June 17, 2020

ESOP Glossary: Breaking down the ESOP jargon

Because we are all about that zen.

ESOP Glossary: Breaking down the ESOP jargon

All the jargon around stocks creates complications that takes the joy out of ESOPs.

And as Marie Kondo says, if it does not spark joy, let it go; we decided to take away the jargon (come on, we cherish ESOPs).

Marie Kondo everything!

If your company is about to start a conversation about ESOPs, it is better to know the lexicon. Let’s begin from the top.

ESOP Term Alias What do they mean What is the impact
Eligible Employee -- A full-time Employee who qualifies for issue of Options under the ESOP policy in India. This is the person who fulfils the minimum conditions of service and other conditions as decided in the appraisal or hiring process. In other countries such as Singapore and the US full time employment is not a requirement. Builds a sense of ownership and gives the employees an opportunity to be a stakeholder. The shared ownership enhances accountability and sense of purpose for employees.
Stock Shares Stock or shares are YOUR piece of the pie. It is, in literal sense, your share in the company. The terms are often used interchangeably It brings in fractional ownership for you in the company and also confers to some rights that can only be availed by owners. For companies, it is proportionate dilution in the ownership.
Options -- Options are NOT shares. They are also exactly what the name suggests. Options provide you with an option to buy shares at an agreed price at a time in the future or sometimes immediately. Until you exercise your right, the options will not convert to shares. Remember, they give you a right, NOT an obligation to purchase stock, at a specified price, for a specified period of time, or when the options expire, which is typically 10 years or more.
Share price -- This is the value of a share. It is similar to MRP on a product, that is how much can you buy or sell each stock for on a particular day. The share price is the value of the share as decided by the company’s investors or financial advisors.. Thus, until someone buys and sets an actual price per share, the share price in a company is imaginary.
Exercise price Strike Price The exercise price is the price at which an option can be purchased or sold when converting an option to a share. It is the amount on the basis of which you will make a trade with the company. It is predetermined at the time of the grant. The exercise price is calculated as per the fair market value or your last valuation. It also depends on the company and ESOP laws of your country. You will always want it to be as low as possible.
Exercise -- The act of materializing your options to convert them into shares is called ‘Exercise’. In pure layman terms, it is acting on your options. You pay the share price/strike price to convert your options into shares. You also get ownership in the company. At this point, the company revises their shareholder status. We advise you to get in a consultant and a tax advisor to comply with the rules prevalent in your country.
Exercise Date -- The date from when you can exercise your options in the company. You can not exercise before this date. Your company will not let you sell your shares unless there is an acquisition or an IPO.
Spread -- In simple math, Spread=Share price - Strike Price For instance, if the share price is $80 and the exercise price is $20, then $60 is the spread. If the company’s stock option has to be profitable to you, the share price has to be more than the strike price. To calculate the profit made at exercise, you take the spread and multiply it by the number of options you have.
Vesting schedule -- Vesting literally means to give someone the legal power to something. Vesting schedule for ESOPs defines the period in which you will earn the right to buy the shares as you don’t get all shares at once. Companies pick a period of time to vest their shares, which is generally 4-5 years. It is advised to have monthly issuance instead of quarterly. Remember, ESOPs are for shared ownership and are not a retention tool.
Cliff -- Probation period for vesting. This is the period of no vesting within the vesting schedule. But when that period is over (i.e. hit the cliff), the benefit is fully vested. Eg: If the vesting schedule is 4 years with a 12 month cliff, then no vesting occurs for the first 12 months, but at the end of it, you will get all the accrued benefit. After the cliff is hit, the vesting is continued as planned (monthly or quarterly). Cliff is often used with new employees so that ESOPs are not misused and the company retains its culture-fit.
Maturity Exercise period The period from the date of vesting of options till the date the options can be exercised. On the expiry of this period, any Options that have not been exercised will lapse and cease to be valid for any purpose. Companies need to define this exercise period and also establish that this includes unprecedented events like termination of employment. If you do not exercise these options before you leave, the options stand lapsed.
ESOP Pool -- The ESOP pool refers to a block of company equity that has been reserved for employees of a company. If your company survives long enough and issues shares to all the staff, they will eventually run out of shares. That is why they need to have a definite pool.
Expanding the pool -- Expanding the pool refers to adding more options to the ESOP pool at every stage of funding. This enables the company to give out more options to current and new employees or a significant hire. Pool expansion is to avoid extreme situations like running out of ESOPs. Companies also use this pool for comfortable senior hiring..
Rules -- The ESOP textbook that you should know before you deal with ESOPs. You should know it like the back of your hand. The rules might seem trivial but they are extremely crucial for your ESOPs. Companies can start with the basics like you can’t transfer them to people, use shares as a loan etc. To know more about this, watch a course or get a consultant as there are a lot of rules you can add or remove. You can also talk to us.
Accelerated vesting -- Accelerated vesting allows you to quicken the schedule by which you gain access to restricted company stock or stock options issued as an incentive. The rate typically is faster than the initial or standard vesting schedule. This arrangement is used by some founders and key executives during a triggering event that is pivotal to the company. For instance, acquisition. The employees under this clause vest fully before the vesting schedule says so. Please note that this is not the norm but is also not unheard of. With ESOPs, it is not standard to put in these kinds of acceleration of vesting provisions. We have generally observed that it is the CxOs who receive vesting acceleration provisions. There are two types of acceleration, single trigger vesting double trigger vesting
Single trigger vesting -- The best clause the founder will find. In this scenario, acceleration is triggered solely by sale of the company or a change in its control. It is called “single-trigger” acceleration because it depends only on one event from one party involved, which is generally the company. This clause is generally to reward you for all your years of hard work and contribution to lead to a result for the company. Under this clause, all the vesting restrictions stand lapsed in connection with the sale.
Double trigger vesting -- Double-trigger acceleration requires two events to trigger acceleration and they can be from either parties. Example: The sale of the Company and the involuntary termination of the employee. A double-trigger typically starts with the sale or change of control but does not cause acceleration until a second event occurs. This second event could include the termination of the founder without cause or if he or she leaves the company within a set time period. The company can include as many triggering events as they want as long as they define and spell them out clearly in the employee compensation plan. Double-trigger acceleration is fairly popular with early stage companies and aims to align the interests of the employees, the investors, and the potential acquirers with 3 things: providing a safety net for key employees, some of whom may be removed in the consolidation during post-closing integration — CFOs are particularly susceptible for this; reducing dilution from automatic acceleration, and; easing the complaints of the acquirer by preserving the requirement of ongoing service to ‘the Company’ in order to vest. Meaning you need to keep working to get the value of your shares.

ZenEquity has a goal of making ESOPs accessible and comprehensive. Knowing the industry colloquial is the first step to reach there.

Is there anything about ESOPs that you need to understand better? Contact us!