Overview
Employee Stock Option Plan is an employee benefit plan that allows workers to own a stake or ownership interest in the company either in the form of shares. Companies typically tie distributions from the plan to vesting, which gives employees rights to employer-provided assets over time, before they retire or resign or any other event as mutually agreed by parties. Therefore, ESOPs are used by start-ups or other businesses as a corporate finance strategy to align the interests of their employees with those of their shareholders.
Being the third largest start-up ecosystem with 77000+ recognized start-ups and one of the largest growing economies in the world, ESOPs are being increasingly used by start-ups to boost creativity & innovation and retain talents. Last year, notable start-ups Nykaa, Zomato, Policy Bazaar, and Paytm, as well as Flipkart Group, Byju’s, and Ola expanded their ESOP pool while entering 100Cr Crore, while Edu-giant Unacademy expanded its ESOP pool to 238 Mn from 99K options, taking the total ESOP valuation to exceed $500 M.
Further, in 2021 39% of the Indian start-ups reported offering ESOPs to candidates while interviewing them for jobs, while around 53% of the startups offered ESOPs before the candidates accepted job offers, showing that start-ups are progressing towards offering ESOP options to their new employees as part of their CTC. All of these show the increasing relevance of ESOPs to attract new talent.
ESOP-Meaning & Definition
Section 2(37) of the Companies Act, 2013 describes ESOPs as the stock options given to the directors/employees/officers of either the company itself or its holding/subsidiary company, a specific right to purchase the shares of the company at a pre-determined rate in future after the end of a certain vesting period. Therefore, ESOPs is a scheme where a company proposes to increase its subscribed share capital through the issue of further shares to its employees.
Every company that wishes to allot stock options to its employees can only do so following the provisions of the Companies (Share Capital and Debentures) Rules, 2014, and the Companies Act, 2013. In case the company is a listed company, it will be required to follow the SEBI (ESOPs) rules in addition to the Companies (Share Capital and Debentures) Rules, 2014.
How do ESOPs work?
Since ESOPs are employee benefit plans who offer employees an ownership interest in the form of shares of stock. Thus, they offer the sponsoring start-up company and the participants various tax benefits, making them qualified plans, and are often used as a tool by the employers as a corporate finance strategy to align the interests of their employees with their shareholders.
Apart from this, there are no qualifying criteria for the type of size of the company or any particular category of employee to be considered to offer ESOPs. ESOPs could be used by businesses of all sizes, whether small or bigger including largely listed corporations.
What are the various types of ESOPs?
- Employee Stock Option Scheme (ESOS)-Employee Stock Option Schemes are the most commonly used form of employee ownership. ESOS option confers a right to buy shares of the company at a later date without any obligation on the employee. Such stock options are subject to vesting requiring fulfillment of certain conditions such as continued service over a certain period. Once these options are vested in the employee, they can exercise the options to get shares by payment of the pre-decided exercise price.
- Employee Stock Purchase Plan (ESPP)-Employee Stock Purchase Plans or ESPP allow an employee to purchase shares of any particular company usually at a discounted price from the fair market value of the shares. The stock options offered under the ESPP are subject to terms that contain details regarding the tenure and price for the exercise of options by employees. Usually, ESPPs are offered to offer shares as part of a public issue of shares.
- Stock Appreciation Rights (SARs)-Although, SARs are not technically considered employee stock options, however, they are similarly issued by a company. Companies often issue SARs to their employees who could profit from the SARs whenever there is a rise in stock prices of the company, as companies make cash payments equal to the appreciation of the company’s stock over a specified duration to employees. Thus, unlike ESPP & ESOS, SARs employees are not required to pay any exercise price and offer equity upside without exposure to any downside to employees.
- Restricted Stock Units (RSU)-Restricted Stock Units Plan allows employees the right to receive shares on a pre-decided date subject to happening any certain event or fulfillment of specified conditions.
Who is eligible to receive ESOP?
Though, there are no fixed eligibility criteria for offering ESOP options to employees. Rule 12(1) of Companies (Share Capital and Debentures) Rules, 2014 prescribes the following could be issued ESOPs by the company-
- Any permanent employee of the company who is either working in India or outside India.
- A Director of the company, irrespective of being a Whole-time or Part-time director except for an independent director.
- A permanent employee/ director of either a subsidiary company/holding company/an associate company, either in India or outside India.
However, the following shall be disqualified from receiving ESOP from the company-
- Employees who are either promoters of the company or belong to the promoter group of the business;
- A Director who either directly or indirectly (through anybody corporate or any relative) holds more than ten percent of the outstanding equity shares of the company.
But, these two conditions shall not be applicable in the case of Startups for ten years from the date of incorporation.
Process of issuing ESOPs to Employees of Unlisted Company
Under section 62(1)(b) of the Companies Act 2013 to be read along with the Companies (Share Capital & Debentures)Rules 2014, the process of issuance of ESOP options to employees of a company is as provided below-
- Prepare the draft for ESOP-Firstly, the committee appointed by the board shall be required to draft an ESOP in confirmation with the applicable provisions of the Companies Act 2013 & Companies (Shares Capital & Debenture) 2014.
- Make preparations for a valid board meeting– Preparation for Board Meeting-Next, the company shall be required to convene a board meeting, for which it should prepare a draft resolution which shall be required to be prepared to be passed in the board meeting.
- Send Board notice to the Directors -The company shall be required to send an advance notice to all the directors before at least seven days from the date of the board meeting.
- Pass a special resolution at a General Meeting- On the date of a board meeting, the board of directors shall be required to pass a special resolution accepting the issuance of the ESOPs to employees including the terms & conditions of ESOPs. In the meeting itself, the company shall also determine the price of shares that will be issued in pursuance of the ESOP scheme. After this, the company shall be required to determine the price of shares which will be issued according to ESOP. After this, the board of directors shall also fix the time & date for the convening of the general meeting and pass a special resolution for issuing of ESOP.
- Filing of form MGT-14 with ROC-the Company shall be required to send a copy of the draft minutes to all the directors within 15 days from the conclusion of the meeting, and further need to file the MGT-14 form to the Registrar of Companies within 30 days from the date of the meeting.
- Send advance notice of general meeting- All the directors, shareholders, and auditors of the start-up company shall be sent advance notice of the general meeting with the agenda for ‘ESOP Approval to employees of the company” at least 21 days from the date of the general meeting.
- Passing special resolution at the General meeting-On the date of the general meeting, the company shall be required to pass a special resolution for the issuance of shares under the ESOP scheme to the eligible employees, including the directors and officers of the company.
- Filing MGT-14 with ROC-On the passing of the special resolution, the start-up company shall be required to file MGT-14 to the Registrar of Companies within 30 days from the date of receiving approval of shareholders through special resolution in the general meeting.
- Sending of Options-Finally, the selected employees of the company will be sent the options to exercise their rights under the ESOP scheme.
- Maintaining a register of ESOP- Afterwards, the company shall be required to preserve & maintain details of ESOP in the Register of Employee Stock Options in the prescribed form SH-6 and should be preserved in its registered office. The entries made in the ESOP register will be authenticated by either the Company secretary or any other person authorized by the board of directors for such purposes.
It is to be noted that in case the start-up is a private company, it needs to ensure that the provisions related to the issue of ESOP should be contained in its articles of association. Where the articles of association contain a restriction regarding the issue of ESOPs, then such a private company shall convene an extraordinary general meeting of shareholders, and alter the provisions to enter the provisions of issuance of shares through ESOP. After which, the company could proceed with the above-mentioned provisions.
Process of Issuance of ESOPs for Listed Company
In the case of a listed company, the process flow of issuing ESOP options to employees starts with the constitution of a board committee namely ‘The Compensation Committee to draft an ESOP scheme under the provisions of the law.
Subsequently, approval is to be obtained to draft the ESOP resolution & send the notice of general meeting is to be sent to the shareholders and a copy of the ESOPs scheme should be sent to the Stock Exchange as per the Listing Agreement. For this, a notice is sent for General Meeting and approval for the ESOP scheme is taken from the shareholders by passing a special resolution.
Then, the stock exchange in which the company is listed shall be required to provide a copy of the proceedings at the General meeting. After the special resolution is passed, all the required forms should be submitted to the ROC.
Next, the ESOP scheme is announced at the meeting of the Compensation Committee and will obtain an undertaking from the respective employee in accordance with the SEBI (ESOP) regulations. Finally, it has to be filed with the Securities Exchange Board of India (SEBI) &Chief Commissioner of Income Tax to make it valid as an ESOP. Finally, the scheme is listed on the stock exchange.
It is to be noted that the listed company must notify the stock exchange in accordance with schedule V before finally exercising the option& take the in-principle approval of the Stock Exchange, and whenever any ESOP is exercised by the listed company, the Stock Exchange must be notified as per schedule VI.
Disclosures to Be Made While Issuing ESOP
Every company shall be required to make certain disclosures in the explanatory statement attached to the notice for passing the special resolution to issue ESOP options to their employees-
- Number of stock options to be granted;
- Any class of identification for employees who can participate in the ESOP;
- Any conditions for vesting period of ESOP;
- The Maximum period within which ESOPs can be vested;
- Exercise price & the process of exercise;
- Lock-in period, if any decided;
- Grant the maximum number of options for each employee;
- Methods decided to be used by the company to value its options,
- Conditions under which the options vested in an employee could have lapsed;
- Statement that the company shall always comply with the applicable accounting standards concerning ESOPs.
Tax Implications of ESOP
ESOPs are subject to taxation in two instances for employees-
At the time of exercising the ESOP- When the eligible employee exercises his ESOP option after the end of the vesting period, it shall be considered a pre-requisite for taxation purposes. Thus, the difference between the FMV (as on the exercise date) and the exercise price is taxed as perquisite.
Exception-However, as per an amendment in FY20-21, an employee receiving ESOPs from any eligible start-up shall not be subject to taxation at the time of exercising his ESOP option. Accordingly, the TDS on the ‘perquisite’ shall stand deferred to the earliest of the following events-
- Expiration of five years from the year of allotment of ESOPs
- Date of exercise of ESOP sale by the employee; or
- The date on which the employment of the such employee is terminated.
At the time of sale by the employee – as a capital gain – After the ESOP options are vested in the employee, he may choose to sell all the shares once bought by him. If the employee sells such shares, he shall be subject to payment of taxes as a capital gain for the price difference between the sale price and FMV on the date of exercise of the option.
Advantages of ESOP for employees
An employee stock option plan (ESOP) is a popular method to incentivize employees for their work by offering them a chance to hold the ownership of the company in near future for a pre-determined exercise price that is way lower than the prevailing market rate at a such future date. As ESOPs are shared as a part of the remuneration package of an employee, companies can use ESOPs to encourage employees to focus on corporate performance and share price appreciation. Thus, holding an ESOP makes an employee innovate or perform better and feel more appreciated, and be essentially rewarded for their hard work and commitment. There are various real-world examples of success stories of employees who earned huge wealth & success together with the founders of the businesses. For instance, when google went public, the Google founders Sergey Brin and Larry Page became one the richest people in the world including their stock-holder employees who earned millions too.
Conclusion
Therefore, ESOPs are practically a win-win situation for the employers as well as the employees of the company as it allows the benefit of encouraging employees to work harder with a commitment to augmenting the growth of the start-up business, and at the same time, it rewards and appreciates the employees for bigger financial rewards.
However, it is to be noted that no two ESOPs could be the same, and could be a point of friction between the employer-employee if they fail to understand the terms and conditions related to the exercise of their option and conditions of vesting of options. Thus, it is necessary to be extra aware of the rules and make the most of the benefit bestowed upon the employee by not potentially missing out on such a big bonus.
