Employee Stock Option Plan (ESOP)

Employee Stock Option Plan ESOP

Employee Stock Option Plan (ESOP) is an employee benefit scheme under which the company encourages its employees to acquire ownership in the form of shares. These shares are allotted to the employees at a rate considerably lesser than the prevailing market rate. Apart from the employee-benefit motive, ESOPs are also meant to align the interests of the employees with that of the shareholders. It is believed that the employees, who are also the shareholders, will focus better on company performance and growth so that the value of their shares appreciates.

Many companies use employee stock options plans to compensate, retain, and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. The fixed price is often called the grant or exercise price. Employees who are granted stock options hope to profit by exercising their options to buy shares at the exercise price when the shares are trading at a price that is higher than the exercise price.

ESOP is governed through Section 62(1) (b) of the Companies Act, 2013 (CA, 2013) and SEBI (ESOS and ESPS) Guidelines, 1999 as amended.

Relevant Definitions:

A. Employee:

  • An employee can be a person who is:
    • A permanent employee of that organization;
    • A director of that organization;
    • Employees of a subsidiary of that Company.
  • However, employees do not include:
    • Any employee(s) who was or is a promoter or an employee(s) of the promoter group.
    • Any director who (directly or indirectly) owned more than 10% of the equity shares of the organization.

B. Grant: The grant of an ESOP refers to the commitment made by the employer by issuing the ‘Letter of Grant’ informing concerned employees about their eligibility to avail benefits under the scheme.

C. Vesting: It is the process which gives an employee the right to own shares in his company over a period of time. The rights over these shares are non-forfeitable.

D. Exercise: The company initially, grants an Option. If an employee decides to convert this option into shares, it is called ‘exercising’ the option.

E. Exercise Price: Also known as Strike Price, this is the price at which these shares are offered to the employees. It is usually below the current market price and is pre-determined. The employee has to pay the strike price and own the equivalent shares.

F. Exercise Period: After the vesting period, the employees are given some time to exercise the options granted to them. This is known as ‘Exercise Period’.

Who is entitled to ESOP?

  • Essentially, the employees of a company are entitled to the Employee Stock Option Plan (ESOP) but the Company sets a certain criteria to make employees eligible for the same.
  • Benefits under the ESOP scheme can be claimed by:
    • A permanent employee of the company working in or outside India;
    • A part-time or whole-time director of the company;
    • An employee of holding, subsidiary or associate company, whether in India or outside India.
  • Promoters or Directors of the company holding more than 10 percent of its equity cannot take part in an ESOP.

How does ESOP work?

The ESOP scheme can be provided by the Company through two ways:

Equity Route: In Equity Route, the equity shares are being issued to existing employees when they exercise this option.

Procedure to be followed in order to formulate ESOPs through equity route:

Step 1- The first step involved is to constitute a Compensation committee:

  • Provisions with regard to the formation of the Compensation Committee are contained under Section 5 of the aforesaid guidelines.
  • It is to be formulated by the Board of Directors of the Company having Independent directors in the majority. The committee is responsible for the formulation of rules and regulations of ESOP.

Step 2- Preparation of Plan: After that, the Compensation Committee shall form a plan in accordance with the guidelines as notified.

Step 3- Approval form the Board: Once the plan is prepared, the compensation committee shall take the approval from the Board and in case the said Company is listed, the said plan shall also requiring permission from the stock exchange as well.

Step 4- Approval of Shareholders: A special resolution shall be required to take approval form the shareholder of the Company. 3/4 of the shareholders shall approve the said plan.

Trust Route:

  • Under this route, an Employee Welfare Trust is being formed by the Company for the administration of ESOP.
  • Company issue scrips to this trust which ultimately transferred to the employee whenever they exercise this option.

Lock-in period: The maximum period is 1 year and employees cannot enjoy such benefits as of shareholders until the option is exercised.

Transferability of shares:

  • It is to be noted that the shares given under this scheme are not transferable.
  • In case of death of an employee(s) the shares shall be transferred to his/her legal heir or his/her nominee.
  • It is to be noted that all right under the scheme shall be taken back in case of resignation or termination of the employee.
  • The time frame within which the option of ESOP should be exercise shall be mentioned in the approved plan.

Valuation: Basically, there are two methods that can be used in the valuation.

  • Fair value method.
  • Intrinsic value method.

It is optional for the companies to decide the method to be choose from and the same shall be disclosed in general meeting.

Benefits of ESOP Scheme:

  • Employee Stock Option Plan (ESOP) offers several benefits to the company as well as the employee who choose to exercise their rights. Let us understand the two types of benefits separately.

Benefits for Company:

  • ESOPs are a form of aligned incentives. They create ownership interest among employees so that they work together for the common goal of company growth. This leads to a highly motivated workforce that wants to achieve more so that their organization’s share value appreciates.
  • All other benefits that a company enjoys are related to the same fact.
  • Researches have shown that after exercising their ESOPs, employees show more loyalty to the company. They work in harmony to reduce wastage in the organization and brainstorm on finding new ways of increasing productivity.
  • ESOPs also increase the employees’ trust in the management and the company itself.

Benefits for Employees: Employees also enjoy several benefits of an ESOP:

  • ESOPs definitely bring financial benefits to the employees in the form of higher pay, benefits and overall wealth generation. It also allows a comfortable retirement for them.
  • Holding the shares of the company, they feel more responsible towards the organization. They actively participate in the company’s decision making processes which, in turn, make them more optimistic towards the organization.
  • As a combined effect of monetary and non-monetary benefits, ESOP gives better job security and job satisfaction to the employees.

Tax Implications:

  • The ESOPs attract taxes at two instances:
  • At the time of exercising and
  • At the time of selling.
  • When exercising your option, it is considered as a perquisite and hence taxed.
  • When these shares are sold by the employee, there will be either capital gain or capital loss which needs to go through taxes.
  • TDS is deducted by the employer in the first instance of perquisites, while in the second instance the difference between the fair market value of the shares (the value at which it was purchased) and the selling price is termed as capital gain and taxed accordingly.

Some important points to be noted here include:

  • Options vested by the company to its employees are not taxable.
  • If the shares belong to a company based outside the country, the profits on selling it will be considered as short-term capital gains and taxed accordingly.

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