In Volume 3 of The basics of ESOPs, we talked about what’s the best time to create an ESOP pool and what happens when an employee leaves before the options are vested. In this volume, we will talk about the definition of key ESOP terms that you need to be aware of.
A. General key terms
● Grant Date: The date on which ESOPs are issued to the employee is usually the date on which the compensation committee of the Board approves the grant to the employee.
● Grant Letter: The letter given by the company through which ESOPs are issued to the employee.
● Fair Market Value (FMV): Fair Market Value of shares is usually obtained by the company to calculate its income tax liability at the time of exercise. Note that the company gets the FMV through a valuation certificate obtained from a merchant banker.
● Expiry Date: This is the date when the option expires and cannot be exercised. The employee/ grantee loses the right to exercise the option. The option is canceled (lapsed).
● Volatility: measure of the amount by which a price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Volatility of a share price is the standard deviation of the continuously compounded rates of return on the share over a specified period.
B. Vesting-related terms
● Vesting: amount of time an employee must work before acquiring a certain benefit. An employee would only be eligible to exercise his/her stock options and become a shareholder in the company after the options have been vested.
● Vesting period: The period between the grant date and the date on which all the specified vesting conditions of ESOP grant are satisfied. A very common vesting period is 4 years with a one year cliff
● Vesting Conditions: Conditions that must be satisfied for the employee to become entitled to receive ash, or shares of the enterprise, pursuant to an employee share-based payment plan. Includes service conditions and performance conditions
● Service Conditions: Conditions which require the employee to complete a specified period of service
● Performance Conditions: Conditions which require specific performance targets to be met (such as a specified increase in the enterprise’s share price over a specified period of time)
● Accelerated Vesting: This allows an employee to quicken the schedule by which his/her ESOP vesting happens. Accelerated vesting generally occurs at the time of mergers & acquisitions
● Vested Options: Number of options for which vesting date has been completed (in the past)
● Unvested Options: Number of options for which vesting date has NOT yet arrived (still in the future)
● Cliff Period: This is the minimum period after the grant date when the first options get vested.
● Time based vesting: Time based vesting is based on continued employment or association with the company. Options will vest based on the vesting schedule specified in the grant letter as long as the employee is associated with the company
● Performance based vesting: Vesting is linked to performance parameters defined in the grant letter. These could be related to individual or company performance.
C. Exercise-related terms
● Exercise Price/ Strike Price: The price at which options are granted. This price will be mentioned in the Grant Letter issued to the grantee
● Exercise: Converting the vested options into shares by paying the exercise price and applicable tax. Literally this is about the employee exercising the right to purchase shares of the company. Note that an employee can exercise (or purchase shares) only after his options have vested, not before.
● Exercise Period: After vesting, the employee earns the right to get the stock or an equivalent of the company. But the employee can get those shares or its equivalent only within a certain period of time and this is called the exercise period
● Exercise Date: The date on which the employee exercises (his right to purchase shares) and receive shares of the company.
● Exercise Price: The price at which the employee buys the shares. This price is, in most cases, lower than the prevailing share price
● Exercise Tax: At the time of exercise (purchase of shares), not only does the employee need to pay the exercise price, he/she also needs to pay an income tax.
● Expected Life of an Option: the period of time from grant date to date on which an option is expected to be exercised
● Intrinsic Value: the amount by which the quoted market price of the underlying share in case of a listed enterprise or the value of the underlying share determined by an independent valuer
● Market Condition: condition upon the exercise price, vesting or exercisability of a share or a stock option depends that is related to the market price of the shares of the enterprise, such as attaining a specified target that is based on the market price of the shares of the enterprise relative to an index of market prices of shares of other enterprises.
● Reload Feature: a feature that provides for an automatic grant of additional stock options whenever the option holder exercises previously granted options using the shares of the enterprise, rather than cash, to satisfy the exercise price.
● Reload option: new stock option granted when a share of the enterprise is used to satisfy the exercise price of a previous stock option
● Repricing (of an employee stock option): Changing the existing exercise price of the option to a different price
Watch this space for Volume 5 of the Basics of ESOPs series by Qapita where we will talk about the exercise of these ESOPs.