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ESOP Terms 101: Must-Know Terms in 2024

  • Written Written by Shubhika Sundriyal 21 March 2024 | 4 min read
  • Editor's Note :

    Looking for the ultimate ESOP cheat sheet? This comprehensive blog will save you from googling every word you come across and help you get a straightforward breakdown of ESOP terminology for effortless understanding.

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Navigating through the new Employee Stock Option Plan (ESOP) terms during your study can be confusing, with the abundance of jargon often prompting you to search for definitions online.

But, don’t worry. We've simplified the process for you. Our comprehensive ESOP terms cheat sheet will provide a quick reference for the most frequently used terms in ESOPs. This resource will assist you in quickly grasping the terminology associated with employee ownership, facilitating a better understanding and informed decision-making.

ESOP Terms Cheat Sheet

In India, ESOPs are regulated both by the Companies Act, 2013 and Securities, and the Exchange Board of India Regulations, 2021. Companies can choose to establish an ESOP either through direct implementation or opting for a trust structure.

Let’s dive into the ESOP terms cheat sheet for 2024.

1. Accelerated Vesting

Employee stock ownership plans (ESOPs) come with a vesting period. This means that options can be exercised only after the vesting period is over. However, sometimes, the company can choose to shorten the vesting period of an employee. They may choose to do so to motivate the employee. This is known as accelerated vesting.

2. Buy Back

When a company opts to repurchase its own shares, it’s termed a buyback. The company acquires the shares either from the open market or from the existing shareholders at a price exceeding the current market value. The company may choose to buy back when it intends to regulate the valuation of its shares or to prevent shareholders from accumulating a majority stake in the company.

3. Cliff

A cliff refers to a vesting schedule where employees gain ownership rights only after a specific period, typically one year. If an employee leaves before the cliff, they receive no stock benefits. For instance, with a one-year cliff, an employee who resigns within the first year receives no shares, but those who stay past the cliff date are entitled to the agreed-upon stock options or grants.

4. Dilution

When the earnings or book value per share decreases as a result of issuing additional shares to shareholders, it is termed dilution. Consider when a new shareholder acquires ownership of company shares. This influx of new shares leads to a dilution of share value for existing shareholders.

5. ESOP

The Employee Stock Option Plan (ESOP) or Employee Stock Ownership Plan is designed to provide company shares to employees at a discounted price compared to the current market value. It acts as an innovative employee compensation plan, fostering more dedication and encouraging a sense of ownership among employees toward the organization. To establish and execute their ESOP plan, companies are required to adhere to the regulations specified in the Companies Act, 2013.

6. ESOP Pool/ Equity Pool

An option or equity pool is the number of shares reserved for employees of an organization. It acts as a form of equity that can be issued to employees in the future. When attracting new investors to a company, the establishment of an ESOP is considered a crucial step. This is because investors often insist on creating this pool before finalizing their investment, as it shows a commitment to fostering a motivated and dedicated workforce.

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7. Exercise

In ESOPs, exercising the right refers to the action taken by an employee to acquire company shares at a predetermined price. This move allows the employee to convert their options into actual shares after the vesting period, thereby capitalizing on any increase in the company's value over time and realizing a potential profit.

8. Exercise Period

During the exercise period, granted to employees upon receiving company options, a predetermined time frame is explicitly outlined. Within this designated window, employees have the freedom to exercise their options, transforming them into shares. Failure to execute this process within the specified period results in the automatic expiration of the options.

9. Exercise Price/ Strike Price

The exercise or strike price is the predetermined cost at which an ESOP holder has the right to purchase a single share of the company's stock. This price is established at the time of the ESOP grant.

10. Exit Event

In the case of an ESOP, the term "Exit Event" refers to a significant corporate event that triggers the distribution of benefits to participants in the ESOP. An Exit Event occurs when the company undergoes a liquidity event, such as a merger, acquisition, or initial public offering (IPO).

When such an event takes place, it often leads to the sale or transfer of the company's ownership, resulting in a change of control. This triggers the distribution of the accumulated value of the ESOP shares to the employees who participate in the plan. The employees may receive cash, stock, or a combination of both, depending on the terms of the ESOP and the specifics of the Exit Event.

11. Fair Market Value (FMV)

FMV, or Fair Market Value is the value at which the company’s options can be traded in the open market. It is the price at which both the buyer and the seller find a mutually beneficial agreement, as the buyer is willing to purchase and the seller is willing to sell at this particular price.

12. Initial Public Offering (IPO)

When a private firm decides to go public by selling its first shares of company stocks in the market, it is called an IPO or Initial Public Offering. It implies that the company's ownership undergoes a shift from being privately held to being public through the sale of shares.

13. Grant Letter

A grant letter acts as a legally binding agreement provided by the company to an ESOP holder. This document comprehensively defines the specifics of the ESOP granted to the employee, including the allocated number of options, the duration of the vesting period, and the exercise price at which the employee can sell the options.

Moreover, the grant letter explicitly outlines the potential scenarios that may arise if an individual opts to depart from the company before the vesting period concludes. It also addresses the implications for the ESOP options in the event of the employee's termination. By clearly defining these conditions, the grant letter ensures transparency and establishes a framework for the rights and obligations of both parties involved in the ESOP agreement.

14. Option-Holder

The person who is granted the options of a company is referred to as the option-holder. He/she is not obliged to make any upfront payments upon receiving the options. However, he/she does possess the right to purchase shares at a predetermined price, and after the completion of a specified vesting period.

15. Liquidity Event

A liquidity event occurs when shareholders have the opportunity to convert their shares into cash or other easily tradable assets. Such events commonly take the form of mergers, acquisitions, or Initial Public Offerings (IPOs).

16. Pre-money valuation

The pre-money valuation represents the value of a company prior to its public listing or obtaining external investments. This valuation is frequently used by investors to assess the company's worth before making financial commitments. Although venture capitalists (VCs) and angel investors typically evaluate this, it is crucial for every founder to understand, regardless of their current engagement in seeking investment opportunities.

17. Post-money valuation

The post-money valuation is an estimation of a company's value that takes into account external funding or capital injections received. It reflects the approximate market worth of a startup after securing funding from venture capitalists or angel investors. Prior to incorporating these funds, the valuation is known as the pre-money valuation. Essentially, the post-money valuation is calculated by adding the pre-money valuation to the new equity obtained from external investors.

18. Spread

Spread refers to the difference between the grant price of stock options and the fair market value (FMV) of the underlying stock at the time of exercise.

A favorable spread indicates that the stock has increased in value, leading to a financial benefit for employees. On the other hand, an unfavorable spread occurs when the stock's value is below the grant price, causing employees to incur a financial loss upon exercising their options.

19. Vesting Period/ Schedule

Upon completing a designated waiting period, an ESOP holder attains the right to claim ownership of their stock options — a process commonly known as vesting. The employer defines the specific vesting period upon the initial grant of options. This acts as a powerful incentive for employees to commit to the organization for an extended duration, fostering improved dedication and motivation in their work.

Consider a two-year vesting period where an employee earns 50% ownership rights each year. This means they become fully vested at the end of the second year. If the employee leaves before two years, they may lose some or all of the ownership benefits.

20. Reverse Vesting

Reverse vesting is a mechanism where in a co-founder or investor is granted upfront ownership of company shares as an incentive for a sustained commitment to the organization. In the event that the individual chooses to depart from the company, the company retains the option to repurchase these shares at no additional cost, effectively mitigating potential profit gains for the departing party.

That’s all for now! No, this is not an exhaustive sheet of ESOP terms; there’s more to familiarize yourself with.

Interested in Learning More?

If you liked reading this ESOP terms cheat sheet and are interested in diving deeper into the ESOP world, then check out this page - Glossary.

We’re sure this will help you expand your ESOP knowledge, whether it’s to set up a plan within your company or to understand your own ESOP plan functioning.

Remember, it’s best to consult a financial advisor to discuss your unique ESOP policy and transactions.

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