Employee Stock Option Plan (ESOP)

Overview

We aim to help companies use ESOPs as a tool to attract, retain, and incentivise their top talent. Our services include consultation on ESOP policies, drafting of ESOP schemes, and providing ongoing assistance to ensure that ESOPs align with your company's objectives and regulatory norms. With Vakilsearch, your business can leverage ESOPs to foster a culture of ownership and boost employee engagement.

What Is an ESOP or the Employee Stock Option Plan?

An Employee Stock Option Plan (ESOP) is a benefit plan that offers employees the right to buy company shares at a predetermined price. It's a tool companies use to attract, retain, and reward employees. ESOPs help to align employees' interests with the company's growth and success.

Benefits of Employee Stock Option Plan

• ESOPs motivate staff as their benefits grow with the company's market share price
• They help keep employees in the company, reducing turnover
• Employees get rewarded for their hard work during challenging times
• ESOPs prevent major cash outflows from the company.

Advantages and Disadvantages of an Employee Stock Option Plan

Advantages of ESOP

Motivation and Retention: ESOPs boost employee motivation and help in retaining talent as they create a sense of ownership among employees.

Tax Benefits: ESOPs come with specific tax advantages for both employers and employees.

Cash Flow: They help companies preserve cash, as they are a form of non-cash compensation.

Disadvantages of ESOP

Dilution of Ownership: ESOPs can lead to dilution of ownership and control as employees become shareholders.

Fluctuating Market Risk: The benefit of ESOPs is tied to the company's stock price, which can be volatile.

Administrative Costs: ESOPs involve certain administrative costs and complexities in their implementation and management.

How Does an Employee Stock Option Plan Work?

Let us see on how an ESOP work from the explanation given below:

When a company offers ESOPs, they are held in trust for a specific amount of time. The vesting term is the time frame in question. Employees may then exercise their ESOPs after the vesting time has passed. The quantity of shares to employees that may be offered, their price, and the recipients are all determined. Following this, the chosen employees will have the opportunity to exercise their ESOPs and purchase company shares at allowed prices, which are below market value.

Cost of ESOPs and Distributions

The cost of ESOPs can vary depending on the specific plan. However, there are some common costs that employers may incur, such as:

• The cost of setting up and administering the plan
• The cost of buying shares for employees
• The cost of providing loans to employees to purchase shares
• The cost of taxes

Checklist for Employee Stock Option Plan 2023-2024

• Check the articles for any specific provision on the issue of share under employee stock option scheme
• The date and members of the compensation committee should be included in the board meeting
• Notice of general meeting including the number of ESOP to be granted
• Likewise, hold a general meeting for approval of shareholders by way of ordinary resolution. Additionally, include the authorisation for the issue of ESOP shares and the formation of the compensation committee
• There must be a compensation committee (CC). The CC shall be a committee of board directors consisting of a majority of independent directors
• Approval of shareholders by separate resolution
• The requirement of a draft copy of certificates
• Filing of Form-PAS-3
• Disclosure in Director Report (DR)
• Maintenance of the register of ESOP in SH-6 at the registered office of the company or such other place as the board may decide
• Entities in the register shall be authenticated by CS or any other person authorised by the board.

Eligibility for Employee Stock Option Plan

According to the IRS (Indian Revenue Service), the maximum age an employer can impose to be eligible for an ESOP is 21. Moreover, he/she must be eligible for ESOP in the year of joining the company. An employer can restrict eligibility to employees with two years of service but only if the plan has immediate vesting.

How to Register an Employee Stock Option Plan

Draft The ESOP Rules

Your ESOP rules set out the terms that apply to all options granted under the ESOP plan, including the process for granting options, how and when employees can exercise their options, and what happens to the options on an exit event, or if an employee leaves. The document will include the following schedules:

• Schedule 1: A grant letter setting out the terms of the options you want to grant to recipients.
• Schedule 2: The form of the exercise notice to be delivered to the company when an option holder wants to exercise their vested options.
• Schedule 3: An option certificate which records the number of options, exercise price and vesting provisions.

Approve the Rules And the Option Pool

Once you are satisfied with the ESOP rules, your directors and shareholders will need to sign some corporate approval documents to adopt the ESOP rules and set up your option pool.

Board And Shareholder Approval

There are some resolutions which include:

• The approval of the Employee Stock Option Plan rules.
• The total number of options in the ESOP pool.
• Authorisation for the board to grant options to recipients of their choosing, and
• Authorisation to issue shares on any exercise of the options.

Shareholder Waivers And Consents

Your constitution and shareholder’s agreement may include pre-emptive rights on the issue of new shares. If this is the case, these shareholders with preemptive rights will need to sign a waiver in respect of any options granted the ESOP.

Grant your options

Prepare Your Directors’ Resolutions:

Each time you want to grant options, you should ask your corporate secretary to prepare a new set of directors resolutions in writing, approving the grant of options to a specific recipient.

Send Each Recipient Their Grant Letter:

Once you have received the letter, you can issue them their option certificate. You can find the option as the certificate form in schedule 3. Here the schedule should be left blank and a separate option certificate provided to the recipient. That is, you need to create a fresh, separate word doc.

Update Your Register Option

Internally, you should also be keeping an option register, which is a record of all the options the company has granted, the vesting schedules, expiry dates, and exercise dates.

Documents for Employee Stock Option Plan

• Minutes of a board meeting.
• Special resolution approving ESOP along with the explanatory statement.
• Minutes of the general meeting.
• Boards report.
• Register of employee’s stock option plan.
• PAS- 3, MGT- 14.

Tax Implication of ESOPs and ESOP Calculation

ESOPs (Employee Stock Option Plans) are a popular form of employee compensation that offer employees the opportunity to purchase company stock at a discounted price. Here are the tax implications of ESOPs:

Tax on Exercise: When an employee exercises their ESOPs, they are required to pay tax on the difference between the exercise price and the fair market value of the shares at the time of exercise. This is treated as a perquisite and is taxed as a part of the employee's salary income.

Capital Gains Tax: If the employee sells the ESOP shares, capital gains tax will be applicable. The capital gains tax rate will depend on the holding period of the shares.

Dividend Tax: If the company pays any dividends on the shares held by the employee, it will be taxed as per the applicable tax rate.

At a price below the share's fair market value (FMV) as of the vesting date, employees can purchase the shares. As a result, the discrepancy between the FMV and the exercise price of the share is treated as a prerequisite and is taxed at his income tax slab rate.

If the employee sells the shares, capital gains tax will be due on the difference between the sale price and the FMV on the date the share was activated. 10% tax would be applied to gains over ₹1 lakh if the gains were released from selling the shares after the initial purchase period of 12 months. However, if the shares are sold within a year, the gains would be subject to a 15% tax rate.

Is ESOP Beneficial for Employees?

A company may give its workers stock options as a form of motivation. It would be an incentive for the employee to give it his all because they would profit if the company's stock prices rose. Although the main advantages that ESOP offers to employers are motivation, employee retention, and rewarding effort, there are a number of other noteworthy benefits as well. Some of them includes:

Financial Incentives: ESOPs offer employees the opportunity to purchase company stock at a discounted price, which can be a significant financial incentive. This can help to attract and retain talented employees.

Ownership Stake: ESOPs allow employees to have a stake in the company's success and to benefit from its growth. This can lead to greater job satisfaction and motivation.

Tax Benefits: ESOPs can offer tax benefits to employees, such as lower capital gains tax rates if they hold the shares for a certain period of time.

Diversification: If the employee sells the ESOP shares, they can diversify their investment portfolio and reduce their risk.

Retirement Benefits: ESOPs can be a valuable source of retirement savings for employees, particularly if the company's stock performs well over time.

ESOPs to Employers

ESOP Plan offer a number of benefits to employers, including:

Increased employee engagement and productivity

ESOPs can help to increase employee engagement and productivity by giving employees a stake in the company's success. When employees own stock in the company, they are more likely to be invested in its performance and to go the extra mile to help it succeed.

Reduced employee turnover

ESOPs can also help to reduce employee turnover by giving employees a reason to stay with the company. When employees own stock, they are more likely to feel valued and appreciated and less likely to look for other job opportunities.

Improved financial performance

Studies have shown that companies with ESOPs tend to outperform companies without ESOPs. This is likely due to the fact that ESOPs help to motivate employees and reduce turnover.

Tax benefits

ESOPs offer a number of tax benefits to employers, including the ability to deduct contributions to the ESOP plan and the ability to defer capital gains taxes on the sale of shares to the ESOP.

ESOPs to Employees

Employee Stock Ownership Plans (ESOPs) offer a number of benefits to employees, including:

Ownership in the company

ESOPs give employees a stake in the company's ownership. This can help employees to feel more invested in the company's success and to take more pride in their work.

Potential for wealth creation

ESOPs can help employees to build wealth over time. As the company's stock price increases, the value of the employee's ESOP shares will also increase. Employees can then sell their shares for a profit or hold them until retirement and receive a distribution from the ESOP.

Retirement savings

ESOPs can help employees to save for retirement. ESOP shares are typically held in a tax-advantaged retirement account, such as a 401(k) plan or a profit-sharing plan. This means that employees can grow their retirement savings without having to pay taxes on their earnings.

Job security

ESOPs can help to improve job security. ESOPs are typically structured to benefit long-term employees. This incentivises employees to stay with the company and contribute to its success.

Procedure for Issue of Employee Stock Option Plan

The Article of Association (AOA) should authorised the issues of ESOP shares. If the AOA doesn’t have this particular clause an extraordinary general meeting has to be conducted before initiating the process to alter the aoa and include this provision.

• The first step in the process used to prepare an ESOP draft a deering to the Companies Act of 2013
• Subsequently a board meeting has to be conducted where the draft resolution should be presented to all the directors and the shareholders
• All the shareholders of the company and the directors should accept the ESOP scheme for further resolution
• The price of the shares to be issued and the fixed time and date should be discussed in the general meeting to pass the special resolution for issuing the ESOP
• An MGT-14 has to be filed with the ROC for passing the board resolution. The draft minutes should be passed on to all the directors within 15 days of conclusion
• The special resolution for issuing the shares under the ESOP scheme should be passed in the general meeting to the employees directors and offices of the company. After passing the special resolution the MGT-14 form has to be filed with the RoC within a time window of 30 days from the day of passing the resolution
• Register of employees stock option has to be created and maintained in form SH-6 all the particulars of the ESOP has to be entered and granted to the employees.

Why Companies Offer ESOPs to Their Employees?

There are many reasons why companies offer ESOPs to their employees. Some of the most common reasons include:

• To attract and retain top talent
• To motivate employees and improve productivity
• To reward employees for their contributions to the company
• To align the interests of employees with the interests of the company

ESOPs from an Employee's Perspective

ESOPs can be a valuable benefit for employees. They can provide employees with an opportunity to own shares in the company they work for, which can give them a sense of ownership and pride. ESOPs can also help employees save for retirement and build wealth.

ESOP Taxation

The taxation of ESOPs can be complex. However, some of the key tax implications for employees include:

• When employees purchase shares through an ESOP, they may be able to defer taxes on the purchase price.
• When employees sell shares through an ESOP, they may be liable for capital gains taxes.
• When employees receive distributions from an ESOP, they may be liable for income taxes.

What Happens to ESOPs When the Company Is Listed?

When a company is listed on a stock exchange, the ESOP shares can be sold on the open market. This can provide employees with an opportunity to cash out their shares and realize their investment gains.

To Whom Can The ESOP Be Issued?

The issuance of ESOPs in India is governed by various regulations, including the Companies Act, 2013, and the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014.

• ESOPs can be issued to all permanent employees of the company. This includes employees who are working in India or abroad. The company can also issue ESOPs to its directors, but not to independent directors
• ESOPs can also be issued to employees of the company's subsidiaries or holding companies. However, the employees of the subsidiary or holding company must meet the eligibility criteria specified in the ESOP scheme
• ESOPs can be issued to employees who are also members of the promoter group, provided that they are not promoters themselves
• ESOPs cannot be issued to non-employees, such as consultants, advisors, or contractors. However, the company can issue equity shares to non-employees, subject to certain conditions.

Process and Allotment of ESOP

The process and allotment of ESOPs in India involves the following steps:

• Grant of ESOPs: The ESOPs will specify the number of shares that can be purchased, the exercise price, and the vesting period to the eligible employees as per the terms of the scheme
• Exercise of ESOPs: The employees can exercise their ESOPs after the vesting period is over and the options become exercisable. The exercise price will be the price specified in the ESOP agreement. It is mandatory for the company to ensure that it has a liquid shares available for ESOP scheme
• Allotment of Shares: Once the ESOPs are exercised, the company will allot shares to the employees who have exercised their options. The share allotment must be paid within 15 days from the date of exercise of ESOP
• Transfer of Shares: The company must transfer the shares to the employees' Demat accounts within two days of the allotment of shares. The company must also inform the stock exchange where its shares are listed about the allotment of shares to employees
• Payment for Shares: The employees must pay the exercise price for the shares allotted to them. The payment must be made within six months from the date of allotment of shares
• Compliance with Regulations: The company must comply with all applicable regulations while issuing and allotting ESOPs to its employees
• Reporting Requirements: The company must also comply with the reporting requirements of the SEBI regulations. This includes making periodic disclosures to the stock exchange and filing the necessary reports with SEBI.

Why Vakilsearch?

Vakilsearch helps you to have a seamless experience in the process of ESOP that includes:

• Determine whether other owners are amenable.
• Conduct a feasibility study.
• Conduct a valuation.
• Hire an ESOP attorney.
• Obtain funding for the ESOP plan.
• Establish a process to operate the ESOP plan.

To avoid complexities in the processes mentioned above, one must choose an efficient legal advisory company and Vakilsearch is the answer!