A Detailed Guide to Employee Stock Option Plans (ESOP)

Employee stock options refer to a kind of compensation contract between an employer and an employee that carries some characteristics of financial options. Let us get into the details of this plan and understand the concept -

What exactly is ESOP?

As per Quoting of Section -

Section 2(37) of the Companies Act, 2013, 'employees stock option' means the option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.

However, a company is not allowed to issue ESOP to the following employees-

• As employee who is a promoter of the company or
• An employee who is belonging to the promoter group or
• A director who either himself or through anybody corporate or through his relative holds more than 10 % of the outstanding equity shares of the company, whether directly or indirectly.

The above conditions do not apply to Start-up Companies for a period of 10 years from the date of its incorporation.

So, in simple words, The Employee Stock Option Plan (ESOP) is an employee benefit plan wherein a right is given to the employees to acquire the shares of the company for which they are working. It is issued by the company for encouraging employee ownership in the company. These shares are allotted to the employees at a concessional/discounted rate.

During old times, ESOPs were given to remunerate senior employees and to acknowledge their proven contribution to the company. However, in modern times, ESOPs are used as compensation and motivational tools. Employee Stock Options in India has gained immense popularity in recent times with the emergence of a vibrant startup ecosystem in the country.

Parties in the Plan

There are two main parties in the ESOP-

• the grantee (employee) and
• grantor (employer).

The employee(grantee) is given equity compensation in the form of Employee stock options, usually with certain restrictions, one of the most important of which is the vesting period by the employer(grantor).

What is Vesting Period?

The vesting period is the time period that an employee is required to wait in order to be able to exercise their Employee stock options. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.

Vesting Date

The dates on which the employee becomes entitled to exercise the right to acquire the shares is called as 'vesting date” The stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company. 

The Options Agreement

The stock options plan is made by the company's BOD and it has full details of the employee's rights. The options agreement will provide the key details of your option grant such as the vesting schedule, how the employee stock options will vest, what shares are represented by the grant, and the strike price. There may be chances to negotiate certain aspects of the options agreement. Also, it is advised to discuss the options agreement with a financial advisor before signing the agreement

Let us take an example

An employee is granted the right to buy 1000 shares, with the options vesting 25% per year over 4 years with a term of 10 years.

So, 25% of the Options, for the right to buy 250 shares would vest in one year from the option grant date, and next 25% would vest two years from the grant date, and so on.

Now, if you don't exercise your 25% vested options after one year, you would have a cumulative increase in exercisable options. Thus, after year two, you would now have 50% vested options. If you do not exercise any of the options in the first 4 years, you would have 100% of the ESOs vested after that period, which you can then exercise in full or in part. After 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the 10-year period (counting from the date of the option grant)

Process of Issue of Stock Options

Section 62(1)(b) of the Companies Act, 2013 and Rule 12 of Companies (Share Capital and Debentures) Rules, 2014 ('Rules”) provides for the issuance of ESOP. The process for issuing ESOP by a company are:

• Preparation of the draft of ESOP in accordance with the Companies Act, 2013 and Rules.
• Preparation of the notice for the board meeting. Also, a draft resolution is to be passed in the board meeting.
• Then send the notice of the board meeting to all the directors at least seven days before the meeting.
• The company has to pass the resolution for the issuance of shares through ESOP as well as will have to determine the price of shares to be issued pursuant to ESOP and fix time and date and approve for calling the general meeting to pass a special resolution for issuing ESOP.
• Send the draft minutes of the board meeting to all the directors within 15 days of its conclusion.
• File a form called MGT-14 with the Registrar of Companies (ROC)after passing the Board Resolution.
• A notice of the general meeting is to be sent to all the directors, auditors, shareholders and secretarial auditors of the company at least before 21 days of the date of the meeting.
• Pass the special resolution for the issuance of shares under the ESOP to the employees, directors and officers of the company in the general meeting.
• File MGT-14 form with the Registrar of Companies within thirty days of passing the special resolution in the general meeting along with the documents.
• Send options to the employees, directors and officers of the company for purchasing shares under ESOP.
• Maintain a ‘Register of Employee Stock Options' in Form No.SH-6 and enter the particulars of the ESOP granted to the employees, directors or officers of the company.

For Private Companies

In case of private companies, the procedure should be authorised by the Articles of Association (AOA).

If the AOA does not authorise, then the company should hold an extraordinary general meeting (EGM) for alteration of the AOA to include the provisions of issuance of shares through ESOP and then proceed with holding the board meeting for the passing of the resolution and getting the shareholder's approval for ESOP Scheme.

Is ESOP good for employees? 

Being an employee holding employee stock options, the company can provide unique rewards. Participants in the plan can get significant retirement benefits at no monetary cost to them. Also, an ESOP is an excellent way to enhance the company's ability to recruit and retain top. With an ESOP plan, an employee gets the benefit of acquiring the shares of the company at the nominal rate, and selling them (after a defined tenure set by his employer) and making a profit.

The Tax Implications

There are different stages at which taxation is to be kept in mind

Grant of Option

Grant of Option is not a taxable event. The employees are not bound under any tax liability at the point of grant of option.

When the options are exercised

The difference between the Exercise Price and the Market Price is treated as perquisite in the hand of the employee. The employer will deduct tax at source on the employee exercising the option, treating the same as perquisite.

When the option is sold

If the employee sells the acquired shares for less than or up to one year after exercise, then this transaction will amount to short-term capital gains and would be taxable at normal income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate.

Disclosures in the explanatory statement while issuing ESOP

An explanatory statement is annexed to the notice for passing special resolution for issuance of ESOP. Some important things are required to be disclosed in that statement which is as follows -

• The class of employees who can participate in the ESOP,
• The total number of stock options which is to be granted,
• Vesting period of ESOP,
• Maximum period within which the options can be vested,
• The exercise price and process of exercise,
• The lock-in period,
• The grant of the maximum number of options for an employee,
• The methods used by the company to value its options,
• The conditions of lapsing of the options vested in employees,
• A statement that the company will comply with the applicable accounting standards.