What are ESOPs
The ESOPs or Employee Stock Options Plan is a plan or a scheme for employees, where they have an option to purchase the shares of the company. The employee gets the right to purchase the shares at a pre-determined price at a future date. Mind you, it’s an option and not an obligation.
Example of ESOP
Greenwolf Advisors, a company grants its employees, a right to purchase 120 shares at Rs 40 per share, if the employee works for the company for the next 3 years. As per the plan, at the end of every 1 year, 40 shares will get vested to the employee and employees may exercise their right to buy the shares.
If the pre-determined price (i.e., Rs 40 as stated above) is lesser than the market price (say Rs 100) of the shares, the employee may exercise the option since the difference between the exercise price and market value (I.e., Rs 60 per share) will be their gain. That means the employee gained Rs 60 per share by exercising the option under the ESOP plan. They will realize this gain by selling the shares.
Oh, I used the word ‘vested’ above.
What does Vested means in ESOP?
Vested means the option holder is now eligible to exercise the right to purchase the stock. In the above case, while the ESOP scheme is for 3 years with the right to buy 120 shares, after completion of 1 year only, I am eligible to buy 40 shares. That means after 1 year, 40 shares get vested to the employee, after 2 years, 80 shares get vested and after 3 years, 120 shares get vested.
I also used the word ‘exercise’ above.
What does Exercise mean in ESOP?
Exercise means exercising my right to purchase the shares after they got vested. Once the employee exercises the option to purchase the shares, the company allots them the shares exercised in accordance with the ESOP plan.
Ultimately, an employee can sell what has been exercised, can exercise what has been vested, and vest what has been granted.
What are the benefits of ESOPs for employers?
The benefits of ESOPs for employers are:
- Increasing productivity:
A person who feels belonged contributes more than the one who feels deserted. ESOPs give employees shares of the company, which means employees get ownership of the company. This sense of ownership links employees with the success of the company and their performance and productivity goes up pushing up the overall performance of the company. - Attracting top talent and employee retention:
“We cannot give you a great package, but together we can create wealth.”
A company may attract top executives on regular pay along with ESOP incentives. This allows companies to offer incentives linked with the performance of the company, even if it pays lesser regular compensation.
The company also gets to retain the existing employees by efficiently setting up a vesting period in the ESOP plan. Existing employees may get retained for longer with a sense of ownership in the company. - Exit strategy for owners:
Owners looking to retire from the company need not sell the company to a third party and trust that it will be owned by the employees holding shares in the company. This will also ensure the confidentiality of the business secrets of the company.
What are the benefits of ESOPS for employees?
The benefits of ESOPs for employees are:
- Buy shares at a discounted price:
A predetermined price under the ESOP plan is a nominal price intended to give the employees gain when they exercise the option and sell it. This helps the employees to monetize the company’s stock. - Opportunity to be a part of the company:
Employees can get a chance to enjoy ownership in the company till the time they hold the shares. If the company grows even after they cease to be employees of the company after holding the shares, they will still continue to get benefits of the company’s growth in valuation. - Dividend
If the company earns a profit and distributes it among its shareholders, employees too can enjoy such sharing in the profit.
What are the legal implications of ESOPs
The legal implications of ESOPs are:
- Companies Act, 2013
- Income Tax Act, 1961
- IFRS 2 and IndAS 102
- SEBI Rules and Regulations
- FEMA, 1999
- ICDR Rules and Regulations
How to Issue ESOPs
The steps to issue ESOPs are:
- Check Articles of Association
Check if the Articles of Association (AOA) authorize the company to issue ESOPs. If AOA does not allow the company to issue ESOPs, they need to be amended by passing a special resolution by shareholders. - Drafting of ESOP plan:
ESOP plan will cover aspects like the number of share options to be granted, strike price/grant price/exercise price, vesting period, cliff period, the time frame within which vested option may be exercised, administration of ESOPs, employees’ exit terms with respect to ESOPs, etc. - Adoption of ESOP Plan by the Board
The board to adopt the ESOP plan in the board meeting - Adoption of ESOP Plan by shareholders
The shareholders in the EGM (Extraordinary General Meeting) will adopt the ESOP plan with a special resolution. - Filing with MCA
The filing with MCA will be required to be done in the form of MGT-14 - Issue grant letter
A grant letter can be issued to the employees giving an option to them to exercise the right to buy shares of the company at a predetermined price after the vesting period or achieving the performance or milestone. - Vesting Period
On attaining a certain period, or achieving the performance or milestone as mentioned in the ESOP plan, the employee becomes eligible to buy the shares of the company. - Exercise the option
Once the vesting period is over, the employee can exercise the right to avail shares of the company. The employee needs to communicate his acceptance to exercise the right to the company within such time as mentioned in the ESOP plan.
The company will allot the shares to the employee on exercising of the option by the employee. - ‘Register of Employee Stock Options Plan’
Maintain a ‘Register of Employee Stock Options Plan’ in form SH-6 and all the particulars of the ESOP granted to the employees, directors, and officers should be mentioned therein.
What are the Tax Implications of ESOPs for a Company
The tax implications on ESOPs are:
The loss incurred by the company to grant an option to the employee at a price lower than the market price is allowed as an expense to the company. Such expense is allowed every year whenever the right to avail option becomes due. However, such difference is taxable in the hands of an employee in the form of perquisites.
Hence, the valuation becomes a critical factor in determining the taxability of the employees and must be done judiciously to strike a balance between tax implications and the value provided for the employee.
The valuation of the share is determined by a merchant banker in the case of an unlisted company.
Hope this blog gives you an overall idea about ESOPs. Greenwolf Advisors is helping companies with issuing ESOPs for their employees.