Startups thrive on ideas, agility, and motivated people. But retaining top talent and ensuring harmony among founders—especially as equity and control come into play—requires solid legal instruments. Two of the most important tools in this regard are:
- Founder Agreements – to govern relationships, responsibilities, and rights between co-founders.
- Employee Stock Option Plans (ESOPs) – to incentivize and retain employees by giving them a share in the company’s growth.
This article explores what these are, why they matter, and how to implement them properly, with detailed insights into best practices and legal considerations.
PART I: Founder Agreements
1. What Is a Founder Agreement?
A Founder Agreement is a legal document that outlines the roles, responsibilities, equity ownership, decision-making powers, and other terms governing the relationship between co-founders of a startup.
It’s best to sign this agreement before incorporation or at the early stages of the business.
2. Key Clauses in a Founder Agreement
2.1 Equity Split
- Specifies how much equity (shares) each founder owns.
- Includes vesting schedules (e.g., 4-year vesting with 1-year cliff) to protect the company if a founder leaves early.
2.2 Roles and Responsibilities
- Clearly define each founder’s designation, KPIs, and decision-making powers (e.g., CTO manages tech, CEO handles business operations).
2.3 IP Assignment
- Founders must assign all intellectual property created for the startup to the company.
2.4 Capital Contributions
- Who contributed how much money, time, or assets.
- Reimbursement terms, if any.
2.5 Confidentiality and Non-Compete
- Prohibits founders from disclosing confidential info.
- Restricts working with or starting competing businesses during and after their tenure.
2.6 Exit and Termination
- Procedures for voluntary exit, death, disability, or misconduct.
- Includes buyback clauses and treatment of unvested shares.
2.7 Dispute Resolution
- Preferably through arbitration, with a defined jurisdiction and method.
2.8 Decision-Making and Voting Rights
- Defines unanimous vs majority decisions (e.g., new funding rounds, major hires, company sale).
2.9 Future Funding and Dilution
- Agreement on how future funding rounds will dilute ownership.
- May include anti-dilution protections or pro-rata rights.
3. Why You Must Have a Founder Agreement
- Prevents disputes and ambiguity.
- Essential for investor due diligence.
- Clearly assigns IP ownership to the company.
- Ensures commitment through vesting and restrictions.
- Protects the company during founder exits or disputes.
4. Common Mistakes to Avoid
- Not signing an agreement at all.
- Not including vesting or IP transfer clauses.
- Keeping equity split vague or equal despite differing contributions.
- Failure to update agreements as the business evolves.
PART II: ESOPs (Employee Stock Option Plans)
1. What Is an ESOP?
An Employee Stock Option Plan (ESOP) is a scheme where startups grant employees the right to purchase shares of the company at a predetermined exercise price after a vesting period.
It helps startups:
- Retain and attract top talent
- Motivate employees to align with company goals
- Conserve cash during early stages
2. How ESOPs Work
Step-by-Step Flow:
- Create an ESOP Pool (typically 5%–15% of total equity)
- Board and shareholder approval of ESOP policy
- Grant options to selected employees (with letters)
- Vesting over time (e.g., 4 years with 1-year cliff)
- After vesting, employees can exercise options (buy shares)
- Upon exit (IPO or acquisition), employees can sell shares
3. Key Terms in an ESOP Policy
3.1 Grant Date
The date on which the company grants stock options.
3.2 Vesting Period
Time over which options become exercisable. Standard: 25% after 1 year, rest over 3 years.
3.3 Cliff
Minimum period before any options vest (usually 1 year).
3.4 Exercise Price
The price at which employees can buy each share. Typically nominal in early stages.
3.5 Exercise Period
Timeframe after vesting within which the employee must exercise the option, often 6 months to 10 years.
3.6 Exit Event
ESOPs may become liquid (sellable) during an IPO, acquisition, or buyback.
4. Legal and Regulatory Framework (India)
- Governed by the Companies Act, 2013 and SEBI regulations (for listed companies).
- Unlisted companies must pass a special resolution to issue ESOPs.
- ESOPs cannot be issued to promoters or independent directors (in some cases).
- Board and shareholder approval required for adoption and grants.
5. Tax Implications (India)
| Event | Tax Treatment |
|---|---|
| Exercise | Taxable as perquisite (difference between FMV and exercise price) |
| Sale | Capital gains tax on profit from sale of shares |
Note: Employees must pay tax even if liquidity is not available (in case of unlisted shares), which can be burdensome.
6. Best Practices for ESOPs
- Keep ESOP pool reserved early to avoid dilution surprises.
- Be transparent with employees about potential value and risks.
- Offer ESOP buyback as part of retention strategy after Series A/B.
- Consider phantom stock or SARs for senior staff if actual equity is sensitive.
7. ESOP vs Sweat Equity vs Phantom Stock
| Feature | ESOP | Sweat Equity | Phantom Stock |
|---|---|---|---|
| Form | Option to buy shares | Shares given for non-cash work | Cash equivalent, no real equity |
| Requires Exercise | Yes | No | No |
| Dilution | Yes | Yes | No |
| Taxable | At exercise and sale | At grant | At payout |
Conclusion
Both Founder Agreements and ESOPs are essential tools in the startup ecosystem:
- Founder Agreements establish trust, clarity, and accountability at the top.
- ESOPs empower startups to retain and motivate employees while conserving cash.
However, both require careful legal structuring, timely execution, and ongoing governance. Ignoring them, or managing them poorly, can lead to costly litigation, talent loss, or investor fallout.