Regulatory Amendment to Allow Founders to Exercise ESOPs
The Securities and Exchange Board of India (SEBI) has proposed amendments to the employee stock option plan (ESOP) regulations, allowing founders of IPO-bound companies to retain and exercise their ESOPs even after being classified as promoters. This change aims to address existing ambiguities in the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2023 (SBEB and SE Regulations), which currently prohibit promoters and members of the promoter group from holding ESOPs.
SEBI’s proposal, outlined in a consultation paper released on March 20, includes a provision allowing an employee who later becomes a promoter to continue holding and exercising their ESOPs, provided that the options were granted at least one year before the company decides to go public.
Key Highlights: SEBI’s Proposed ESOP Changes for IPO-Bound Companies
- Current regulations prohibit promoters and promoter group members from receiving ESOPs.
- SEBI proposes allowing employees identified as promoters at the time of an IPO to retain their ESOPs, provided they were granted at least one year before the company decides to list.
- A one-year cooling-off period has been suggested to prevent misuse, ensuring that ESOPs are not issued just before an IPO for undue benefits.
- SEBI aims to resolve ambiguities around ESOP treatment when founders are classified as promoters due to IPO disclosure requirements.
Current SEBI ESOP Regulations and the Issue with IPO-Linked Promoter Status
Under existing SEBI SBEB and SE Regulations, ESOPs can only be granted to employees who are not classified as promoters or part of the promoter group. However, in cases where a startup founder or senior executive is later categorized as a promoter due to IPO disclosure requirements, it is unclear whether they can still exercise their ESOPs.
This regulatory gap creates challenges for startup founders, who may have received stock options as part of their compensation but could lose them upon being classified as promoters during an IPO process.
To address this, SEBI has proposed an explanation under Regulation 9(6) of the SBEB Regulations, clarifying that ESOPs granted to an employee before they were identified as a promoter will remain valid.
SEBI’s Proposed Amendment: Safeguarding ESOPs for Founders
The consultation paper suggests inserting an explanation under Regulation 9(6) of the SBEB Regulations, 2023, stating:
“An employee, identified as a ‘promoter’ or ‘promoter group’ in the draft offer document filed by a company in relation to an initial public offering, who was granted options, SARs, or other benefits under any scheme prior to being identified as a ‘promoter’ or ‘promoter group’, shall be eligible to continue to hold, exercise, or avail any such option, SAR, or benefit, in accordance with its terms and granted, prior to one year from the date when the company (i.e. its Board) decides to undertake an Initial Public Offering and, in compliance with these Regulations.”
Cooling-Off Period to Prevent ESOP Misuse
To prevent potential misuse, SEBI has proposed a mandatory one-year cooling-off period between the granting of ESOPs and the company’s decision to go public.
Why the cooling-off period is necessary:
- It prevents companies from issuing last-minute ESOPs just before an IPO to benefit founders unfairly.
- Ensures ESOPs are a genuine long-term compensation tool rather than a pre-IPO incentive.
- Maintains investor confidence by ensuring transparency in ESOP allocations.
How it balances founder benefits and regulatory compliance:
- Founders who genuinely received ESOPs before an IPO decision can still exercise them.
- It aligns with SEBI’s objective of protecting minority investors and ensuring fair corporate governance.
Impact of SEBI’s Proposal on Startups and IPO-Bound Firms
If implemented, SEBI’s proposed ESOP regulation changes will have a significant impact on startups and companies preparing for an IPO.
Positive impact:
- Provides clarity for founders and early-stage employees regarding ESOP eligibility when their company goes public.
- Encourages long-term commitment and retention of key personnel in startups.
- Makes ESOP structures more attractive to investors and employees.
Challenges and concerns:
- Some investors might argue that allowing promoters to retain ESOPs blurs the lines between employee compensation and ownership stakes.
- The one-year cooling-off period may not fully eliminate the risk of pre-IPO ESOP manipulation.
SEBI’s Move to Ensure Fairness and Prevent Regulatory Arbitrage
SEBI’s proposal aims to strike a balance between protecting employee stock options and preventing any misuse in the lead-up to an IPO.
- Promoters should not lose their ESOPs unfairly: If ESOPs were granted before a person was identified as a promoter, they should be allowed to retain and exercise them.
- Preventing last-minute ESOP allocations: By mandating a one-year cooling-off period, SEBI ensures that companies cannot grant stock options opportunistically just before an IPO.
- Aligning with global best practices: Many international markets allow startup founders to retain ESOPs even after becoming promoters, making India’s market more investor-friendly and competitive.
The consultation process is expected to gather feedback from industry stakeholders, including startup founders, investors, and financial experts, before SEBI finalizes its regulatory amendments.
