase the shares based on their ESOPs.

Exercise period: The period during which employees can exercise their ESOPs and purchase shares, after which the options will lapse.

Exercise date: The date on which an individual employee chooses to exercise their option.

Spread: The difference between the fair market value of a share on the exercise date and the strike price is the spread or discount. This is essential to calculate the exercise tax, which determines the employee’s tax liability on exercising options.

ESOP terminology can be confusing and overwhelming. trica is here to simplify your work, streamline your policy and seamlessly execute the transactions on time. Click here to know how we can help.