Startups need actions, not words

In recent years, there has been an increasing focus on startups and the immense potential they bring to the economy. The government of Pakistan also seemed aware in this regard, at least partially so, as indicated by the recent amendments made to the Companies Act, 2017. 

You see, the current company law regime in Pakistan is not favorable for startups as it places high regulatory and compliance costs that bigger companies may conveniently bear, but which are unsuited for startups. The government recognised this, and made the amendments.  

However, bizarrely, the aforesaid amendments to the Companies Act were made through an Ordinance, which has lapsed on account of not being approved by Parliament within the requisite time of four months. While it is expected that the startup friendly amendments introduced through the said Ordinance will be incorporated in the Companies again through another Ordinance or act, it is clear that the present government’s oral commitments regarding the facilitation of small businesses are not translating into any sustained measures on the ground.

One of the key challenges for any startup is hiring and retaining quality human resources during the course of its expansion. Bigger companies naturally have deeper pockets, which prove instrumental in attracting and retaining high quality human resources. 

On the other hand, with the limited money available, Startups typically face a tradeoff between expanding or spending on infrastructure, as well as spending on marketing versus offering high wages or monetary rewards to its employees.

In this context, Employee Stock Option Programs (ESOPs) are becoming increasingly popular within the startup ecosystem, as they allow a startup to reward select employees and provide such employees with a significant incentive to continue and prolong their employment with the startup, without requiring the startup to directly use any of its revenues that it may have raised. 

ESOPs essentially work by granting these select employees an option or right to buy a specified amount of shares in the company at a future date. The option to buy is at a predetermined price that is expected to be lower than what the price of the shares is anticipated to be when this option is eventually exercised down the road. Consequently, the value of the benefit being conferred on the employees through ESOPs is the differential between the market value of the issued shares and the price at which the shares were actually issued to the select employees.

For instance, under an ESOP, an employee of a company may be conferred the right to subscribe to 2,000 shares in such company, at such employee’s completion of two years of employment with the company, at a predetermined price of Rs. 100 per share. If the market price of each share at the time of the share issuance is actually Rs. 1,000 (on account of the company’s expansion, good performance, etc.), and if the employee chooses to subscribe to the offered shares, such employee will essentially be conferred a monetary benefit.

ESOPs not only incentivize select employees to stick with the company until such a  time that they are eligible to subscribe to the offered shares under the ESOP, but also lead to a greater alignment in the incentive structure of the select employees and the company. Better company performance will lead to an increase in the market value of the company’s shares, which in turn will lead to an increase in the value of the benefit being conferred on the select employees under the ESOP. 

Under the erstwhile Companies Ordinance of 1984, and the Companies Act of 2017, only public limited companies were permitted to carry out ESOPs. Through the Companies (Amendment) Ordinance, 2020, private limited companies were also permitted to undertake ESOPs. Startups are typically incorporated as private limited companies, since they have a comparatively less stringent regulatory regime and provide a statutory right of first refusal to their shareholders. 

Unfortunately, the mode and manner in which such ESOPs could be undertaken by private limited companies was never specified through the promulgation of relevant rules or regulations.  This, coupled with the fact that the Ordinance has also lapsed, means private companies are barred from undertaking an ESOP under the provisions of the Companies Act, 2017. 

Private limited companies can still undertake ESOPs through a contractual arrangement referred to as contractual ESOP. These are typically put into effect by setting up a trust to both acquire the company’s shares and hold such shares for the benefit of the select employees until the shares are directly transferred to them, if, among other things, the employee completes the period of employment with the company that has been stipulated under the trust deed.

However, there are numerous advantages for undertaking a statutory ESOP as opposed to a contractual ESOP. Contractual ESOPs are relatively complicated to execute, involving the setting up of a trust, requiring a settlor to fund the subscription of the company’s shares by the trust, and given that there will likely be a time gap between the issuance of the shares and their transfer to the select employees, all the rights and privileges associated with the issued shares (including voting rights and dividends) have to be managed during such gap period. The trust deed also needs to account for the possibility that the selected employees may end up leaving the company during such a gap period, thus leaving their shares in a state of limbo.

In contrast, statutory ESOPs are relatively simple and easy to set up. A scheme is required to be drawn up specifying the details of the share option being provided including any lock-in period, the exercise period, and the exercise price. The scheme is then approved by the shareholders. The approved scheme is then submitted to the Securities and Exchange Commission of Pakistan (SECP) for its approval. The SECP’s review is compliance based as opposed to being a substantive review, and if all the applicable procedural requirements have been fulfilled, the scheme is approved. The costs involved with statutory ESOPs are also typically less compared to contractual ESOPs. 

Consequently, given the SECP’s apparent focus on facilitating startups, it is expected (or at least hoped) that the government will reintroduce the appropriate enabling amendments in the Companies Act, and the SECP will enact the rules and regulations, allowing private limited companies to set up statutory ESOPs at the earliest. Currently, some private limited companies intending on issuing ESOPs are unsure whether it would be wise to go ahead with contractual ESOPs, or wait for the enactment of the relevant enabling regime for statutory ESOPs in the hope that the same will be done in the near future.

The startup market in Pakistan has clearly picked up and the government and the regulatory authorities must do their part. Mere constant repetitions of buzzwords like ‘ease of business’ will only get us so far unless proactive steps are taken.

Asghar Leghari
The author is practicing lawyer and partner at Leghari & Darugar. Asghar Leghari can be reached at [email protected]

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