Shubhika Sundriyal
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Editor's Note:-Confused by ESOP terms? This blog will save you from googling every word you come across and help you get a straightforward breakdown of ESOP terminology for effortless, quick understanding.
Are you feeling lost while coming across terms like ‘exercise period’ and ‘strike price’ when reading about Employee Stock Option Plans (ESOPs). Does it often send you down a rabbit hole of Google searches?
Don’t worry. We've simplified the process for you. Our comprehensive ESOP terms glossary will provide a quick reference for the most frequently used terms in ESOPs. This will assist you in quickly grasping the ESOP terminology associated with employee ownership, facilitating a better understanding and informed decision-making.
In India, ESOPs are regulated both by the Companies Act, 2013 and Securities, and the Exchange Board of India Regulations, 2021. Companies can choose to establish an ESOP either through direct implementation or opting for a trust structure.
Let’s dive into the ESOP terms cheat sheet for 2025.
Employee stock ownership plans (ESOPs) come with a vesting period. This means that options can be exercised only after the vesting period is over. However, sometimes, the company can choose to shorten the vesting period of an employee. They may choose to do so to motivate the employee. This is known as accelerated vesting.
Example: If your vesting schedule is 4 years but due to a merger, your company accelerates it to 2 years, you benefit sooner.
When a company opts to repurchase its own shares, it’s termed a buyback. The company acquires the shares either from the open market or from the existing shareholders at a price exceeding the current market value. The company may choose to buy back when it intends to regulate the valuation of its shares or to prevent shareholders from accumulating a majority stake in the company.
Example: A company may choose to buy back shares of its company with an FMV of ₹100 at ₹120 per share.
A cliff refers to a vesting schedule where employees gain ownership rights only after a specific period, typically one year. If an employee leaves before the cliff, they receive no stock benefits. For instance, with a one-year cliff, an employee who resigns within the first year receives no shares, but those who stay past the cliff date are entitled to the agreed-upon stock options or grants.
Example: If there’s a 1-year cliff and you leave within 10 months, your equity benefits stand nullified.
When the earnings or book value per share decreases as a result of issuing additional shares to shareholders, it is termed dilution. Consider when a new shareholder acquires ownership of company shares. This influx of new shares leads to a dilution of share value for existing shareholders.
Example: As a co-founder, if you’re granted 1% of the company shares and the company decides to get more employees under its ESOP scheme, your stakes in the company could reduce to 0.7%.
The Employee Stock Option Plan (ESOP) or Employee Stock Ownership Plan is designed to provide company shares to employees at a discounted price compared to the current market value. It acts as an innovative employee compensation plan, fostering more dedication and encouraging a sense of ownership among employees toward the organization. To establish and execute their ESOP plan, companies are required to adhere to the regulations specified in the Companies Act, 2013.
Example: An employee is granted 1,000 shares with a market value of ₹100 at ₹50, thus benefiting from the gain.
An option or equity pool is the number of shares reserved for employees of an organization. It acts as a form of equity that can be issued to employees in the future. When attracting new investors to a company, the establishment of an ESOP is considered a crucial step. This is because investors often insist on creating this pool before finalizing their investment, as it shows a commitment to fostering a motivated and dedicated workforce.
Example: A startup may create a 10% ESOP pool to grant stock options to new hires in order to attract them.
In ESOPs, exercising the right refers to the action taken by an employee to acquire company shares at a predetermined price. This move allows the employee to convert their options into actual shares after the vesting period, thereby capitalizing on any increase in the company's value over time and realizing a potential profit.
During the exercise period, granted to employees upon receiving company options, a predetermined time frame is explicitly outlined. Within this designated window, employees have the freedom to exercise their options, transforming them into shares. Failure to execute this process within the specified period results in the automatic expiration of the options.
Example: Suppose an employee has an exercise period of 3 years. The employee must exercise their options within this period, otherwise the vested options lapse, resulting in no gain.
The exercise or strike price is the predetermined cost at which an ESOP holder has the right to purchase a single share of the company's stock. This price is established at the time of the ESOP grant.
Example: If an employee chooses to buy their company options at ₹30 when the FMV is ₹150, ₹30 is the exercise price.
In the case of an ESOP, the term "Exit Event" refers to a significant corporate event that triggers the distribution of benefits to participants in the ESOP. An Exit Event occurs when the company undergoes a liquidity event, such as a merger, acquisition, or initial public offering (IPO).
When such an event takes place, it often leads to the sale or transfer of the company's ownership, resulting in a change of control. This triggers the distribution of the accumulated value of the ESOP shares to the employees who participate in the plan. The employees may receive cash, stock, or a combination of both, depending on the terms of the ESOP and the specifics of the Exit Event.
FMV, or Fair Market Value is the value at which the company’s options can be traded in the open market. It is the price at which both the buyer and the seller find a mutually beneficial agreement, as the buyer is willing to purchase and the seller is willing to sell at this particular price.
Example: If your shares’ market worth is ₹80 but you are able to buy the shares at ₹20, ₹80 is the FMV.
When a private firm decides to go public by selling its first shares of company stocks in the market, it is called an IPO or Initial Public Offering. It implies that the company's ownership undergoes a shift from being privately held to being public through the sale of shares.
A grant letter acts as a legally binding agreement provided by the company to an ESOP holder. This document comprehensively defines the specifics of the ESOP granted to the employee, including the allocated number of options, the duration of the vesting period, and the exercise price at which the employee can sell the options.
Moreover, the grant letter explicitly outlines the potential scenarios that may arise if an individual opts to depart from the company before the vesting period concludes. It also addresses the implications for the ESOP options in the event of the employee's termination. By clearly defining these conditions, the grant letter ensures transparency and establishes a framework for the rights and obligations of both parties involved in the ESOP agreement.
Example: An employee’s grant letter mentions the framework of the ESOP policy extended to the employee - Granted 1,000 shares, with a vesting of over 4 years and a 1-year cliff period.
The person who is granted the options of a company is referred to as the option-holder. He/she is not obliged to make any upfront payments upon receiving the options. However, he/she does possess the right to purchase shares at a predetermined price, and after the completion of a specified vesting period.
A liquidity event occurs when shareholders have the opportunity to convert their shares into cash or other easily tradable assets. Such events commonly take the form of mergers, acquisitions, or Initial Public Offerings (IPOs).
The pre-money valuation represents the value of a company prior to its public listing or obtaining external investments. This valuation is frequently used by investors to assess the company's worth before making financial commitments. Although venture capitalists (VCs) and angel investors typically evaluate this, it is crucial for every founder to understand, regardless of their current engagement in seeking investment opportunities.
Example: If your startup’s pre-money valuation is ₹100 Cr and it raises ₹20 Cr, then post-money is ₹120 Cr.
The post-money valuation is an estimation of a company's value that takes into account external funding or capital injections received. It reflects the approximate market worth of a startup after securing funding from venture capitalists or angel investors. Prior to incorporating these funds, the valuation is known as the pre-money valuation. Essentially, the post-money valuation is calculated by adding the pre-money valuation to the new equity obtained from external investors.
Example: If you invest ₹5 Cr in a company with a pre-money valuation of ₹20 Cr, its post-money is ₹25 Cr.
Spread refers to the difference between the grant price of stock options and the fair market value (FMV) of the underlying stock at the time of exercise.
A favorable spread indicates that the stock has increased in value, leading to a financial benefit for employees. On the other hand, an unfavorable spread occurs when the stock's value is below the grant price, causing employees to incur a financial loss upon exercising their options.
Example: If the FMV of stock options is ₹200 and the strike price is ₹50, then your spread will be ₹150 per share.
Upon completing a designated waiting period, an ESOP holder attains the right to claim ownership of their stock options — a process commonly known as vesting. The employer defines the specific vesting period upon the initial grant of options. This acts as a powerful incentive for employees to commit to the organization for an extended duration, fostering improved dedication and motivation in their work.
Consider a two-year vesting period where an employee earns 50% ownership rights each year. This means they become fully vested at the end of the second year. If the employee leaves before two years, they may lose some or all of the ownership benefits.
Reverse vesting is a mechanism where in a co-founder or investor is granted upfront ownership of company shares as an incentive for a sustained commitment to the organization. In the event that the individual chooses to depart from the company, the company retains the option to repurchase these shares at no additional cost, effectively mitigating potential profit gains for the departing party.
That’s all for now! No, this is not an exhaustive sheet of ESOP terms; there’s more to familiarize yourself with.
Still curious about some ESOP terms? Check out our full glossary of terms that you can refer to.
We’re sure this stock options cheat sheet will help you expand your ESOP knowledge, whether it’s to set up a plan within your company or to understand your own ESOP plan functioning.
Remember, it’s best to consult a financial advisor to discuss your unique ESOP policy and transactions.
An ESOP or employee stock option plan refers to a company scheme that allows its employees to buy company shares at a discounted price. This gives employees a sense of ownership in the company while enabling loyalty within the company.
The fixed price at which employees can buy company shares is referred to as the exercise price. FMV is the current market value of these shares, which is often higher than the exercise price.
The time period that an employee must wait to own all their granted stock options is called the vesting period. And the time period that an employee must wait for any option to vest is called the cliff period.
The exercise period is the period within which an employee can convert their vested options into shares. Failure to exercise within the exercise period results in a lapse of all options.
When new shares are issued, the ownership percentages and value of existing ESOP shares reduces. This is called dilution.
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