EMPLOYEE STOCK OPTION PLANS (ESOPs)
APPLICABLE LAWS AND PROVISIONS
The Companies Act, 2013, governs ESOPs by laying down the basic rules for how companies can grant stock options to their employees. Section 62(1)(b) read with Rule 8 of Companies (Share Capital and Debentures) Rules, 2014 authorizes companies to issue ESOP’S to employees, directors or officers ensuring shareholders’ approval. SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 also need to be followed (Listed Companies)
INTRODUCTION
ESOP (Employee stock option plans) is a corporate benefit plan designed to reward and retain employees in the company. ESOP provides employees with an opportunity to acquire a share in the wealth of the company at concessional rate. Unlike traditional salary or cash bonuses, ESOPs provide employees with equity-linked rewards, which creates a sense of belonging and alignment with the company’s long-term objectives. ESOP’s also acts as a golden handcuff to employees because they are intentionally structured to tie an employee’s financial future to the company.
PROCEDURE OF ISSUANCE OF ESOP’S
Section 62(1)(b) of the Companies Act, 2013 and Rule 12 of Companies (Share Capital and Debentures) Rules, 2014 governs the issuance of ESOP.
- Verify whether the company’s Article of Association (AOA) authorizes the issuance of Employee Stock Option Plans (ESOPs). If explicit authorization is lacking, the company must amend the AOA by obtaining shareholder approval in a general meeting.
- Formulate the comprehensive ESOP Scheme document, ensuring it clearly defines core terms such as eligibility criteria, vesting schedules, and the exercise period.
- Convene a meeting of the Board of Directors to pass a board resolution approving the draft ESOP Scheme and authorizing the issuance of notice to call an Extraordinary General Meeting (EGM).
- Hold the general meeting and pass the special resolution to approve the ESOP scheme.
ELIGIBILITY FOR ESOP’S
The extant regulations pertaining to ESOPs lays down some criteria for who eligible employees could be. For instance, Explanation to Rule 12 (1) of Companies (Share Capital and Debentures) Rules, 2014 states that –
For the purposes of clause (b) of sub-section (1) of section 62 and this rule 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 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 anybody, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.”
EXECUTION OF ESOP’S
- Grant the options: Issue formal grant letters to eligible employees offering them a specific number of options at a predetermined exercise price.
- Vesting Period: Upon completion of the vesting period, employees fulfill the tenure requirement and acquire the right to purchase the shares.
- Exercise and Allotment: Employees submit their exercise application and pay the required exercise price, after which the Board of Directors convene Board meeting to formally allot the shares.
- Filing of Form PAS-3 allotment of shares: The company must file the Return of Allotment with the Registrar of Companies (ROC) within 30 days from the date of allotment.
TYPES OF ESOP’S
- Employee Stock Option Scheme (ESOS) – This is the most common type of ESOP. An employee stock option scheme (ESOS) grants an employee the contractual right to acquire corporate shares at a fixed, predetermined exercise price, which is frequently set below current fair market value. Distributed as a strategic component of executive or staff remuneration, these options typically mature over a designated vesting period tied to time-based or performance-driven metrics. Upon exercise, participants enjoy full shareholder privileges, including voting entitlements and dividend distributions
- Employee Stock Purchase Plan (ESPP)- An employee stock purchase plan (ESPP) allows employees to purchase company stock at a discounted price and gradually increase their ownership stake in the business through periodic investments. ESPP allows participation in company profits as well, in the form of dividends.
- Restricted Stock Units (RSU’s)- These are a type of ESOP that allow employes to convert RSU’s into company’s share in exchange for a certain number of years working for the company or when specific performance milestone is achieved.
- Stock Appreciation Rights (SARs)– These are a type of ESOP that allows employees to receive payment based on the appreciation of company stock over a certain period. Companies can use SARs to provide employees with stock benefits without diluting their equity.
- Phantom equity plan – A Phantom Equity Plan (PEP) is a type of ESOP that allows employees to receive payment based on the value of the company’s stock without actually owning any shares. Companies provide mock stocks to them that tracks the value and performance of company’s real shares.
ROUTES FOR ISSUING ESOP’S
Under Indian law, a Company can issue ESOPs broadly through two routes – the Direct Route and the Trust Route – The choice depending on whether the Company is listed or unlisted and its own preference for administrative simplicity versus flexibility.
Direct Route
Under the direct route, the company issues stock options directly to eligible employees. Upon the employee’s decision to exercise these options, the company executes a fresh issuance of equity capital. This process increases the total outstanding share capital of the Company, and the employee also becomes the registered shareholder of the company.
Trust Route
Here the company set up an Employee Welfare Trust (EWT) which acts as an intermediary – holding shares and transferring them to employees upon exercise of options, instead of the Company allotting fresh shares directly. This mechanism eliminates the need for issuance of fresh equity shares, thereby preventing the dilution of the company’s existing equity capital structure. Consequently, this route is widely utilized by listed entities leveraging secondary market liquidity.
Governing law (Listed Companies): SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, the SEBI Regulations mandate the trust route in specified circumstances, such as secondary market acquisition-based schemes.
Two Sub-methods of funding the trust:
Primary acquisition: the company allots fresh shares to the trust, which then transfers them to employees on exercise.
Secondary acquisition: the trust purchases existing shares from the share’s market/promoters, capped at 2% of the paid-up capital per year and 5% cumulatively and subject to shareholder approval and specific SEBI disclosure norms.
It requires trust deed, trustee appointments separate demat account, annual disclosures (for listed entities), and adherence to related party transaction norms since the trust is typically treated as a related party.
As the Trust is structured exclusively as a non-business entity for ESOP administration, it does not possess independent liquidity to fund open-market share acquisitions. Consequently, pursuant to the enabling provisions of Section 67 of the Companies Act, 2013, the company may legally advance loans or provide financial assistance to the Trust, thereby enabling it to acquire and hold the requisite equity shares for subsequent allotment to employee beneficiaries.
BENEFITS OF ESOP’s
- Psychological ownership: An ESOP cultivates psychological ownership by tangibly linking an employee’s daily efforts to the company’s financial success and building an emotional investment in the organization.
- Wealth accumulation: ESOP acts as a wealth building engine , especially when combined with compounding stock value. For employees confident in their company’s trajectory, stock option can grow into a significant financial asset over time.
- Enhance company culture: Ownership drives accountability. Teams become more transparent, collaborative , and focus on value creation when everyone has skin in the game.
- Better productivity: Since employees themselves want to gain profits earned by the company , ESOP can boost employee productivity.
ESOP IN STARTUP
An ESOP is a benefit that gives employees the right to buy a small part of company’s shares at fixed price in the future which means that if the startup grows and becomes valuable over time, this gives employees a chance to earn extra money on top of their salary.
Startup may offer ESOPs to their promoters, directors and employees without the restrictions on promoter participation that applies to other private companies. Additionally recognized startups can enjoy deferred tax payments of ESOPs.
CONCLUSION
ESOP serves as a bridge connecting an employee’s daily contributions to the overarching success of the organization. It is one of the best ways to reward employees, enhance profitability, generate the spirit of ownership and make employees more loyal towards the company. ESOP can act as an emotional investment in the company by the employee. It is a vital internal corporate action which helps to retain talented and skillful employees in the company.
For any further query or consultations, please connect with us:
J. K. Gupta & Associates
(Company Secretaries & Insolvency Professionals)
Email: cs@jkgupta.com; Mobile: 9953887741
Delhi || Noida