Procedure for Issue of ESOP & benefits of its introduction in Startups

Procedure for introducing ESOP scheme and benefits of introducing ESOP scheme in Startups

In recent years,startups have proven to be very successful in India. It has been observed that startups are budding at a rate of 10-12% per year. Startups to be successful must retain their hardworking employees and at the same time have to save the capital. ESOPs is such a tool which is offered as compensation to the employees. ESOP full form refers to Employee Stock Options.  Employee stock options scheme will be governed by the provisions of Companies Act,2013.

ESOP meaning:

Employee stock options scheme is rolled out by startups as a retirement package for the employees. This is also offered as compensation to the employees for working in the company. This will motivate the employees to work harder for the company. ESOPs are option contracts that offer the employee to buy the shares of the company at a discounted price in a future date.

Issuance of ESOP to the employees will make them work harder to increase the stock price of the company as they are ought to buy the shares in a predetermined rate, which is usually lesser than the market price when they are going to buy the shares.

ESOP Vesting Period:

This is the time the employee should wait to exercise the options (i.e to buy the shares of the company).

ESOP Valuation:

ESOP Valuation can be done in two methods:

1) Accounting Valuation

2) Tax Valuation

Accounting Valuation:

Accounting valuation is used to determine the employee compensation cost involved in the employee stock options plan of the company, at the time of ESOP grant itself which will be distributed over the vesting period of ESOP.

Two methods of doing ESOP valuation are Intrinsic Value method and Fair Value Method 

Intrinsic Value Method :

Intrinsic Value method is a simple method to calculate the price of the options. It is the difference between the current market price of the share and the exercise price of the option.

Example: If a company issues ESOP to its employees at Rs.75 per share after 2 years, whose current market price is Rs.100, then the intrinsic value of the options will be (100-75)Rs.25/-

Fair Value Method:

Fair value method relies on various option pricing models such as the Black-Scholes model or the binomial model. Black-Scholes model is preferred to the binomial model as it considers a wide variety of factors such as expected life of the option, exercise price, fair value per share, expected volatility of the share price, expected dividend yield and risk-free interest rate.

Tax Valuation:

This is used to determine the perquisite tax payable by the employees for opting to ESOP. Ideal determination of the fair value of the options and the perquisite tax of the employees will lead to the success of any ESOP scheme.

ESOP Taxation:

The employees who want to convert the ESOP to shares will be imposed a tax liability in two stages under the Income Tax Act,1961.

When Exercising an ESOP Option:Income tax is applicable when the employees exercise their options and convert them into equity. This tax is charged at the perquisite value determined by the company while drafting the ESOP plan.

Tax calculation is as follows:

Tax = Fair market value of the share (on the date of exercising the option) – Amount recovered from employees for such shares (exercise price)

When the employee sells the share: When the employee sells the share at a higher price than the ESOP price then this will amount to capital gains. Tax rates vary depending on the type of capital gain (short term or long term).

Capital Gain = Price of the shares sold – Price on the date of exercise of the option.

PROCEDURE FOR ISSUING ESOP:

1. Drafting the ESOP scheme.

2. Approval of the drafted scheme in a Board meeting.

3. Convening the general meeting for approval of the scheme by the shareholders. The following particulars have to be attached to the notice for passing the resolution:

a) Total number of stock options to be provided

b) Information on the class of employees entitled to participate in the ESOP scheme

c) The appraisal process for determining the eligibility of the employees to participate

d) Period of vesting

e) Maximum period within with the options shall be availed

f) The exercise price or formula for calculating the exercise price

g) Exercise period and its process

h) Lock-in period (if any)

i) Maximum number of options per employee and in total

j) Method of valuation of options

k) Conditions for which the options vested may be terminated Eg: Code of conduct of employee etc.

l) The period within which the employee can exercise the options if terminated or resigned from the company.

m) A statement saying that the company will comply with the accounting standards

4. Approving the ESOP scheme by passing a special resolution ( normal resolution in case of a Private company). The approval from shareholders shall be obtained by the company by passing a separate resolution if,

a) Grant of options to a subsidiary or holding company

b) grant of an option to identified employees, during any one year, equal to or exceeding 1 percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of an option.

5. Filing Form MGT-14 within 30 days of passing the resolution to submit the special resolution.

6. Granting options to the eligible employees, following approval of the ESOP scheme by the shareholders.

7. Vesting of Options. There should a minimum gap of 1 year between the grant of options and vesting of options.

8. Employees exercising options.

9. Allotment of Shares. File for PAS-3 with the Registrar of Companies(RoC) when the options are exercised by the employees.

10. Maintainanceof a Register of ESOP in Form SH-6.

ESOP has so far proven to be very successful for startups as they retain their hardworking and suitable employees. This will also motivate the employees as the company offers ESOP by placing trust in his contribution to the company. They will work hard to increase the share price of the company during the vesting period.

Benefits of ESOP for startups:

ESOP as discussed is used as a powerful tool in many startups to get the following benefits.

1. Stabilisation of Cashflow-The startup holds a chance to stabilise its cash flow during the vesting period, as they do not have to spend at the time of ESOP grant. They need to spend only a less amount for the employee, they can substitute the cash benefits with the grant of ESOP. During the vesting period, the company has a lot of time to stabilise its cash flow. Startups generally do not have much of cash flow within the company and ESOPs will act as a saviour for maintaining the cash flow.

2. Employee Attraction– Young generation employees are now more attractive towards startup as the success rate of startups in India has increased in recent years. Offering ESOP to the employee will attract more employees to work for the company. A well-planned ESOP scheme may also attract experienced employees to work for your startup.

3. Employee Retention – As soon as employees get awarded with their ESOPs they will have the vesting period in which they cannot exercise their options. The chances are high that the employee will not resign his job during the vesting period ESOP.

4. Default Motivation – As employees are going to experience their options soon as the vesting period is over, they will have the pride of ownership of the company. This will also motivate them to work even harder for the company as they understand that their work contributes to an increase in the share price of the company. This in turn will reward them for their shares.

5. Job security for employees – In general, a company offers ESOP to employees who are contributing more to their company. In the case of Startups, employees may doubt their job security as a startup is not well recognized. Offering ESOPs will bring confidence in Job security among employees. So they will not be entitled to confusions in choosing the next job in this competitive world.