ESOPs in Private Limited Companies

Separation of ownership from management has been one of the principal foundations of corporate law. In this context, the idea of granting your employees stock options aims at bridging the gap between ownership and management, by giving the employees not just monetary compensation but also a sense of ownership through stock options.
There is significant literature on employee stock options (ESOPs) for public limited companies in India, but little has been written about how they can be used by private limited companies.
The issue of granting ESOPs acquires particular significance in the context of start-ups who do not offer significant compensation to their employees/ consultants but wish to offer ESOPs to retain talent and to also give them a sense of ownership and belonging. Set forth below is a summary of key issues to keep in mind while instituting an ESOP plan:
(a) Legal requirements: There are no specific guidelines/ rules or regulations under the Companies Act, 1956, that deal with employee stock option plans of a private limited company. Critical issues which arise in instituting an ESOP plan have been addressed below.
(b) Who can the options be granted to? While technically there is no prohibition to grant options to ‘promoters’ (persons who are in overall control of the company) they should ideally be excluded, because it is possible for them to get additional shares in the company through a preferential allotment. Similarly, there is no requirement that ESOPs should only be given to full time permanent employees of the company.
(c) What should be the ceiling for ESOP grants? There is no ceiling prescribed in law, however, a limit of 10-15% of the paid up capital is typically the market practice.
(d) Market price of the shares: Since in private limited companies, there is no market for the shares it is impossible to arrive at a valuation of the equity shares, unless they are valued by independent valuers, which exercise may itself be expensive. A possible solution is to use the book value of the shares.
(e) Disclosure requirements: A great step forward is the creation of an ESOP policy plan document and circulating the same to the employees. This increases transparency and creates trust among the employees in favour of the company. Typically plan documents contain details such as vesting schedule, lock-in requirements and eligibility.
(f) Enforcing the ESOP plan: While there is no one rule on who should institute the ESOP plan, ideally it should be enforced by persons who are not beneficiaries of the plan or are in no way interested in the results of the plan. Whilst, there are no independent directors in a private limited company, a possible solution is institution of the plan by independent trustees. If that however, becomes too cumbersome, then the Board of Directors could be responsible for the instituting the plan, provided that they are not beneficiaries of the plan.
Conclusion: As a start-up, ESOPs are probably on your mind as you consider bringing in the best talent to scale your business. While we have outlined the rules above which apply to you from a legal perspective, the most important rules when it comes to giving ESOPs are equity and fairness. As long as the plan you draft is fair, it is almost certain to get approved by the Court if, god forbid, a dispute should arise.
 
[About the author: Contributed by Hrishikesh Datar, founder of vakilsearch.com, online legal services provider (Legal Advice, Legal Documents & more.]
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