Employee stock option plan (ESOP) or Equity incentive plan is the scheme used by the companies to give ownership interest to its employees. ESOP is regulated by Section 62(1) (b) of the Companies Act, 2013 and SEBI (ESOS and ESPS) Guidelines, 1999.The latest amendments in the guidelines were given by the SEBI in 2014 followed by an amendment in 2015.
In this blog post we shall discuss the Employee Stock Option Plan and the various provisions related to the same.
What is ESOP?
ESOP or Employee Stock option Plan is an employee-owner method which provides ownership stake to its employees. This method is used by the organization to attract, encourage and retain its employees. The employees are given an option and it does not obligate the employee to accept this scheme.
An ESOP is an option given to its whole time directors and permanent employees the benefit or the right to purchase the stock of the company at a predetermined price.
Benefits of ESOP
Thus giving ESOPs to employees helps the companies and even start-ups to attract potential employees, to retain and motivate the employees.
Who is an employee?
According to the guidelines provided by SEBI an employee is:-
An employee does not include
All the listed companies are regulated by the SEBI (ESOS and ESPS) Guidelines, 1999 and all the unlisted companies are regulated by the Rule 12 of Companies (Share Capital and Debenture) Rules, 2014.
The ESOPs can be issued through two routes
In this route the company issues equity shares of the company to the employees as and when they exercise the option.
In the trust route the company forms an Employee Welfare Trust for the administration of ESOP in the company. The company issues shares to the trust which is forwarded or transferred to the employees upon exercise of options.
Procedure followed for the formulation of ESOPs through equity route
Step 1- Constitution of Compensation committee
Section 5 of the guidelines provide for the formation of a compensation committee. A compensation committee is formulated by the board of directors (BOD) and consist of a majority of independent directors. The Board of directors can also choose a merchant banker, however it is optional. This committee is set up to formulate detailed terms and conditions for the ESOP.
Step 2- Framing of the plan
The Compensation Committee frames a plan. The plan must be in accordance with the guidelines provided by SEBI. The Compensation committee is for the administration and superintendence of the ESOP plan.
Step 3- Presentation to the BOD and approval
After formulation of the plan by the compensation committee the BOD approves the plan. In case the company is listed, the plan should have an approval from the respective stock exchange.
Step 4- Approval of Shareholders
The shareholders approve the plan through a special resolution. The plan should be approved by a majority of 3/4thShareholders. A separate resolution should be passed if there is grant of ESOP to employees of any subsidiary or holding company.
Step 5- All necessary information
The shareholders should be provided with all the documents necessary for them to formulate an informed decision. The explanatory details shall disclose prescribed statements like number of shares issued, amount at which issued, lock-in period, exercise period, method of accounting etc.
Variations in the terms of ESOP
The company shall not vary from the terms of ESOP approved in any manner that will result in the detriment of the shareholders. The notice of variation should be given to the shareholders containing all the details of the variation and should also contain the employees who will be benefitted by the variation.
The variation should be approved by a special resolution in the general meeting. The option of reprising of the shares is given to the company if it is not detriment to the interest of the employees and the shareholders.
Lock in period
Their shall be a maximum of one year of lock in period. The employee cannot enjoy any benefits of a shareholder like share in dividend or voting right until shares are issued on exercise option.
Transferability of shares
The shares are not transferable. The employee cannot alienate the share in any manner.
In event of death of an employee the shares shall vest to the legal heir or the nominee of the deceased.
In case of resignation or termination of the employee, all the rights vested in him can be retained. The plan should specify the time period within which the employee can exercise his option. An employee terminated in case of misconduct will not have any vested right in the issued shares.
Valuation of Stock Option
There are two methods used in the valuation of the stock option.
Intrinsic Value Method
Intrinsic value is the value at the date of grant. For example: if the market value of a share at the time of grant is ₹150 and the shares were issued at ₹100, the intrinsic value of each share will be ₹50 which should be shown by the company as a compensation expense.
If the shares were issued at ₹170, the intrinsic value will become -20 which need not be shown.
Fair value method
In this method if the market value of each share is ₹150 and the shares are issued at ₹170, the fair value of each share will be ₹20. In this method the employee has the right to purchase the share at a future date when the market value of each share is more than ₹170.
In Intrinsic value method the employee has no option to buy shares at a later period.
Companies can choose from any of the above method. However, they have to disclose it in the general meeting and should also follow the accounting guidelines provided by SEBI in guidelines of 2014.
Taxation of ESOP
Income tax should be paid in two situations
The income is treated as perquisites which form part of the salary of the employee. The employer is required to deduct TDS and the income is calculated as the difference between the fair value of each share and the market value.
The gains arising out of ESOPs are capital gains. The capital gain is the difference between the sale price and the price at which it was awarded to the employee. The tax should be paid in the year of the sale of ESOP.
Long Term– When the ESOPs were held by the employee for more than 36 months (3 years) from the date of purchase the capital gain tax rate is 20%.
Short Term– When the ESOPs were held for less than 36 months (3 years) from the date of purchase the capital gain tax is 10%.
Disadvantages of ESOPs
The main concern for ESOPs is dilution. With every share granted to the employee the shareholders share gets diluted.
ESOPs have proved to be very effective tools for both big companies and start-ups. Companies use these to retain their workforce and the talent whereas start-ups use these tools to hire fresh talent and to attract more workforce. These work as a boon for companies which cannot afford to pay high salary. Besides this the sense of ownership acts as a motivation for the employees to work hard and diligently.