Thursday, September 17, 2020

Employee Stock Option Plans (ESOPs) for Start Ups

An Employee Stock Option Plan (ESOP) is an employee benefit that intends to give employees a share in the ownership of a company. The concept is more prevalent in start-ups, where the initial team works hard to create an intangible asset of high value in the long term, while agreeing to take relatively smaller remuneration packages in the first few years. In such cases, employee stock options become a good way to build ownership, and link employee compensation to the high value of the company or its product, which the business plans to achieve in a few years.


Definition & Validity of ESOPs in India
Eligible Employees
Important Terms used in ESOPs
Process for Implementing an ESOP Scheme
Compliance related to ESOPs
Valuation of ESOPs
Taxation of ESOPs for Employees

Definition & Validity of ESOPs in India

ESOPs can be issued by private limited companies, unlisted public companies, as well as listed companies.

As per Section 2(37) of the Companies Act, 2013, employees' stock option means 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 predetermined price.

Further, Section 62(1)(b) provides that a company may, subject to compliance with conditions as prescribed under the Rules (in case of an unlisted company) and SEBI Regulations (in case of listed companies), offer shares to the employees under a scheme of employees' stock option.

Thus, an ESOP is an option or a right offered by a company to its employees to purchase its shares at a pre-determined price on a future date or event. Such event may be a specific date or achieving a certain milestone in terms of valuation or entry of a new investor.

Eligible Employees

An employee means a permanent employee of the company who has been working in India or outside India, or a director of the company, whether a whole time director or not but excluding an independent director.

Promoters and Founders of start-ups may not be eligible for ESOPs if they fall under the following restriction in the definition of employees eligible for ESOPs, as per the provisions of the Companies Act, 2013 read with the Companies (Share Capital and Debentures) Rules, 2014:

(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 10% of the outstanding equity shares of the company.

However, the Ministry of Corporate Affairs (MCA) vide Notification dated 19-Jul-2016 issued the Companies (Share Capital and Debentures) Third Amendment Rules, 2016 by which promoters and Directors of start-ups holding more than 10% of the shares were permitted to be issued ESOPs within the first 5 years from the date of incorporation. To be eligible for such exception, the company has to be an eligible and registered start-up under the DPIIT.

Important Terms used in ESOPs

(i) Option: a right (but not an obligation) to purchase the shares of the company on the fulfillment of the conditions mentioned in the ESOP scheme at a pre-determined price, which is decided at the time of grant of options. There is no ownership at the time of being granted the option. The ownership comes in only when such option is exercised as per the scheme.

(ii) Share Price: the price is not publicly available for private limited companies as they would not be listed on the stock exchange. Thus, such price is determined at a time when a valuation is conducted for the purpose of issuing additional shares in the company to a new investor, or at the time of transfer of shares from one investor to the other.

(iii) Exercise Price or Strike Price: the pre-determined price at which you would be allotted the shares in case the option is exercised.

(iv) Spread: difference between the exercise price and the fair market value of the share on the date of exercising the option. The option will only be exercised if the spread is positive, i.e. the share price is more than the exercise price.

(v) Vesting Schedule: employees get the option to exercise their right in ESOPs only after the options have vested. Therefore, vesting means earning of the right. Such options vest (or become eligible as exercisable options) over a period of time. It is traditionally seen that ESOPs vest for employees over a four year period, where no ESOPs may vest for the first year, and then the granted options may vest in equal installments at quarterly duration, with all of the granted options vesting at the end of four years (in this example).

(vi) Cliff: it means the specific time when none of the granted options are vested. However, they all vest in one go after crossing the cliff. This may be said to be the first year duration as mentioned in the above example.

(vii) Maturity: the period in which the option can be exercised. If the vested options are not exercised within this period, the option to exercise them expires.

(viii) ESOP Scheme: the scheme specifies all the rules that govern the ESOPs with respect to grant, vesting, exercise, expiry, transfer, etc.

Process for Implementing an ESOP Scheme

Quick summary of the steps of implementation is as under.
a) Draft an ESOP Policy
b) Obtain Board of Director's approval
c) Obtain Shareholders' approval
d) Issue Grant Letters to eligible employees
e) Vesting would be as per the period prescribed in the policy
f) Options may be exercised on completion of an event or an acquisition or an investment

Detailed Procedure

(i) Draft the ESOP Scheme: The ESOP Policy needs to be drafted taking into account the various factors as explained in the section relating to important terms above. The Scheme should have the following sections:
- Introduction
- Definitions
- Eligibility of Employees
- Option Pool or Quantum of Incentive
- Grant Procedure
- Vesting of Options
- Exercise Period
- Pricing Method
- Transferability
- Rights and Obligations
- Rescinding of Options
- Other Necessary Disclosures

(ii) Convene Board Meeting: Issue a Notice inviting the Board of Directors for a meeting. Such Notice should be accompanies by an agenda and the draft policy for discussion. The notice may be issued at least seven days before the date of the meeting, or may be issued at a shorter notice if complied with all provisions for such shorter notice as prescribed in the Company's Articles of Association.

(iii) Pass Board Resolution: If the Board approves the policy after deliberation, decide on the date on which an Extraordinary General Meeting (EGM) may be called to obtain shareholders' approval on the same.

(iv) Convene General Meeting: Issue a Notice to convene EGM at least 21 clear days prior. The Explanatory Statement shall contain the following disclosures as required under the law.
- total number of options to be granted
- class of employees eligible to participate in the scheme
- appraisal process for determining the eligibility
- vesting qualifications and period
- exercise price
- method of valuation of options
- lock-in period during which the ESOPs cannot be transferred
- maximum number of options to be granted per employee and in aggregate
- situations when options may lapse
- exercise period
- a statement specifying that the company shall comply with the applicable laws and accounting standards

(v) Obtain Shareholders' Approval: An ordinary or special resolution, as specified above, may be required for passing the scheme of ESOPs

(vi) Filing of Form MGT-14: The Notice of the EGM, Explanatory Statement, certified copy of the shareholders' resolution must be attached to MCA e-Form MGT-14 and filed within 30 days of the EGM.

(vii) Issue Grant Letters: The eligible employees may be given grant letters for granting of ESOPs along with a copy of the policy as well as all drafts for exercise of option, transfer, etc.

(viii) Period Between Grant and Vesting: At least one year must elapse between granting of option and its vesting.

(viii) Filing of Form PAS-6: When the option is exercised by an employee, MCA e-Form PAS-6 is to be filed online with certified copies of list of allottees, board resolution and shareholders' resolution.

Compliance Related to ESOPs

In addition to the procedure specified above, the following must be taken care of:

(i) Options granted are not transferable to any other person

(ii) Options granted shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner

(iii) No person other than the employee shall be entitled to exercise the option, except the options would vest to his legal heirs or nominees at the time of death.

(iv) 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.

(v) In the event of resignation or termination of employment, all options not vested in the employee as on that day shall expire.

(vi) Register of ESOP Holders must be maintained in Form SH-6 by the company.

(vii) The company shall have the freedom to determine the exercise price in conformity with the applicable accounting policies.

(viii) The company may vary the terms of ESOP not yet exercised by a special resolution provided such variation is not prejudicial to the interests of the option holders.

(ix) 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 the time such options are exercised and allotment is made.

(x) Disclosures in Directors' Report:
- options granted, vested and exercised during the year
- number of shares arising as a result of exercise of option
- options lapsed
- exercise price
- variation of terms of options
- money realized by exercise of options
- total options in force
- details of options granted to key managerial personnel
- detail of options granted to any other employee who receives a grant of options in any year of option amounting to 5% or more of options granted during that year
- identified employees who were granted option in a year equal to or exceeding 1% of the issued capital

Valuation of ESOPs

(i) At the time of Grant: valuation of fair value of shares to be done by a registered valuer as per ICAI's Guidance Note on Accounting for Employee Share Based Payment.

(ii) At the time of Exercise: the Income Tax Act, 1961 provides that such value should be as determined by a merchant banker on the specified date

Taxation of ESOPs for Employees

(i) On Exercising the Option: When an employee exercises the option after vesting and the shares are allotted, the amount computed as the difference between the fair market value of shares FMV (as on date of exercising the option) and the exercise price is taxable as a perquisite under the head income from salaries. The employer may deduct TDS on this amount from the regular payout to the employee.

(ii) On Sale of Shares: When the employee sells those shares, the amount computed as the difference between the sale price and the FMV as on exercise date is taxed under the head capital gains, which may be long term or short term depending on the period of holding.

Legal References