Employee Stock Option Plan (ESOP)

If you are running your own business, then you must know that bonuses are one of the best motivators. The employees feel that they get rewarded for their work. This can bring very good results for both you and your business. Employee Stock Option Plan is also similar to a bonus. By owning shares of the company, the employee feels more connected to the company. If the company stock prices increase, they profit from it as well. ESOPs may be one of the best rewards. In this article, we will discuss, the “Employee Stock Option Plan (ESOP)”.

Meaning of ESOP

The Employee Stock Option Plan (ESOP) is an employee benefit plan. It is issued by the company for its employees to encourage employee ownership in the company. The shares of the companies are given to the employees at discounted rates.

Section 2(37) of the Companies Act, 2013 defines an Employees Stock Option as the option given to the directors, employees or officers of the company or of its holding or subsidiary company, the right to purchase or benefit or subscribe to the shares of the company at a predetermined price on a future date.

All companies other than listed companies should issue it in accordance with the provisions of the Companies Act, 2013 and Companies (Share Capital and Debentures) Rules, 2014. Further, in the case of listed companies, they have to issue in accordance with the Securities and Exchange Board of India Employee Stock Option Scheme Guidelines.

ESOP benefits the company as well as its employees. It benefits the startups where employees can be rewarded after the company goes public. Any employee of the company can be offered ESOP if they are eligible.

Eligibility for getting ESOPs

Rule 12(1) of Companies (Share Capital and Debentures) Rules, 2014 states that ESOP can be issued to,

• Permanent employee of the company who is working in India or outside
• Director of the company, including a whole-time or part-time director but not an independent director
• Permanent employee or director of a subsidiary company in India or outside India, or holding company, or an associate company

However, a company cannot issue ESOP to,

• Employees belonging to the promoter group or is a promoters of the company
• Directors who either themselves or through anybody corporate or through his relative hold more than ten per cent of the outstanding equity shares of the company, whether directly or indirectly

However, the exceptions do not apply to Startup Companies for a period of ten years from the date of their incorporation

Benefits of ESOP

The benefits of ESOP are,

• Keeping the employees motivated
• It is a mode of payment instead of cash
• It gives a sense of ownership

Hence, giving ESOPs to employees can help your company to attract, retain and motivate employees.

Process of Issuing ESOP

Section 62(1) (b) of the Companies Act, 2013 and Rule 12 of Companies (Share Capital and Debentures) Rules, 2014 govern the issuance of ESOP.

The process for issuing ESOP by a company is,

• Prepare the draft of ESOP in accordance with the Companies Act, 2013 and Rules
• Prepare the notice for the board meeting and the draft resolution to be passed in the board meeting
• Send the notice of the board meeting to all the directors at least seven days before the meeting
• Pass the resolution for the issuance of shares through ESOP, determine the price of shares to be issued pursuant to ESOP and fix the time and date and approve calling the general meeting to pass a special resolution for issuing ESOP
• Send the draft minutes of the board meeting to all the directors within fifteen days of its conclusion and file the MGT-14 form with the Registrar of Companies of passing the board resolution
• Send notice of the general meeting to all the directors, auditors, shareholders and secretarial auditors of the company at least before twenty-one days of the date of the meeting
• Pass the special resolution for the issuance of shares under the ESOP to the employees, directors and officers of the company in the general meeting
• File the MGT-14 form with the Registrar of Companies within thirty days of passing the special resolution in the general meeting along with the documents
• Send options to the employees, directors and/or officers of the company for purchasing shares under ESOP
• Maintain a ‘Register of Employee Stock Options’ in Form No.SH-6 and enter the particulars of the ESOP granted to the employees, directors or officers of the company
• If a private company wants to issue ESOP, then it should ensure that the Articles of Association (AoA) authorize for issuance of shares through ESOP. If the AoA does not authorize, then the company has to first hold an extraordinary general meeting to alter the AoA to include the provisions of issuance of shares through ESOP and then proceed with holding the board meeting for the passing of the resolution and getting the shareholder’s approval for ESOP Scheme

Further, ESOPs can be issued through two main routes,

• Equity Route
  In this route, the company issues equity shares of the company to the employees as and when they exercise the option.
• Trust Route
  In the trust route, the company forms an Employee Welfare Trust for the administration of ESOP in the company. The company issues shares to the trust which are forwarded or transferred to the employees when they exercise their options.

Lock-in period

A maximum of one year of lock-in period has to be there. The employees cannot enjoy any benefits of being a shareholder such as a share in the dividend or voting right until shares are issued on the exercise of their option.

Transferability of shares

The shares are not transferable. The employee cannot alienate the share through any means. In event of the death of an employee the shares shall vest to the legal heir or the nominee.

In case of resignation or termination of the employee, all the rights vested in them can be retained. The plan has to specify the time period within which the employees can exercise their options. An employee terminated in case of misconduct will not have any vested right in the issued shares.

Valuation of Stock Option

There are two methods used in the valuation of the stock option.

• Intrinsic value method
  Intrinsic value is the value at the date of grant. For example, if the market value of a share at the time of grant is ₹180 and the shares were issued at ₹120, the intrinsic value of each share will be ₹60 which should be shown by the company as a compensation expense. However, if the shares were issued at ₹190, the intrinsic value will become -10 which need not be shown.
• Fair value method
  In this method, if the market value of each share is ₹120 and the shares are issued at ₹130, the fair value of each share will be ₹10. In this method, the employee has the right to purchase the share at a future date when the market value of each share is more than ₹130.

However, in the Intrinsic Value Method, the employee has no option to buy the shares at a later period.

Companies can choose from any of the above methods. However, they need to disclose it in the general meeting and also follow the accounting guidelines provided by SEBI in the guidelines of 2014.

Taxation on ESOP

Income tax should be paid during two situations,

• Issuing ESOPs
  The income is treated as perquisites which form part of the salary of the employee. The employer is required to deduct TDS and the income is calculated as the difference between the fair value of each share and the market value.
• Sale of ESOPs
  The gains arising out of ESOPs are capital gains. The capital gain is the difference between the sale price and the price at which it was awarded to the employee. The tax should be paid in the year of the sale of ESOP.

Long Term, When the ESOPs are held for more than 36 months (3 years), by the employee, from the date of purchase the capital gain tax rate is 20%.

Short Term, When the ESOPs are held for less than 36 months (3 years), by the employee, from the date of purchase the capital gain tax is 10%.

Disadvantages of ESOP

The main concern with ESOP is dilution. With every share that is granted to the employee, the shareholder’s share gets diluted.

Conclusion

ESOP is a very effective tool for both big companies and start-ups. You use these to retain your workforce and the talent. If you are running a start-up then you can use these tools to hire fresh talent and attract more workforces. It works as a boon for companies which cannot afford to pay high salaries. Besides, it is the sense of ownership that acts as a motivation for the employees to work hard and be diligent.