ESOP: An Incentive Tool For Startup Founders

Since the last few years, India has witnessed an immense wave of entrepreneurship by virtue of which numerous startup founders have gained recognition and fame which led them to be the front runners of their own ventures. However, most of these startups are bootstrapped and therefore, attracting and retaining good talent is a huge challenge. In such situations, Employee Stock Option Plan (“ESOPs”), acts as a great catalyst through which such entities can hire and keep resources engaged with the vision of the company. To briefly understand what ESOPs are, these are a form of employee benefit plan intended for employees to gain ownership in the company over a period. As the startup grows and the investors step in, the founders who initially chose to work without salaries, start feeling the crunch and require additional support to supplement the amount of time and effort they are investing to grow the business. At times, the situation is such that post raising multiple rounds of investment, the founder’s/co-founder’s shareholding is drastically reduced, and in such situations, the investors look at incentives such as ESOPs to keep the founder’s/co-founder’s skin in the game. However, the Companies Act, 2013 does not allow grant of ESOPs to promoters/founders/co-founders of a company. So, are there any exemptions available to founders/co-founders or promoters working in a startup when it comes to the grant of ESOPs? 

In this article, we will delve into the concept of grant of ESOPs to promoters and will discuss the possible trends observed in the startup arena while undertaking the same. 

Grant of ESOPs under the Companies Act, 2013

Generally, ESOPs have become a widespread and the most effective tool opted by several organizations to acknowledge and reward the employees for their efforts by making them key stakeholders of the organization. However, as profound as it sounds, issuing ESOPs to promoters comes with its own set of limitations. At the outset, the Companies Act, 2013 prohibits the grant of ESOPs to promoters as they are explicitly excluded from the definition of an ‘employee’. This restriction is enumerated under Rule 12 (i) explanation of the Companies (Share Capital and Debentures) Rules, 2014 (“Share Capital Rules”) (relevant extract reproduced below):

“Employee” means-

(a) ……

(b) ……

(c) an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company but does not include-

(i) an employee who is a promoter or a person belonging to the promoter group; or

(ii) a director who either himself or through his relative or through anybody corporate, directly, or indirectly, holds more than ten percent of the outstanding equity shares of the company.”

However, the said prohibition is not applicable to startups registered with the Department for Promotion of Industry and Internal Trade (“DPIIT”), but why? 

Reasons for creating this exception

Startups are mushrooming at a fast pace in the economy but as the name suggests, it is still in the preliminary stage of growing wherein, the funds are not in surplus to effectively carry out the business operations. However, in light of the challenges faced by a startup company in terms of operational expenses, minimal capital, valuation concerns and the restriction existing under the Companies Act, 2013, the Companies Law Committee (“Committee”) was formulated to address the aforementioned concerns. The Committee was formed with the mandate to make recommendations on issues arising from the implementation of the Companies Act, 2013 and study the recommendations suggested from various stakeholders. Furthermore, the Committee in its February 2016 report recommended that in order to encourage startups, this restriction imposed under the Companies Act, 2013 may be relaxed to enable issuance of ESOPs to promoters who may be working as employees or employee directors or whole-time directors which would help the promoters to gain from increase in future valuation of the company without in any way impacting finances of the company during its initial years. 

As a result, the Committee recommended certain changes specifically for encouraging and to create a positive environment for start-ups such as allowing start-ups to raise deposits for its initial 5 (five) years without any upper limits, allowing startups to issue ESOPs to promoters working as employees etc. Accordingly, proviso to Rule 12 of the Share Capital Rules was carved out as an exception to a startup company registered with the DPIIT wherein, the conditions mentioned in sub-clauses (i) and (ii) of explanation to Rule 12 (i) of the Share Capital Rules will not be applicable to a startup company up to 10 (ten) years from the date of its incorporation or registration. 

Further, as per DPIIT notification dated February 19, 2019, an entity shall cease to be a startup and the exemption granted to a startup in relation to ESOPs shall cease to exist in the following events:

• on completion of 10 (ten) years from the date of its incorporation/registration; or
• turnover for any previous year exceeds 100 (one hundred) crore rupees.

Grant of ESOPs to Promoters in a Startup

• Grant of ESOPs to promoters is an incentive at an early stage of their business wherein, they can decide to draw less salary and contribute more cash towards the growth of their venture so that eventually, the market valuation of the company increases, and the promoters can reap the benefits under the ESOP plan while working in the capacity of an employee or employee director or whole-time director.

• As the company grows and raises multiple rounds of investments which eventually leads to founder’s diluting their controlling stake to such an extent that they end up holding stakes in single digits approximately ranging from 5% (five percent) to 9% (nine percent) in the company. Due to dilution of their majority stake, usually the promoters tend to lose interest to work towards the growth of the company. Therefore, to keep the promoters incentivized and motivated in the long run despite such dilution, the investors and the management of the company tend to offer additional stakes to the promoters by way of ESOPs to boost their holdings and drive them to scale up their ventures for a longer term. In fact, in 2021 certain companies who were going for IPO’s granted ESOPs to their promoters/founders to keep their skin in the game so that they don’t leave the company soon after listing of the stock.

Grant of ESOPs: Tool to attract Co-founders 

In addition to the above aspects, one needs to also consider that from an early stage, the founder along with a small team of individuals work towards building a business. On raising further rounds of investment, the founder expands its business by hiring more manpower and skilled individuals, this may include onboarding a co-founder (depending upon the skill set) at a later stage if the company is a registered startup as otherwise, a co-founder may be categorized in the promoter group and therefore, not be eligible to get ESOPs. Even though, promoter may not be able to offer a substantial ownership stake to the co-founder, but he/she can attract such a co-founder by way of granting ESOPs. Onboarding a co-founder also reflects a positive approach in the eyes of the investor wherein, it portrays that the founder is willing to not only grow his/her business in terms of profits but also build a strong foundation basis the people who share the same vision or may be useful in terms of future growth of the startup. 

Conclusion

The exemptions given to startup companies to grant ESOPs to promoters is a progressive step undertaken by the Government of India towards creating a prosperous investment market and boost the Indian economy. The grant of ESOPs to promoters is beneficial from an investor’s point of view to motivate the promoters to consistently work hard towards the growth of the company despite, diluting their controlling stake in the company. In return, grant of ESOPs to promoters benefits them monetarily as well as retains their value in the startup. Also, from a promoter’s perspective, granting of ESOPs can be construed as a valuable tool with respect to onboarding a co-founder at a later stage in the startup. 

It will be interesting to witness whether the relaxations and incentives with respect to grant of ESOPs to promoters are also extended otherwise under the Companies Act, 2013, to companies other than startups, probably with certain restrictions.