Finding the right share-based compensation structure for promoters of startups that, at the same time, protect the interests of financial investors is challenging. While the goal is the same, that is to keep promoters incentivised despite the dilution of their stakes and to ensure they have skin in the game, legal and commercial considerations have forced startups to adopt alternate structures.
The traditional share-based incentive model grants employee stock options (ESOPs), which vest after a particular time or when milestones have been reached. ESOPs are easy to grant and easy to clawback in the event that the promoter leaves or if the vesting conditions are not met. Promoters looking to increase their voting power may exercise their vested options and receive shares in the company. After such an exercise, promoters may sell the shares for liquidity. ESOPs are more tax efficient than most other incentive structures.
Sweat equity rewards promoters for past performance although not providing the same flexibility as ESOPs. Sweat equity is not easy to issue as company law requires that a third party be engaged to determine the monetary value of the services provided by the receiver.
The Companies Act, 2013, does not permit a company to grant ESOPs or sweat equity to promoters or persons belonging to the promoter group unless the company is a startup registered with the Department for Promotion of Industry and Internal Trade. A company can register as a startup if, among other requirements, it is less than 10 years old and has fewer than INR1 billion (USD12 million) in revenue. Companies that do not meet these thresholds must adopt alternative compensation models for promoters such as granting phantom stock options (PSOPs) and partly paid shares or warrants.
PSOPs allow companies greater flexibility than partly paid shares as they may be used to reward recipients by pricing the options at par or to incentivise them by pricing the options at the fair value at the time of the grant. An increase in the valuation may entitle the PSOP grantee to a proportionate cash bonus. The company can also impose conditions for vesting. The grant of PSOPs does not entail dilution of the company’s capital. Unfortunately, PSOPs are illiquid unlike ESOPs, which permit holders to exercise their options and sell the shares. Cash received on the exercise of PSOPs is taxed as salary in the hands of the promoter.
Partly paid shares and warrants, and optionally convertible preference shares (OCRPs) are increasingly popular among startups that are in the mid to late stages of funding. Partly paid shares and warrants may be issued at fair value, but require the promoter to pay only a nominal amount upfront. The balance may be paid at the time of a liquidity event where there is certainty of receiving a cash consideration. In the case of partly paid shares and OCRPs, the promoter benefits from having the consideration subject to capital gains tax as opposed to such consideration being taxed as salary. In addition, OCRPs allow a promoter to redeem the cash or earn dividends.
Partly paid shares and OCRPs are, however, more difficult to clawback on termination of employment. In such an event, the company will need to seek a transfer of the instruments to a trust formed for the benefit of employees or find a purchaser for the instruments. The events agreed for the clawback and pricing of the purchase are usually heavily negotiated in shareholder agreements. A workaround to this difficulty may be to issue warrants as, at the time of granting them, the company will have greater flexibility to impose conditions for their forfeiture. However, warrants are not very popular in India. There is regulatory uncertainty whether they are securities and whether the company, therefore, has to comply with the conditions under the law for private placements when issuing warrants.
Each model of promoter compensation has unique features that work better for companies at the various stages of their growth. While ESOPs work best for early stage startups, PSOPs are a viable alternative for mid-stage to late-stage companies that are not registered startups. Share warrants, partly paid shares and OCRPs, being tax efficient alternatives to PSOPs, may be used by late-stage companies where clawback clauses are not so critical.
Swathi Girimaji is a partner and Sachit Ram is an associate at Bharucha & Partners.
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