ESOPs are setting new market trends daily, and more and more companies and startups are choosing it as their preferred incentive-sharing method. In this wake, it is very important for every employee to understand fundamentals of ESOPs and all the technical terms related to it to be able to exercise your ESOPs wisely.
Through this article, we will introduce common words used in the ESOP terminology for you to understand ESOPs and how to exercise them in a simplified manner.
Employee stock option plan refers to an employee benefit plan under which a company grants stock options to its employees. Companies use ESOPs to attract and retain talent by allowing their employees to purchase shares of the Company at a price fixed on the date of grant.
To understand more about ESOPs, head to our What is ESOP article.
Employee: The term "employee" refers to a permanent worker for a corporation who may be based in India or elsewhere. Additionally, this would apply to any full-time independent director as well as any subsidiary or associate company's staff.
3) Employee compensation
It refers to the overall expense an employee causes the business due to his salary, which includes his base pay, deferred compensation, bonus, and any form of commission. However, employee compensation does not include the fair value of options granted under employee stock option plans. Additionally, the discounts at which ESOP employee shares are offered are also not considered to be a portion of employee pay.
4) ESOP Pool:
The employee stock options pool is the total number of shares reserved for the company's employees. It's part of the ESOP scheme document and approved by the shareholders. Typically, companies set aside 10-25% of equity for the ESOP pool. Phantom stocks or SARs are the best choice, where a Company wishes to offer employees with rewards that are based on merit or some other discretionary basis – the benefit being since they are given in cash for the shares and no ownership control is given to the employees, handling of these options becomes easy for the owners.
When a company adds more shares to the ESOP pool, it is known as expanding the pool. Companies typically broaden the pool to give more stock options to the existing employees or to make critical hires.
Vesting is the process by which the Option holder earns full rights to their options to be converted into stocks. This can happen by way of meeting certain time-based Vesting conditions or other performance-based milestones. Only Vested Options can be exercised to become stocks. This prevents the employees from joining a company, purchasing stocks at a discounted rate, and leaving the company. Otherwise, it defeats the purpose of ESOP as a mechanism to retain employees. Vesting distributes the number of shares that employees can purchase at a time, which they have been granted.
Itis the process of converting an option into a stock. This can only happen once the vesting period is complete and the exercise price is paid.
7) Exercise Period
Itis the period until which an employee can buy the vested stock options from the company. If an employee fails to purchase the vested stock options during theexercise period, they lapse and are no longer available to the employee to exercise.
8) Exercise Date
It is the date on which an employee exercises options and converts them in the company shares.
9) Exercise Price/Strike price/Grant Price:
It is the price at which employees can purchase the shares once they get vested. Often, the exercise price is lower than the market price.
10) Exercise Tax
When an employee exercises his vested options, they have to pay tax on exercise. In India, it is known as a perquisite tax. The exercise tax is calculated on the difference between the fair market value of the share and the exercise price of the option. Fair market value of the share is required to be determined by a merchant banker in India and an independent valuer in other countries.
Spread is the difference between fair market value of the share and strike price. For example, if the share price is Rs 30 and the strike price is Rs 20, then the spread is Rs 10 (30 - 20). The higher the spread, the better the return employees get.
12) Grant Letter
It refers to the document issued by the company while allotting stock options to their employees. Grant Date means the date the Options are issued to the employee or contractor under the Offer.
13) Expiry date
Date before which an employee must exercise the options. After the expiry date, stock options lapse and the employees lose the right to purchase the stocks.