Employee Stock Option Plan (ESOP)

What Is an ESOP or the Employee Stock Option Plan?

Top talent is managed and recruited by businesses using ESOPs (Employee Stock Option Plans)! Under this employee benefit programme, the business encourages its staff to purchase shares of ownership at a predetermined rate. Employee stock ownership plans (ESOP) are frequently offered by employers to encourage long-term loyalty from their workforce. It encourages workers to deliver better work and show devotion to the organisation.

Let's say a worker receives 400 shares. 100 shares will vest once each year has passed. The value of the shares to employees rises together with the company's value. This controls the staff turnover as well. Read through to find out more about ESOP, pros and cons of ESOP, stock option plan and so on.

Benefits of Employee Stock Option Plan

• ESOPs are a tax-advantaged method that provides shareholders with fair value.
• A 'low and slow' ownership shift is possible with an employee stock option plan.
• People that contribute positively and work for the company for a long time benefit from ESOPs.
• It produces independent, long-lasting businesses that are tax-favoured.
• A legacy is established and maintained by the Employee Stock Option Plan.

Advantages and Disadvantages of an Employee Stock Option Plan

One might have the doubt, what are the pros and cons of an employee stock option plan? Here, let us see a few points explaining few advantages and disadvantages of an employee stock option plan:

Advantages

• Built-in Buyer An Employee stock option scheme can help the enormous number of baby boomers wishing to sell their companies find a buyer in a market that is rapidly becoming saturated with companies up for sale.
• Tax Benefits If the company complies with a comprehensive list of requirements, ESOPs can provide a number of tax benefits. And while establishing an employee stock ownership plan is quite expensive, depending on the firm, its structure, and a wide range of other circumstances, it may be less expensive than selling the business.
• Owner and employee advantages Middle-market businesses can frequently achieve their objectives with a thoroughly thought-out exit strategy. The Employee stock option plan then has the potential to protect the legacy and stability of the company while rewarding key management and employees for their performance and commitment. The ownership of the business is still held by individuals the owner knows and trusts. This can reflect very favourably on the owner who decides to give their staff the reins, and a sale to an ESOP can be made gradually or all at once, allowing the owner options in how to exit the company.

Disadvantages

• High Price These schemes are comparatively expensive to administer and exceedingly complicated. An owner should budget at least ₹ 40,000 simply to get started on the most basic design. The business will have to pay annual fees to third parties for trustee, legal, administrative, compliance, and valuation services during the life of the plan. Transaction costs apply to both the hiring of new employees and the retirement of existing ones.
• Reduced Value An Employee stock option scheme bases its decision to buy stock in a company on a notional valuation study from a licenced firm. This valuation may be considerably less than what a competitive selling procedure with numerous potential bidders and investors may produce. Depending on the industry, a company might often earn a selling valuation that is 20 to 30 percent greater than an ESOP valuation.
• Exhausting Resources Less money is available to invest in the expansion of the company, the employment of talent, the exploration of new markets, etc. as a result of these fees and payments as well as the buyback requirements of an ESOP. The business may find it difficult to invest in development and innovation because supporting the strategy currently takes priority over cash flow and liquidity, which are under constant pressure.
• It's Challenging Many of the parties involved benefit in the form of third party fees, it is difficult to obtain an unbiased judgement about this type of stock ownership plan from the industry. Many plans employ an independent trustee to represent member interests and external companies to handle plan administration and record keeping in order to avoid conflicts of interest. Fiduciary Liability Insurance is also advised to safeguard the company against any allegations of improper handling of employee benefits.

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.

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 shares under ESOP 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 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.

Procedure for Issue of Employee Stock Option Plan

The Article of Association (AOA) should authorised the issues of shares through an ESOP. 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.

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 plan.
• Establish a process to operate the plan.

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