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Photo: iStock
Photo: iStock

Esops don’t guarantee a bonanza

  • Stock options have the potential to create wealth but can be difficult to understand. It’s important to read the fine print carefully before opting for these
  • Employees should always keep a copy of the Esop contract and get it vetted by a lawyer, if required

As the businesses take a hit due to covid-19, some startups are using employee stock options (Esops) to compensate for the pay cuts and retain employees. In the past three months, many startups, including Oyo, Zomato and Grofers, have expanded their Esop pool. For employees, getting stocks seems like a good idea. As the valuations of the companies rise, so do the stock prices, rewarding the employees for their hard work. In theory, Esops can create wealth, but in practice, it doesn’t always turn out like that.

Esops can be difficult to understand and it is important to read the fine print. In the past, Esops became a bone of contention when companies such as RedBus and Techprocess were acquired.

“Many employees don’t pay attention to Esop contracts. They come on board with oral assurances and ignore the paperwork. When things go wrong, they realize they don’t have documents to prove what was promised," said Varsha Iyengar, partner, Arka Law, a Bengaluru-based legal firm. Some aren’t even aware that a contract needs be signed, she added.

We spoke to lawyers and consultants on the things that employees should keep in mind.

UNDERSTAND THE CONTRACT

Asking for the Esop contract upfront can give clarity on many aspects. The contract, typically, lays down the details of when Esops would be vested (available to purchase) and in what quantity.

“An employee can get a fixed number of stock options annually for a few years. For example, an employer can offer 25% of the promised quantity every year for four years. Also, the number of units can increase year-on-year," said Raj Ramachandran, partner, J Sagar Associates, a legal firm. The vesting period is spread over a few years for retention.

A lot of times, Esops are linked to performance. “The vesting conditions may require the employee to achieve a specific performance target. Such details must also be clearly discussed and agreed as it determines the quantum of benefit earned," said Mohini Varshneya, partner and head, Esop services, Corporate Professionals Capital Pvt. Ltd.

There’s one significant caveat that many unlisted companies include in the Esop contract. When an employee wants to sell the shares, the promoters will have the first right of refusal. In other words, an employee cannot sell the stocks to an outsider unless the promoters agree. In such a case, an employee must wait until the employer announces a buyback. According to lawyers, usually companies buy back the Esops when an employee quits.

Once the details are agreed upon, keep a copy of the contract. You can also get it checked by a lawyer to ensure it includes everything you wanted.

Mind the risks on the returns too. “Employees receiving Esops must also keep in mind the risk factors while setting expectations. The returns depend on the company’s market value in the future, which is uncertain. It also depends on the price, investors are willing to pay to acquire stocks of the company, which is highly subjective and varies at different stages of investment," Varshneya added.

LIQUIDITY EVENTS

If a company is going for an initial public offer (IPO), it’s easier to determine the share price, and it’s in the hands of the employees when they want to sell them. But in the case of acquisition or merger, the treatment of Esops depends on the deal that promoters, existing investors, and the acquiring company decides upon.

Employees can feel disgruntled if the exit price for the stocks offered is low or the acquiring company might acquire a part of the vested Esops for the continuing employee and choose not to buy back the vested options of past employees. If the acquirer doesn’t buy back stocks of former employees, there’s nothing much you can do. The stocks would be of no value. If the acquirer is only acquiring Esops partially, the continuing employees will need to wait for some more time until the firm goes for a buyback.

Although such events are uncertain, the employee may ask the employer to facilitate buyback, if the acquiring company does not provide an exit. “If it’s possible, an employee should try to put this condition in the contract," said Iyengar.

Lawyers caution that the terms and conditions of each deal may vary and it’s not possible for an employee to pre-empt all the events. It’s best for employees to understand that mergers and acquisitions may not offer a clear exit option like in the case of an IPO.

BE CAUTIOUS

Employees should always keep a copy of the contract and get it vetted by a lawyer, if required. There have been a few cases where the employees didn’t keep a copy of the contract and the founders changed the terms and conditions without their knowledge, according to lawyers.

In case of any disputes between the employee and promoters, pertaining stock options, they need to file a civil suit to seek relief. Some companies also provide an arbitration mechanism to resolve Esops-related disputes.

When opting for Esops, ensure that the paperwork is in place. Also, remember that they may not necessarily result into a windfall in the future.

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