Employees Stock Option Plan (‘ESOP’)

The ESOP refers to ‘a plan’ for the benefit of the Employees of a Company, who make the Companies operational, profit centres and socially-economically enormous, this is not limited to big known companies but is also common with the small companies; newly incorporated companies. This plan has become famous and appreciated over the time because of the benefits and the recognition it gives to the Employees. It enables an employee to create wealth as the Company grows.

Example: Infosys is one of the earliest IT firms to introduce ESOP and recognised the efforts of its employees via ESOP route.

Common Queries/ questions regarding ESOP

What is ESOP ?

An employee stock option plan (ESOP) is an incentive/bonus/ employee benefit plan that is given to an employee over a period of time towards his commitment and contribution in the Company.

Under this plan the Company (‘Employer’), offers its stocks/shares at low price or a predetermined price based on the terms and conditions entered between the employer and the employee. The option can be exercised by the employee after completing the vesting period (lock-in period), If the employee leaves the organisation before completing the specified period – the ESOP’s get lapsed and the employee will not get any benefit.

What are the Incentives of ESOP ?

For Company: retain employees on a long-term basis; low employee turnover; helps in preserving the cash flow; raising capital easily

For employees: creating additional wealth for the employees; ownership interest; security from the organisation; encouragement to accept challenges, optimising the opportunities and turning into revenue.

What are the 2 ways to exercise ESOP ?

Direct route: The Company grants the option and at the time of exercise, fresh equity issuance is undertaken to allocate equity to the eligible employees. In case the employee decides to exercise the option, the employee becomes the shareholder of the company. In this process, when the employee intends to monetize the shares, the company may have to buy-back the shares, specifically in case of private limited companies or wait for the company to go for a public offering to get an exit from the company (as a shareholder).

Trust route: ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by listed companies. Under the trust route, the company does not have to dilute its existing capital base and the structure is largely preferred by listed entities for secondary market acquisition of the shares. When the employees leave the company, the employees have the option of selling back the shares to the trust or in the secondary market and monetizing the wealth creation by way of subscribing to the shares.

What Introductory terms is used in process of exercising ESOP ?

1. Employees’ Stock Option – 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. (Defined as per section 2(37) of the Companies Act’2013)

2. Employee means–

(a) a permanent employee of the company who has been working in India or outside India; or

(b) a director of the company, whether a whole time director or not but excluding an independent director; or

(c) an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company.

but does not include-

(i) an employee who is a promoter or a person belonging to the promoter group; or

(ii) a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.

However, for a start-up company, as defined in notification number 3[G.S.R. 127(E), dated 19th February, 2019 issued by the Department for Promotion of industry and Internal Trade], Ministry of Commerce and Industry Government of India, Government of India, the conditions mentioned in sub-clause (i) and (ii) shall not apply upto 10 years from the date of its incorporation or registration.

3. Grant Date –The date of agreement between the employer and employee to give an option to own shares.

4. Vesting Date – The date the employee is entitled to buy shares, after conditions agreed upon earlier are fulfilled. This date is also the agreed-on grant date.

5. Vesting Period – The time period between the grant date and vesting date.

6. Exercise Period – Once stocks have ‘vested’, the employee now has a right to buy the shares for a period of time. This period is called exercise period.

7. Exercise Date – The date on which employee exercises the option.

8. Exercise Price – The price at which employee exercises the option. This price is usually lower than the prevailing FMV (‘fair market value’) of the stock/share. An employer and employee agree on ESOP terms on the grant date. Once the employee has fulfilled the conditions or the relevant time period has elapsed, these employee stock options are vested. At this time the employee can exercise them or put simply – buy them. The employee is allowed some time period during which this option to buy can be exercised. Once the employee decides to buy, these stock options are allotted to him at an exercise price which is usually lower than the FMV of the stock. Of course, the employee can choose not to exercise his option. In that case, no tax is payable.

9. Trust– a trust established under the provisions of Indian Trusts Act, 1882 including any statutory modification or re-enactment thereof, for implementing any of the schemes covered by these regulations.

What Tax Applicability ?

I)  As Perquisites : At the time of exercising the option – When the employee has agreed to buy the shares; the difference between the FMV (on exercise date) and exercise price is taxed as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of total income from salary in the tax return.

Advantage for Employees of a Start-up Company – from the FY 2020-2021 onwards, an employee receiving ESOPs from an eligible start-up need not pay tax in the year of exercising the option. The TDS on the ‘perquisite’ stands deferred to earlier of the following events:

Expiry of five years from the year of allotment of ESOPs

Date of sale of the ESOPs by the employee

Date of termination of employment

II) As Capital Gain: At the time of sale of stocks/shares by the employee – The employee may choose to sell the shares once these are bought by him. If the employee sells these shares, another tax event happens. The difference between the sale price and FMV on the exercise date is taxed as capital gains.

What are the FEMA compliance for non-resident shareholders ?

Indian company is permitted to issue “employees’ stock option” to its employees/ directors or employees/ directors of its holding company or joint venture or wholly owned overseas subsidiary/ subsidiaries who are resident outside India, subject to the following conditions:

(1) The ESOP is drawn either in terms of regulations issued under the Securities and Exchange Board of India Act, 1992 or the Companies (Share Capital and Debentures) Rules, 2014 notified by the Central Government under the Companies Act 2013;

(2) The “employee’s stock option” are in compliance with the sectoral cap applicable to the said company;

(3) Issue of “employee’s stock option” in a company where investment by a person resident outside India is under the approval route requires prior Government approval;

(4) Issue of “employee’s stock option” to a citizen of Bangladesh/ Pakistan requires prior Government approval.

Form Employees’ Stock Option (ESOP): An Indian company issuing employees’ stock option to persons resident outside India who are its employees/ directors or employees/ directors of its holding company/ joint venture/ wholly owned overseas subsidiary/ subsidiaries shall submit Form-ESOP to the Regional Office concerned of the Reserve Bank under whose jurisdiction the registered office of the company operates, within 30 days from the date of issue of employees’ stock option.

What are the ESOP compliance as per Companies Act, 2013 and Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 ?

Issue of ESOP in case of Private Limited Company or Unlisted Company:

A company, to comply the following requirements, namely:-

(1) the issue of Employees Stock Option Scheme has been approved by the shareholders of the company by passing a special resolution.

(2) The company shall make the following disclosures in the explanatory statement annexed to the notice for passing of the resolution-

(a) the total number of stock options to be granted;

(b) identification of classes of employees entitled to participate in the Employees Stock Option Scheme;

(c) the appraisal process for determining the eligibility of employees to the Employees Stock Option Scheme;

(d) the requirements of vesting and period of vesting;

(e) the maximum period within which the options shall be vested;

(f) the exercise price or the formula for arriving at the same;

(g) the exercise period and process of exercise;

(h) the Lock-in period, if any ;

(i) the maximum number of options to be granted per employee and in aggregate;

(j) the method which the company shall use to value its options;

(k) the conditions under which option vested in employees may lapse e.g. in case of termination of employment for misconduct;

(l) the specified time period within which the employee shall exercise the vested options in the event of a proposed termination of employment or resignation of employee; and

(m) a statement to the effect that the company shall comply with the applicable accounting standards .

(3) The companies granting option to its employees pursuant to Employees Stock Option Scheme will have the freedom to determine the exercise price in conformity with the applicable accounting policies, if any.

(4) The approval of shareholders by way of separate resolution shall be obtained by the company in case of-

(a) grant of option to employees of subsidiary or holding company; or

(b) grant of option to identified employees, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option.

(5) (a) The company may by special resolution, vary the terms of Employees Stock Option Scheme not yet exercised by the employees provided such variation is not prejudicial to the interests of the option holders.

(b) The notice for passing special resolution for variation of terms of Employees Stock Option Scheme shall disclose full of the variation, the rationale therefor, and the details of the employees who are beneficiaries of such variation.

(6) (a) There shall be a minimum period of one year between the grant of options and vesting of option:

Provided that in a case where options are granted by a company under its Employees Stock Option Scheme in lieu of options held by the same person under an Employees Stock Option Scheme in another company, which has merged or amalgamated with the first mentioned company, the period during which the options granted by the merging or amalgamating company were held by him shall be adjusted against the minimum vesting period required under this clause;

(b) The company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.

(c) The Employees shall not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to them, till shares are issued on exercise of option.

(7) The amount, if any, payable by the employees, at the time of grant of option-

(a) may be forfeited by the company if the option is not exercised by the employees within the exercise period; or

(b) the amount may be refunded to the employees if the options are not vested due to non-fulfillment of conditions relating to vesting of option as per the Employees Stock Option Scheme.

(8) (a) The option granted to employees shall not be transferable to any other person.

(b) The option granted to the employees shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner.

(c) Subject to clause (d), no person other than the employees to whom the option is granted shall be entitled to exercise the option.

(d) In the event of the death of employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.

(e) In case the employee suffers a permanent incapacity while in employment, all the options granted to him as on the date of permanent incapacitation, shall vest in him on that day.

(f) In the event of resignation or termination of employment, all options not vested in the employee as on that day shall expire. However, the employee can exercise the options granted to him which are vested within the period specified in this behalf, subject to the terms and conditions under the scheme granting such options as approved by the Board.

(9) The Board of directors, shall, inter alia, disclose in the Directors’ Report for the year, the following details of the Employees Stock Option Scheme:

(a) options granted;

(b) options vested;

(c) options exercised;

(d) the total number of shares arising as a result of exercise of option;

(e) options lapsed;

(f) the exercise price;

(g) variation of terms of options;

(h) money realized by exercise of options;

(i) total number of options in force;

(j) employee wise details of options granted to;-

(i) key managerial personnel;

(ii) any other employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year.

(iii) identified employees who were granted option, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;

(10) (a) The company shall maintain a Register of Employee Stock Options in Form No. SH.6 and shall forthwith enter therein the particulars of option granted under clause (b) of sub-section (1) of section 62.

(11) Where the equity shares of the company are listed on a recognized stock exchange, the Employees Stock Option Scheme shall be issued, in accordance with the regulations made by the Securities and Exchange Board of India in this behalf.

Issue of ESOP in case of Listed Company Implementation of schemes through trust and additionally follow the provisions of Companies Act 2013:

(1) A company may implement schemes either directly or by setting up an irrevocable trust(s): Provided that if the scheme is to be implemented through a trust the same has to be decided upfront at the time of taking approval of the shareholders for setting up the schemes: Provided further that if the scheme involves secondary acquisition or gift or both, then it is mandatory for the company to implement such scheme(s) through a trust(s).

(2) A company may implement several schemes as permitted under these regulations through a single trust: Provided that such single trust shall keep and maintain proper books of account, records and documents, for each such scheme so as to explain its transactions and to disclose at any point of time the financial position of each scheme and in particular give a true and fair view of the state of affairs of each scheme.

(3) SEBI may specify the minimum provisions to be included in the trust deed under which the trust is formed, and such trust deed and any modifications thereto shall be mandatorily filed with the stock exchange in India where the shares of the company are listed.

(4) A person shall not be appointed as a trustee, if he or she is a director, key managerial personnel or promoter of the company or its holding, subsidiary or associate company or any relative of such director, key managerial personnel or promoter; or ii. beneficially holds ten percent or more of the paid-up share capital of the company. 7 Provided where individuals or ‗one person companies‘ as defined under the Companies Act, 2013 are appointed as trustees, there shall be a minimum of two such trustees, and in case a corporate entity is appointed as a trustee, then it may be the sole trustee.

(5) The trustees of a trust, which is governed under these regulations, shall not vote in respect of the shares held by such trust, so as to avoid any misuse arising out of exercising such voting rights.

(6) The trustee should ensure that appropriate approval from the shareholders has been obtained by the company in order to enable the trust to implement the scheme(s) and undertake secondary acquisition for the purposes of the scheme(s).

(7) The trust shall not deal in derivatives, and shall undertake only delivery based transactions for the purposes of secondary acquisition as permitted by these regulations.

(8) Subject to the requirements of Companies Act, 2013 read with Companies (Share Capital and Debenture) Rules, 2014, as amended from time to time, as may be applicable, the company may lend monies to the trust on appropriate terms and conditions to acquire the shares either through new issue or secondary acquisition, for the purposes of implementation of the scheme(s).

(9) For the purposes of disclosures to the stock exchange, the shareholding of the trust shall be shown as ‗non-promoter and non-public‘ shareholding. Explanation: For the removal of doubts, it is clarified that shares held by the trust shall not form part of the public shareholding which needs to be maintained at a minimum of twenty five per cent as prescribed under Securities Contracts (Regulation) Rules, 1957.

(10) Secondary acquisition in a financial year by the trust shall not exceed two per cent of the paid up equity capital as at the end of the previous financial year.

(11) The total number of shares under secondary acquisition held by the trust shall at no time exceed the below mentioned prescribed limits as a percentage of the paid up equity capital as at the end of the financial year immediately prior to the year in which the shareholder approval is obtained for such secondary acquisition.

(12) The un-appropriated inventory of shares which are not backed by grants, acquired through secondary acquisition by the trust under Part A, Part B or Part C of Chapter III of these regulations, shall be appropriated within a reasonable period which shall not extend beyond the end of the subsequent financial year: Provided that if such trust(s) existing as on the date of notification of these regulations are not able to appropriate the un-appropriated inventory within one year of such notification, the same shall be disclosed to the stock exchange(s) at the end of such period and then the same shall be sold on the recognized stock exchange(s) where shares of the company are listed, within a period of five years from the date of notification of these regulations.

(13) The trust shall be required to hold the shares acquired through secondary acquisition for a minimum period of six months except where they are required to be transferred in the circumstances enumerated in clause (b) of sub-regulation (14) of this regulation 2 [, whether off market or on the platform of stock exchange.

(14) The trust shall be permitted to undertake off-market transfer of shares only under the following circumstances: (a). transfer to the employees pursuant to scheme(s); 2 Sub. by Securities and Exchange Board of India (Share based Employee Benefits) (Amendment) Regulations, 2015 (b).when participating in open offer under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, or when participating in buy-back, delisting or any other exit offered by the company generally to its shareholders.

(15) The trust shall not become a mechanism for trading in shares and hence shall not sell the shares in secondary market except under the following circumstances: (a). cashless exercise of options under the scheme covered by Part A of Chapter III of these regulations; (b).on vesting or exercise, as the case may be, of SAR under the scheme covered by Part C of Chapter III of these regulations; (c). in case of emergency for implementing the schemes covered under Part D and Part E of Chapter III of these regulations, and for this purpose – (i). the trustee shall record the reasons for such sale; and (ii). money so realised on sale of shares shall be utilised within a definite time period as stipulated under the scheme or trust deed. (d).participation in buy-back or open offers or delisting offers or any other exit offered by the company generally to its shareholders, if required; (e).for repaying the loan, if the un-appropriated inventory of shares held by the trust is not appropriated within the timeline as provided under sub-regulation (12) of this regulation; (f). winding up of the scheme(s); and (g).based on approval granted by SEBI to an applicant, for the reasons recorded in writing in respect of the schemes covered by Part A or Part B or Part C of Chapter III of these regulations, upon payment of a non-refundable fee of rupees one lakh along with the application 3 [by way of direct credit in the bank account through NEFT/RTGS/IMPS or any other mode allowed by RBI or] by way of a banker‘s cheque or demand draft payable at Mumbai in favour of the Board.

(16) The trust shall be required to make disclosures and comply with the other requirements applicable to insiders or promoters under the SEBI (Prohibition of Insider Trading) Regulations, 1992 or any modification or re-enactment thereto.