Understanding how ESOPs work in India

Corporate Law & Intellectual Property Rights | By Editor | Last updated on Nov 22, 2019

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Understanding how ESOPs work in India

“Did you know that you can restrict the rights of the ESOP holders while giving them shares? Did you know that death or incapacitation of an ESOP holder does not end your liability for ESOP?”

These and many more. Read on to know all about ESOP

1.What are ESOPs?

Employee Stock Ownership Plans (ESOPs) are basically rights given to employees of a company for 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.

2.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 belongingness amongst the employees and 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.

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

Usually, companies adopt one or more of the following types of plans, with 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)

4. 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.

5. Are all employees eligible to be a part of ESOP?

While the organization can have its separate blue print for determining the eligibility criteria for the purpose of this plan, there are certain 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.

6.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.

6. 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.

7. 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 which 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.

8. 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, i.e. when the Employer sends the Grant Letter to the employees as a part of the ESOP Plan which is in place.

9. 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.

10. What is meant by “Exercise”?

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

11. What is meant by “Exercise Price”?

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

12. 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.

13. What is meant by “Exercise Period”?

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

14. 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.

15. 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.

16. 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.

17.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.

18.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.

19. 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.

20. 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.

21. 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

22. What is Accelerated vesting?

Accelerated vesting is a form of vesting that takes place at a faster pace than the original vesting schedule laid down in the ESOP scheme. Hence, the employee can obtain the benefit much sooner.

23. What percentage of salary to be offered should consist of ESOP?

This depends upon various factors like consideration of employee’s expectation, the level of employment offered (senior level or middle level or beginners), the basic lifestyle of the employee in question, his expectations and so on. For example, usually potential employees at beginner’s level may expect more of cash composition than that of ESOP whereas the senior management might be more inclined towards a stake in the organization.

24. Can conditions for ESOP be changed post acceptance of grant?

Yes, conditions can be changed post acceptance of grant. This is called modification of ESOPs. Usually these changes are undertaken in favor of employees. As a part of these modifications, vesting period may be reduced, exercise price may be reduced and so on. It is done as an added incentive for employee’s morale or rewarding them for extra-ordinary performances.

25. Can ESOPs be transferred or pledged by an employee to third parties?

ESOPs are not shares per se. These are options which may or may not be converted into shares, subject to underlying conditions. Till the time these options are converted, these are not shares and hence there is no property in existence. Thus, ESOPs cannot be transferred or pledged. However, when these ESOPs are converted into shares of the company, those are freely transferrable, subject to terms and conditions of ESOP scheme.

26. Do ESOP holders receive dividends or enjoy voting rights?

No. Again ESOPs are not shares but options. Hence, they do not come with dividend rights or voting rights. Only when these options are converted into shares, these rights can be exercised.

27. What happens when the holder of an ESOP dies before the options are vested?

If the ESOP holder dies before the options get vested to the holders, they vest in their legal heir or nominee.

28. What happens when the holder of an ESOP suffers a permanent incapacitation?

In case an employee suffers permanent incapacitation during the course of his employment, then the vesting period gets preponed. These options are now vested on the date of his incapacitation. This is irrespective of the fact that he is able continue his employment or not.

29. Can the right to transfer or sell shares of the company to third parties by denied to holders?

Once an ESOP holder becomes a shareholder, generally he would be entitled to enjoy the right to transfer his shares to anyone. This might not be an entertaining situation for a closely held private company or an unlisted public company. This issue can be addressed in a carefully drafted ESOP scheme by our experts.

30. What is the difference between ESOP and Sweat Equity?

People usually tend to mix the concepts of Sweat Equity Shares and Employees Stock Options, but it should be well kept in mind that both the concepts differ a lot from various aspects. Sweat Equity shares are those shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing know-how, or IPR, or value additions, by whatever name called.

An ESOP (Employees Stock Option Plan) on the other hand is an option given to the employees to buy certain number of shares of the Company at a pre-determined price.

One of the basic differences between Sweat Equity and ESOP is Sweat Equity can be issued for consideration other than cash while ESOP has to be issued only in lieu of cash.

Write to us for any assistance or support: Setting up an ESOP

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