Key Employee Compensation

Key Employee
Compensation

Performance
Salary Equity Perks
based

Sweat Equity ESOP Revenue share EBIDTA share

Sweat Equity

Basis (Fair Market Salary- Actual salary) * Risk premium = Value of sweat equity
Price Price of shares to be determined by a merchant banker
Accounting Treated as expense to Company and compensation in hands of
employee/director
Eligibility Can be issued to Director or permanent employee (permanent employee for at
least 1 year)
Limitation on issue  In one year, Company cannot issue sweat equity shares of more than
15% of paid up equity share capital, or Rs 5 crore, whichever is higher
 In aggregate, Company cannot issue sweat equity shares of more than
25% of paid up equity share capital
Transfer of sweat  Sweat equity shares shall be locked-in/non transferable for 3 years
equity shares
Escrow of shares /  Vesting of the sweat equity shares with the Employee could be linked
Vesting of sweat to period of stay in the Company subject to the condition that he is not
equity shares terminated for cause
Performance The sweat equity issue could be linked to the following milestones:
expectations Product Milestones
 Product Features
 Compatibility with different platforms (Android, Windows, IOS)
 etc
Marketing Milestones
 Annual Revenue Target
 No. of tie ups with publishing houses
 No. of assignments with direct clients
o Repeat business with these clients
 Relationships developed / Business tie ups across no. of sectors
Buy Back  Promoter and / or other share holders to buy back shares from the
Employee
o Would you like this to be framed as a right or an obligation?
 Company to buy back shares from the Employee (This restricts further
issue of shares by Company for a period of six months from the time of
buy back)
o Would you like this to be framed as a right or an obligation?
ESOP

GRANT
VEST
Receives the rights EXERCISE
Earns the rights
SALE
Exercises the rights
Sells the shares

Eligibility  Can be issued to Directors and permanent Employees

 Cannot be issued to Director who holds more than 10% of equity
Vesting period  This the period between the grant of option to the Employee and date
on which the Employee could convert the option to a share
 Minimum vesting period as per Companies Rules 2014 is 1 year
 Suggested annual vesting is 25%of all options granted to Employee so
that 100% of the options are vested at the end of year 4
 Vesting period could be made contingent to Performance of the
Employee and the Company (Please refer to the performance
expectations mentioned above)
 Employee loses non-exercised shares
Exercise period  No prescribed minimum exercise period
 Suggested exercise period is over a period of 5 years from date of
vesting
Exercise Price  It is the price at which the option is converted into shares at the end of
vesting period
 Suggested exercise price is the Fair Market Value at the end of
preceding Financial year
Accounting treatment  Treated as expense to Company and compensation in hands of
employee/director
Buy back  Promoter and / or other share holders to buy back shares from the
Employee
o Would you like this to be framed as a right or an obligation?
 Company to buy back shares from the Employee (This restricts further
issue of shares by Company for a period of six months from the time of
buy back)
o Would you like this to be framed as a right or an obligation?
 ESOP trust (Registered under Indian Trust Act): A vehicle to buy and
sell shares from Employees.
o ESOP trust is governed by Companies Rules 2014
o This can be the least preferred option as it involves fund
transfer and paper work
Eligibility  Can be issued to Directors and permanent Employees
 Cannot be issued to Director who holds more than 10% of equity
Vesting period  This the period between the grant of option to the Employee and date
on which the Employee could convert the option to a share
 Minimum vesting period as per Companies Rules 2014 is 1 year
 Suggested annual vesting is 25%of all options granted to Employee so
that 100% of the options are vested at the end of year 4
  Vesting period could be made contingent to Performance of the
Employee and the Company (Please refer to the performance
expectations mentioned above)
 Employee loses non-exercised shares

Some of the significant differences between the two are:

Sweat Equity ESOP

Definition Grant of shares at discount or Grant of option to purchase share
without monetary considerations at predetermined price
Eligibility Can be issued to the promoters of Cannot be issued to the
the Company promoters or promoter group
and directors holding more than
10%
Lock-in period Minimum lock in period of 3 years No lock in period. Minimum
vesting period is 1 year
Limitation on issue In one year, Company cannot issue
sweat equity shares of more than
15% of paid up equity share capital,
or Rs 5 crore, whichever is higher
In aggregate, Company cannot issue
sweat equity shares of more than
25% of paid up equity share capital

 
Case Study

We have recently come across the following structure adopted by a new software company

Share holders

 The key product developer is the CEO with 15 years of relevant experience
 2 other share holders are investors.

Total investment by Investors: Rs. 5 crores over a 3 year period

CEO’s Compensation

Salary: Rs. 36 lakhs / annum

Sweat Equity: 20%

Structure:

 The equity of the CEO will be maintained till the end of 3 years.
 Any shortfall in investment will be compensated to CEO by the investors
o In case at the end of 3 years, less than 5 crores is invested, then CEO has the option of
drawing down 20% of the differential shortfall.