It might be unintentional but often some nuances and clauses that aren’t discussed are taken for granted (pun not intended). Remember to check these in your grant letter:
- Is the exercise price nominal or linked to the Fair Market Value (FMV)?
The exercise price of options can be anything that is chosen by the company while giving out the ESOP grant letter. Some startups choose the exercise price as a nominal amount (say INR 10) while some startups choose the exercise price based upon the last round valuation of the company. The more the difference between FMV and exercise price, the more wealth you generate at the time of ESOP sale.
- What’s the vesting schedule? Is it uniform or back-loaded or performance-based?
Participating in an Employee Stock Option Plan gives you the ‘option’ to purchase the company’s stocks at the time of exercise. ESOP vesting is the process through which you get the right to purchase these stocks on a systematic basis or a pre-set calendar; think of the vesting schedule as a timetable according to which you get the right to ESOPs. The most common vesting schedule is uniform annual vesting over 4 years, i.e. after the first year of compulsory ‘cliff’ – you receive 25% of the total ESOPs promised to you every year for 4 years. Some startups offer performance-based vesting which is dependent on you meeting some targets and goals linked to your job function and some other startups opt for front-loaded or back-loaded vesting where you may get a variable amount over years. For instance, 10%, 20%, 30%, 40% over 4 years in back-loaded vesting.
- What happens to your ESOPs when you leave the organization?
When you quit or your employment term is terminated, your unvested ESOPs return back to the ESOP pool but what you need to take note of is the treatment of your vested options. Here you need to look at how much time you will have to exercise options upon quitting. Imagine if you have just a few weeks to exercise, this will mean you have to cough up a few lakhs or even crores of rupees to gain ownership of your shares. Most well-respected startups have a longer period of months or even years to allow employees to exercise their vested options.
- What are the transfer restrictions when you exercise your options?
There might be a provision in the ESOP scheme to allow the company or founder to forcibly buyback (call option) such shares at the current market price. For example, a ‘Right of First Refusal’ or ROFR clause allows the company first to see any sale or transfer offer that you have obtained, and only if the company provides the ROFR waiver, can you go ahead with the sale or transfer of shares.
- How does the company facilitate ESOP liquidity for employees?
Check the ESOP policy and grant letter for how ESOP liquidity has been or will be facilitated for employees in the startup. Does the management even talk about this? Remember, you will make money on your ESOPs only if a liquidity event is provided to you through a secondary transaction, buyback, or eventual IPO.
Be familiar with the basics of ESOPs before signing your grant letter. Know the ESOP policy inside out and sign it only after you have comfort with the above points.