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Employee Stock Option Plan (ESOP)

Vira Advisors 
Updated on 15 February 2021

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Introduction

Employee stock option plan (ESOP) or Equity incentive plan is the scheme used by the companies to give ownership interest to its employees. ESOP is regulated by Section 62(1) (b) of the Companies Act, 2013 and SEBI (ESOS and ESPS) Guidelines, 1999. The latest amendments in the guidelines were given by the SEBI in 2014 followed by an amendment in 2015.

What is ESOP?

ESOP is an employee-owner method which provides ownership stake to its employees. This method is used by the organization to attract, encourage and retain its employees. The employees are given an option and it does not obligate the employee to accept this scheme.

An ESOP is an option given to its whole time directors and permanent employees the benefit or the right to purchase the stock of the company at a predetermined price.

All about Employee Stock Option Plan

Why ESOP?

  • To attract, reward, motivate and retain employees for high levels of individual performance and for unusual efforts;
  • Promote employee ownership culture and reduce the attrition;
  • To improve the financial performance of the Company, which will ultimately contribute to the success of the Company;
  • Enhances job satisfaction of the employee due to ownership participation;
  • Proves to be a good retirement benefit plan for employee;

Benefits of ESOP

  • It keeps the employees motivated as direct stakes are involved.
  • It is a - kind- payment, instead of cash.
  • It gives a sense of ownership.
 

Thus giving ESOPs to employees helps the companies and even start-ups to attract potential employees, to retain and motivate the employees.

Disadvantages of ESOPs

The main concern for ESOPs is dilution. With every share granted to the employee the shareholders share gets diluted.

Who is an employee?

According to the guidelines provided by SEBI an employee is:

  • A permanent employee of the Company
  • A director of the company
  • An employee of a subsidiary

An employee does not include:

  • An employee who is the promoter or an employee of the promoter group (an immediate relative)
  • A director who owns directly or indirectly more than 10% of the equity shares of the company.

All the listed companies are regulated by the SEBI (ESOS and ESPS) Guidelines, 1999 and all the unlisted companies are regulated by the Rule 12 of Companies (Share Capital and Debenture) Rules, 2014.

The ESOPs can be issued through two routes:

a) Equity Route: In this route the company issues equity shares of the company to the employees as and when they exercise the option.

b) Trust Route: In the trust route the company forms an Employee Welfare Trust for the administration of ESOP in the company. The company issues shares to the trust which is forwarded or transferred to the employees upon exercise of options. The Companies Act, 2013 allows Companies to provide money involving purchase or subscription of its own shares or shares of holding company subject to the following:

 
  • The scheme of provision of money to be separately passed by shareholders.
  • Value of shares in the Trust shall not exceed 5% of the aggregate of paid up capital and free reserves of the Company.
  • Valuation of the shares purchased by the Trust is to be made by Registered Valuer, in case of unlisted companies.

Of both the routes, Equity route is widely used as an option by the Companies.

Variations in the terms of ESOP

The company shall not vary from the terms of ESOP approved in any manner that will result in the detriment of the shareholders. The notice of variation should be given to the shareholders containing all the details of the variation and should also contain the employees who will be benefitted by the variation.

The variation should be approved by a special resolution in the general meeting. The option of reprising of the shares is given to the company if it is not detriment to the interest of the employees and the shareholders.

Lock in period

There shall be a maximum of one year of lock in period. The employee cannot enjoy any benefits of a shareholder like share in dividend or voting right until shares are issued on exercise option.

 

Transferability of shares

The shares are not transferable. The employee cannot alienate the share in any manner.

In event of death of an employee the shares shall vest to the legal heir or the nominee of the deceased.

In case of resignation or termination of the employee, all the rights vested in him can be retained. The plan should specify the time period within which the employee can exercise his option. An employee terminated in case of misconduct will not have any vested right in the issued shares.

 

Valuation of Stock Option

In any stock option plan, the valuation aspect plays a very crucial role. The value of stock options is needed upon grant, during interim periods and at the final payment date to facilitate the calculation of the benefit extended to the employees.

Valuation at grant date is required to amortize the Employee Compensation cost over the vesting period. The valuation done at grant date is adjusted for expected attrition rates at end of each reporting period. Companies have to disclose it in the general meeting and should also follow the accounting guidelines provided by SEBI in guidelines of 2014.

Valuation of equity share is required when employees exercise their options. At each exercise date, Companies shares will need to be valued (for unlisted companies) in order to compute the perquisite value taxable in the hands of employee.

Taxation of ESOP

Income tax should be paid in two situations:

a) At the time of exercise of ESOPs

The income is treated as perquisites which form part of the salary of the employee. The employer is required to deduct TDS and the income is calculated as the difference between the fair value of each share and the market value.

b) At the time of sale of ESOPs

The gains arising out of ESOPs are capital gains. The capital gain is the difference between the sale price and the price at which it was awarded to the employee. The tax should be paid in the year of the sale of ESOP.

Long Term- When the ESOPs were held by the employee for more than 36 months (3 years) from the date of purchase the capital gain tax rate is 20%.

Short Term- When the ESOPs were held for less than 36 months (3 years) from the date of purchase the capital gain tax is 10%.

Procedure followed for the formulation of ESOPs through equity route:

Step 1- Constitution of Compensation committee:

Section 5 of the guidelines provide for the formation of a compensation committee. A compensation committee is formulated by the Board of Directors (BOD) and consist of a majority of independent directors. The Board of directors can also choose a merchant banker, however it is optional. This committee is set up to formulate detailed terms and conditions for the ESOP.

Step 2- Framing of the plan:

The Compensation Committee frames a plan. The plan must be in accordance with the guidelines provided by SEBI. The Compensation committee is for the administration and superintendence of the ESOP plan.

Things to focus on while formulating the ESOP plan:

  • Quantum of options;
  • Limit as % of paid up capital;
  • Attractiveness for employees to meet objective of ESOP Plans;
  • Coverage - nationality, levels of employees / employees of holding, subsidiary, associate companies;
  • New joinees - eligibility and effective date of grant;
  • How will grants be dealt with in case of promotions / group company transfers / terminations / retirements;
  • Pricing of options - freely pricable ESOPs can be issued at discount or premium. Different pricing can be done for different category of employees;
  • Freedom to determine exercise price in conformity with Companies Act & / or other regulations;
  • Taxation aspects;
  • Frequency of Grant of options - yearly / half-yearly / quarterly;
  • Minimum period of 1 year for 1st vesting;
  • Vesting - time based or performance based;
  • Vesting - onetime or graded;
  • Vesting - standard across the board or different for key people;

Step 3- Presentation to the BOD and approval:

After formulation of the plan by the compensation committee the BOD approves the plan. In case the company is listed, the plan should have an approval from the respective stock exchange.

Step 4- Approval of Shareholders:

The shareholders approve the plan through a special resolution. The plan should be approved by a majority of 3/4th Shareholders. A separate resolution should be passed if there is grant of ESOP to employees of any subsidiary or holding company.

The shareholders should be provided with all the documents necessary for them to formulate an informed decision. The explanatory details shall disclose prescribed statements like number of shares issued, amount at which issued, lock-in period, exercise period, Vesting (one time or graded) method, accounting method, etc.

Step 5- Issue letter of Acceptance:

After the ESOP plan is formulated, it is management- ™s responsibility to ensure that ESOPs are granted as per the ESOP plan approved by the Shareholders. Management / Compensation committee decides on list of employees to whom ESOPs are to be granted & places it before Board for approval through ordinary resolution. This is again ratified by Shareholders at meeting held at future dates.

After approval from Board of Directors, Management issues letter of acceptance to employees. After receipt of letter of acceptance of option, employees are eligible to exercise options once these are vested as per ESOP plan.

Step 6- Allotment of shares upon exercise of options after vesting:

Hold a Board Meeting at regular intervals during the exercise period for allotment of shares on options exercised by the employees.

Conclusion

ESOPs have proved to be very effective tools for both big companies and start-ups. Companies use these to retain their workforce and the talent whereas start-ups use these tools to hire fresh talent and to attract more workforce. These work as a boon for companies which cannot afford to pay high salary. Besides this the sense of ownership acts as a motivation for the employees to work hard and diligently.


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