FAQs on Setting Up an Employee Stock Option Scheme

• What are ESOPs?

  Employee Stock Ownership Plans (ESOPs) are basically rights given to employees of a company. These rights pertain to buying shares of the company at a fixed price on the date of the grant. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans and Stock Purchase Plans.

• Why do companies offer ESOPs?

  ESOPs are the best and most frequently used tools to retain top notch employees in a company. Apart from this, ESOP has various other advantages like:

  • It instills a sense of Ownership and belonging among the employees.It can get employees highly inspired and focused for their jobs.
  • It helps aligning the interest of the managers with those of the owners.
  • It is a non-cash compensation tool to compete for the best human resources at affordable consideration.
  • It gives an opportunity to corporate to pay without a reduction in book profits.
  • ESOP is the most regular international tool that is used for granting retirement benefits to employees and as succession plan for owners.

• What are the various types of Option Plans available for employees?

  Usually, companies adopt one or more of the following types of plans. There can be variations in the specific terms to make it relevant to its business needs and objectives:

  • Employee Stock Option Scheme (ESOS)
  • Incentive Stock Option (ISO)
  • Employee Stock Purchase (ESP)
  • Stock Appreciation Rights (SARs)
  • Restricted Stock Award (RSA)
  • Restricted Stock Unit (RSU)

• What should be the selection criteria for a particular model of plan?

  The selection criteria would completely depend upon the objective of the implementation of the ESOP Plan. Say, if the objective is to use ESOP as a talent retention tool, then you can plan the vesting period to be longer than usual. If your objective is to use it as an incentive tool, you may keep the exercise price low. This would enable the employee to enjoy an upside when he sells off his holding. Again, if your objective is to use it as a part of remuneration mechanism, the eligibility criteria could be accordingly widened.

• Are all employees eligible to be a part of ESOP?

  The organization can have its separate blue print for determining the eligibility criteria for the purpose of this plan.However, there are few statutory eligibility criteria which you have to keep in mind:

  • An employee who is a promoter or belongs to the promoter group shall not be eligible to participate in the ESOP.
  • A director who either himself or through his relative or through any boy corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company shall not be eligible for ESOP.

• Who are considered as Employees of the Company?

  “Employee” means:

  • a permanent employee of the company working in India or out of India; or
  • a director of the company, whether a whole time director or not; or
  • an employee as defined in sub-clauses (a) or (b) of a subsidiary, in India or out of India, or of a holding company of the company.

• Who is called a Promoter?

  “Promoter” means:

  • the person or persons who are in over-all control of the company;
  • the person or persons who are instrumental in the formation of the company or programme pursuant to which the shares were offered to the public;
  • the persons or persons named in the offer document as promoter(s).
    Provided that a director or officer of the company, if they are acting as such only in their professional capacity will not be deemed to be a promoter.

• How does ESOP work?

  A company grants to an employee the option to buy a certain number of shares in the company at a fixed price after a certain number of years (option period). Before the employee can exercise the option he is usually required to complete the vesting period. This typically means that he has to continue to work for the Company for a minimum number of years before part or all of the options can be exercised.

• What is called “Grant “of an ESOP option?

  Grant is the act of commitment made by the employer through informing the employee of the eligibility for the Options. This is done by way of sending the Grant Letters to the employees as a part of the ESOP Plan which is in place.

• What is meant by “Vesting”?

  Vesting is the process by which a company grants non-forfeitable rights over the shares of the company. Vesting gives an employee rights to own the shares of the company over time. Vesting basically has two parts – Vesting percentage is the portion of the total options Granted which can be exercised on completion of the Vesting Period.

• What is meant by “Exercise”?

  Exercise is the act of paying the Exercise Price to convert the Options into Shares.

• What is meant by “Exercise Price”?

  Exercise Price is the pre-determined price at which the options are offered to the employees.

• Can these Options Lapse or are they valid for a lifetime?

  Options are not valid for a lifetime. After a certain period, typically on termination of employee or expiry of Exercise Period, the Options lapse. Lapsed options cannot be converted into shares.

• What is meant by “Exercise Period”?

  Exercise Period is the period after the Vesting Period within which the employee has to Exercise.

• How are ESOPs taxed in the hands of the employee?

  There are two stages of taxability in the hands of the employee which is as below:

  • The first stage is when the options are exercised by the employee. The benefit, which is the difference between the fair market value (“FMV”) of the shares on the date of which the option is exercised and the amount at which the options were granted to the employee, is treated as a perquisite as per Income Tax Act, 1961 (the “Act’).
  • The second stage is when the shares are sold or transferred by the employee in which case the difference between the sale consideration and the FMV of the shares would be treated as capital gains and will be subject to capital gains tax.

• Can expenses related to ESOP be claimed as deduction by the company?

  Yes, in the hands of the Company issuing the ESOPS, it is allowed to claim ESOP costs as deductions.

• How much stake can be reserved for the purpose of ESOP?

  There is no statutory limit for this. This completely depends upon the objective of the of the ESOP plan, the frequency of the ESOP grant in the company and company’s internal policies and mechanisms.

• Does the employee become a shareholder of the company as soon as the options are granted to them?

  Mere grant of an option does not make an employee shareholder of the company. Options are not shares; they are rights to own shares. These become shares only when employee exercises that right.

• Are private limited companies and closely held companies eligible to issue ESOP to its employees?

  Yes, they can. However, as per Industry practice, since the shares are not publicly traded, employees need to be provided with an exit option.

• Can a holding company issue implement ESOP scheme for the employees of its subsidiary company?

  Yes, it can. However, the Articles of Association of the company must have such enabling provision.

• Is constitution of Compensation Committee compulsory?

  Constitution of Compensation Committee is compulsory only for listed companies. Private limited companies and closely held companies are not required to form such committee compulsorily.

• Is there any legal compliance that is to be taken care of for implementation of ESOP scheme?

  Yes, there quite a few corporate and legal compliances associated with ESOPs. The laws that dictate implementation of Equity Compensation plans are:

  • SEBI (ESOP guidelines)
  • Companies Act
  • Income Tax Act
  • Accounting guidelines (ICAI, IFRS, US GAAP)
  • FEMA