A number of firms have been using a popular method of retaining their high-value personnel. This approach entails issuing firm shares to employees in order to retain them for an extended length of time while also avoiding market debt. The ESOP vesting period is a common practice adopted by corporations issuing shares through an ESOP scheme, where employees have access to the company’s options or shares when the ESOP vesting time expires.
The benefits of share ownership in the company are not received by the employee until the conclusion of the vesting term in ESOP schemes with vesting periods. If the ESOP vesting term is not yet expired, the options granted under the ESOP scheme cannot be utilised by the employee in the event of their departure from the company.
What Is the Vesting Period for an ESOP?
The ESOP vesting period is the time between when employees are granted ESOPs and when they obtain access to the rights associated with the options or shares. Employees can only obtain these shares after the ESOP vesting term has expired.
What Is the Purpose of the ESOP Vesting Period?
The purpose of vesting period in ESOP is as mentioned below:
- Loyalty of employees: The vesting period ensures that employees remain loyal to the company over a medium to long period of time.
- Commercial objectives: ESOP schemes often involve issuing shares to employees and the company aims to achieve its commercial objectives through this. An employee deciding to leave before the vesting period comes to an end may face consequences like selling their shares at a discounted rate or even forfeiting them.
- Tax treatment: The tax treatment of ESOPs is also affected by the vesting period. When an employee’s interests in the shares could potentially be forfeited upon gaining access to them, the vesting period enables the deferral of tax payment on any discount received when acquiring the shares at the end of the vesting period. This creates a tax advantage for the employee by allowing them to postpone their tax obligations.
- Retaining top talent: The vesting period acts as a tool for retaining top talent within the company. By tying the ownership of shares to a vesting schedule, employees are motivated to stay with the company to fully benefit from their equity. This helps the company retain valuable employees who contribute to its success and growth.
- Alignment with company goals: The alignment of employees with the long-term goals and vision of the company is ensured by the vesting period. As time progresses, the shares gradually vest, creating a vested interest for employees in the company’s performance. This vested interest encourages active contributions to the company’s success, fostering a sense of ownership and commitment among employees.
- Encouraging employee engagement: ESOPs with vesting periods encourage employee engagement and involvement in the company’s operations.
- Mitigating risks: Companies face risks associated with employee turnover, especially if key employees leave the organisation. By implementing a vesting period, the company reduces the risk of losing its employees and the potential negative impact on its operations.
- Enhancing employee morale and motivation: The knowledge that they have the opportunity to gain ownership in the company over time can boost employee morale and motivation, which is created by the vesting period.
How Does Vesting of ESOP Work?
Given below is the process for vesting of ESOP in Indian companies:
- Employee participation and vesting period:
- When employees participate in a company’s ESOP (Employee Stock Option Plan), there is a vesting period before the options officially belong to the employee.
- The vesting period is the time between the issuance of the share option and when the participant can exercise their rights.
- Enjoying rights and accessing benefits:
- Only after the completion of the vesting period can participants enjoy their rights and exercise the options.
- Until the vesting period expires, participants cannot access the benefits associated with their rights.
- Departure before vesting period ends:
- If a participant leaves the company before the vesting period is over, the unvested options are no longer available to them.
- Whether due to resignation or any other reason, leaving before vesting completion means forfeiting the unvested options.
- Determining the vesting period:
- The length of the vesting period depends on the rules of the ESOP scheme, set by the company.
- There is no standard vesting period mandated, allowing companies to determine the duration based on their policies and plan structure.
- Typically, vesting periods in Indian companies range from 12 months to 3 years.
- Aligning interests and promoting loyalty:
- Vesting periods exist in ESOPs to ensure that employee actions align with shareholder and company interests.
- Most ESOPs have a standard vesting period to foster long-term loyalty and commitment from employees.
- Immediate vesting could disincentive employees from remaining with the company in the long run.
- Customisation and industry practices:
- Companies have the flexibility to customise vesting periods to suit their objectives and industry norms.
- They can set different vesting periods for different employee groups or incorporate performance-based criteria.
Determining the Ideal ESOP Vesting Period
There is no specific formula or standard guideline for determining the ideal vesting period for an Employee Stock Option Plan (ESOP). It varies based on different factors and company-specific considerations, like:
- Consideration of growth stage: The stage of growth of the company plays a role in deciding the vesting period. Start-ups, which are still in their early and uncertain phase, often opt for shorter vesting periods ranging from 12 to 18 months. This allows for flexibility due to the unpredictability of future stock materialisation. In contrast, well-established blue-chip companies tend to offer longer vesting periods, leveraging their size, proven track record and stronger negotiation power.
- Impact of financial situation: The financial condition of the company also influences the vesting period decision. Early-stage start-ups may choose longer vesting periods to minimise employee attrition during their formative years when exponential growth is expected. Similarly, larger companies prefer longer vesting periods due to the substantial costs associated with employee integration and training.
- Market best practices: Commonly followed market practices suggest vesting periods ranging from 12 to 36 months. This duration is considered effective in allowing companies to harness the full potential of their employees.
Understanding ESOP Exercise Period
Exercise Period is the time period following vesting during which the employee must exercise his entitlement to apply for shares against the option granted to him under the ESOS.
Let’s consider an example to illustrate the ESOP vesting process:
- On 1st July 2022, a company grants its employees 500 options as part of their Employee Stock Option Plan (ESOP).
- The ESOP scheme specifies a vesting period of four years, with 25% of options vesting each year.
- The exercise price for the options is set at Rs. 15 per share and the exercise period is seven years.
Based on this example, the vesting and exercise schedule would be as follows:
| Vesting Date | Number of Vested Options | Exercise Period Until |
|---|---|---|
| 1st July 2023 | 125 | 1st July 2030 |
| 1st July 2024 | 125 | 1st July 2031 |
| 1st July 2025 | 125 | 1st July 2032 |
| 1st July 2026 | 125 | 1st July 2033 |
Potential Scenarios When Employees May Choose not to Exercise ESOP
Mentioned below are the potential scenarios, when employees may choose not to exercise their option of ESOP:
Unlisted company lock-in period:
- In unlisted companies, shares obtained through ESOPs are not freely transferable.
- Once an employee exercises their right to buy shares at a predetermined price, the invested money gets locked.
- If the lock-in period does not align with the employee’s financial situation, they may opt not to proceed with the plan.
- The employee may need to wait until the company gets listed or the promoters provide an exit option.
Market value below predetermined price (listed companies):
- In the case of listed companies, employees may hesitate to exercise their ESOPs if the market value of the share is lower than the predetermined price in the ESOP scheme.
- If the current market value is lower, exercising the options would result in a financial loss for the employee.
- Employees may choose not to exercise their ESOPs until the market value increases to a favourable level.
Final Thoughts
The use of Employee Stock Option Plans (ESOPs) as a means of retaining high-value employees is a popular approach adopted by many firms. ESOP vesting periods play an important role in ensuring the effectiveness of these plans. While there is no standard vesting period, it typically ranges from 12 to 36 months, depending on various factors. The vesting period serves multiple purposes, including encouraging loyalty, aligning employee actions with company goals, providing tax advantages and retaining top talent. Companies must consider their growth stage, financial situation and industry practices when determining the ideal vesting period.
Additionally, employees may choose not to exercise their ESOPs if there are restrictions on share transferability or if the market value falls below the predetermined price. Overall, understanding and carefully managing ESOP vesting and exercising periods is significant for the success of these employee retention strategies.
For more information on ESOP Vesting and Exercising Periods, connect with our experts at StartupFino.
