Incentivising startup founders — ESOPS and sweat equity viable now

The Startup India initiative is one of the cornerstones of the government’s Make in India efforts. It also ties in perfectly with the government’s intention of achieving a digital economy expected to thrive on India Stack-based innovations such as UPI, BHIM, e-KYC, e-Sign, and d-locker, all built on the JAM (Jan Dhan-Aadhaar-Mobile) trinity. Prime Minister Narendra Modi has reiterated on multiple occasions, as has been reflected in Finance Minister Arun Jaitley’s Budget announcement this year, that the intent of Startup India is to create a conducive environment for startups by providing multiple layers of incentives and a hygienic environment for them to set up and prosper in the complex Indian regulatory setup.

Two aspects that have constantly troubled founders^[1] are: (a) their inability to accept employee stock options (ESOPs) in their own startups; and (b) the limited leeway to startups for issuing sweat equity. The restrictions were emanating from the provisions of the Companies Act 2013 (CA). This article discusses the relaxation provided to startups in these respects.

Why are founder ESOPS and sweat equity so important?

As startups grow and seek equity-based funding from investors (seed funders, angel investors, venture capitalists, and private equity funds, in that order), a natural consequence for the founders is a dilution in their equity holding. This could not only result in founders losing principal control over their startup but would also reduce their ability to reap the benefits of the startup’s success — unlike other employees who get to share the upside through ESOPs.

Accordingly, it is neither unusual nor unreasonable for founders to seek ESOPs, particularly when their shareholding in the startup has reduced considerably pursuant to various funding rounds and when they are working as hard as — in fact, in most cases, even harder than — the rest of the employees of the company.

Another avenue for founders to get additional shares is by subscribing to sweat equity — i.e., shares issued to an employee (which could include the founders) in return for know-how, transfer of intellectual property rights, or value additions. However, the problem with sweat equity was that it was restricted to 25 percent of the existing paid-up share capital.

In summary, the ability of founders to retain their percentage shareholding whilst also simultaneously raising third-party funding and sharing the upside was a difficult task in the absence of feasible ESOPs/sweat equity structures.

So what is the position now?

In the above context, the Ministry of Corporate Affairs liberalised the norms for ESOPs and sweat equity for startups under the Companies (Share Capital and Debentures) Third Amendment Rules 2016 (Amendment).

For ESOPs, the Amendment allowed companies that qualify as ‘startups’ under the definition notified by the Department of Industrial Policy and Promotion^[2] to issue ESOPs to founders, or even to those directors that hold more than 10 percent of the share capital (which was hitherto not permitted).

The Amendment liberalised the issuance of sweat equity shares by increasing the limit up to which they can be issued by companies qualifying as ‘startups’, from 25 percent of the paid-up equity share capital to 50 percent.

What is the impact?

Many Indian startups are externally funded. With each round of fund raising, it becomes increasingly important for founders to figure out legitimate means of maintaining their shareholdings at meaningful percentages of the fully diluted share capital. This becomes even more critical when investors are also aligned with the idea. In most cases, investors, in fact, see ESOPs as one of the key incentives to ensure more skin in the game for the founders, resulting in better growth — and faster exit — prospects.

With the founders as well as investors aligned on this, regulatory bottlenecks — such as the ones mentioned above — remained the only hurdle between the commercial objective and its execution. To be fair to the regulator, the restriction on issuance of ESOPs to founders in the CA is an anti-abuse provision as it prevents founders from unduly benefiting from such issuances. However, in the context of startups, since ESOPs and sweat equity align the perspective of the founders as well as investors and other shareholders, it was important to provide some relaxation in this respect. The Amendment does exactly this.

Both the changes are welcome and provide leeway to founders to better structure their cap tables. While many would argue that limiting it to ‘startups’, particularly when the definition is somewhat restrictive, is counterproductive. But then, one must also realise that the government needs to look at such changes from an anti-abuse perspective as well, and extending this relaxation to all ‘non-startups’ would provide yet another option to unscrupulous ‘promoters’ to dupe minority shareholders.

Sanjay Khan Nagra is a Senior Associate and Prasad Subramanyan is an Associate at Khaitan & Co (both specialising in e-commerce and startup sectors). Sanjay is also associated with iSPIRT as a policy expert. In this role, Sanjay has closely worked with various governmental authorities (including the PMO, DIPP, NITI Aayog, MoF, MCA, RBI, and SEBI) to bring about policy reforms including the ones discussed in this article, Startup India Action Plan, convertible notes, deferred consideration, and indemnity escrows for FDI transactions, no taxation on conversion of preference shares into equity shares, reduction of long-term capital gain period for unlisted shares to 24 months, etc.

[1]While the law recognises the term ‘promoter’, in line with general startup parlance — and to distinguish traditional ‘owners of Indian businesses’ from ‘new age entrepreneurs’ — we have used the term ‘founder’ in this article.

[2]‘Startups’ have been defined to mean entities: (a) which are not more than 5 years old from the date of their incorporation / registration; (b) the turnover for which is not more than INR 25 crore; and (c) which work towards innovation, development, deployment or commercialization of new products, processes, or services driven by technology or intellectual property.