ESOP- Meaning, Legal Aspects & Recognition as Start up Kit to Retain Talent

WHAT IS ESOP AND WHY IT IS RECOGNIZED AS START UP KIT TO RETAIN TALENT AS WELL AS LEGAL ASPECTS OF ESOP

Employee Stock Option Scheme usually known as the Employee Stock Option Plan or Employee Stock Ownership Plan or ESOP, as its bare reading suggest that it’s an option provided to the employees of Company to purchase the shares of Company at a predetermined price, therefore, it’s an option with regard to stocks of the company but not a compulsory obligation for employees to whom such offer has been made and another significant aspect is said offer is made at a predetermined price. For instance; ABC Private Limited made a ESOP offer to few employees in the initial days of incorporation at a face value of Rs.10 per share, whereas, said offer terms states that an employee can exercise the option of stocks offered within the period of five years, supposed an employee exercised the grant offer within two years when fair market value of each stock was Rs.200, however, he was required to pay Rs.10 per stock instead of Rs.200.

The issue of Shares under ESOP is governed by the provisions of Companies Act, 2013, Section 62(1)(b) and Rule 12 of Companies (Share Capital and Debentures) Rules, 2014 (the Rules) states the requirements, procedure and manner of issue Shares to Employee under ESOP. It is to be noted that the provisions of the Act and the Rules thereunder provides only basic framework in relation to issue of Shares under ESOP, therefore, terms and conditions with respect to employee stock offer scheme and eligibility criteria of employees is decided by the board of directors.

Section 62(1)(b) states that the Company can issue Shares to its Employees under the Employee Stock option subject to passing special resolution and other provisions contained in the rules, However, in case of Private Company and IFSC Public Company, ordinary resolution is sufficient instead of special resolution.

Briefly there are two modes two issue ESOPS, where under first mode company creates a Trust and allot the Shares to that Trust, thereafter, that Trust transfer the Shares to Employees after the vesting period, as and when Employees apply for the same, within the exercise period, where as in second mode the Company makes allotment of Shares to Employees after vesting period, as and when Employees apply for the same, within the exercise period.

SCOPE OF EMPLOYEES UNDER ESOP

(a) A permanent Employee of the Company, whether, working in or outside India; or

(b) A Director of the Company, whether a Whole Time Director or not but excluding an Independent Director; or

(c) An Employee as defined in Clauses (a) or (b) above, of a Subsidiary, in India or outside India, or of a Holding Company of the Company.

But does not include-

(i) An Employee who is a Promoter or a person belonging to the Promoter Group; or

(ii) A Director who either himself or through his relative or through any Body Corporate, directly or indirectly, holds more than ten percent of the outstanding Equity Shares of the Company.

Provided that in case of a Startup Company, as defined in notification number G.S.R. 127(E), dated 19^th February, 2019 issued by the Department for Promotion of industry and Internal Trade, Ministry of Commerce and Industry, Government of India, the conditions mentioned in sub-clause (i) and (ii) above shall not apply upto ten years from the date of its incorporation or registration.

ESOP AS STARTUP GEAR TO RETAIN TALENT

India is experiencing an era of entrepreneurs and startups, whereas, government has tried to create a startup ecosystem in past few years with the objective to encourage innovation, manufacturing and employment, accordingly, for any startup; deployment of funds for operations, expansion and research is prime requirement, however, each of these aspect is dependent upon the efficient human resource, therefore, when startups is not in capacity to pay high salary or wanted to utilize the funds for business in such instance; startups tend to offer the stocks to employees at predetermined discounted price or at face value with the objective to retain the talent as well as to encourage the talent. From a founder’s point of view, ESOPs are a key hiring tool to attract the best talent without having to pay high salaries like a multinational firm. They are crucial in the early stages when a startup may not be well funded. For employees, these are meant to align incentives and work by giving them a stake in the company. Flipkart, Car Dekho, Oyo are among many other well-known startups who have issued ESOPS to retain and encourage the talent.

Nevertheless, ESOP terms are usually drafted in such a manner so as to encourage the retention of employees for a specific tenure, generally, such offer came with the stipulations that said offer of stock at discounted price is subject to the condition that employee must work for a specific tenure in the organization. It’s also an industry practice that such offer tend to lapse in instance if any employee has been terminated from the organization. However, few industry practices is to allot share after resignation or lay off if exercised in specified period as defined in offer, for instance; foodtech unicorn Zomato, which laid off hundreds of employees, is letting employees vest their ESOPs. However, as reported by “Money control” India’s startups–from billion-dollar companies to year-old firms, have laid off more than 10,000 people, wherein, their ESOPS were terminated overnight without any specific discrepancy on their part.

It is to be noted that regime of ESOP is not limited to startups; many established organization issues ESOPS to encourage and reward their employee. For an instance; Recently, Infosys has granted a total of 37,88,260 stock incentive units to specific key managerial person and eligible employees under its 2015 “incentive compensation plan” and “Expanded ownership program 2019”

HOW ESOPS ARE BENEFICIAL FOR EMPLOYEES

ESOPS provides ownership stake to the employees of the company and in the growth years of company they can either sale their stake in open market or can liquidate their stock in any buy back scheme for ESOPS as may be issued by the company. Flipkart’s sale to Walmart and Citrus Pay’s sale to PayU are some instances of employees striking it rich. More recently, social commerce firm Meesho, online car portal CarDekho and payments platform Razorpay, all gave early ESOP holders some liquidity. Nevertheless, recently, amazon backed general insurance startup “Acko” has concluded its first liquidity program worth 2 million USD, wherein, eligible staff were allowed to liquidate their stocksfrom 40 percent to 100 percent of their vested ESOPS. Though there are several issues when it comes to buybacks, wherein, Taxes aside, the issues with ESOPs in Indian startups is that once exercised, employees have no opportunity to liquidate their shares but to wait for either IPO or the company’s cash back offers.

HERE ARE SOME IMPORTANT TERMS USED UNDER THE ESOP, LET’S UNDERSTAND THEM:

Option

Option means the option given to an Employee, which gives them a right to purchase or subscribe the Shares of the Company at a future date at a pre-determined price.

Grant of option

Grant of option means the process by which the Company issues options to eligible Employees under the ESOP.

Vesting

Vesting means the process by which the Employee becomes entitled to receive the Shares of the Company under ESOP.

Vesting period

Vesting period means the period after which the Employee can exercise the option granted to him under ESOP.

Exercise

Exercise means process of getting Shares of the Company by the Employee in exchange of option granted to him.

Exercise period

Exercise period means the time period after vesting period within which an Employee should exercise his right to apply for shares against the vested option.

Exercise price

Exercise price means the price, if any, payable by the Employee for exercising the option.

CONDITIONS FOR ISSUE OF SHARES UNDER ESOP

A. The approval of Shareholders by way of separate resolution shall be obtained by the Company in case of:

(a) Grant of option to employees of Subsidiary or Holding Company; or

(b) Grant of option to identified Employees, during any one year 1% or more of the Issued Capital (excluding outstanding warrants and conversions) of the Company at the time of grant of option.

B. There must be a minimum gap of one year between the grant of options and vesting of option:

However, in a case where options are granted by a Company under its ESOP in lieu of options held by the same person under an ESOP in another Company, which has merged or amalgamated with the first mentioned Company, the period during which the options granted by the merging or amalgamating Company were held by him will be adjusted against the minimum vesting period required under this clause.

C. The Company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.

D. The Employees will not have right to receive any dividend or to vote or in any manner enjoy the benefits of a Shareholder in respect of option granted to them, till Shares are issued on exercise of option.

E. The amount, if any, payable by the Employees, at the time of grant of option:

(a) May be forfeited by the Company if the option is not exercised by the Employees within the exercise period; or

(b) The amount may be refunded to the Employees if the options are not vested due to non-fulfillment of conditions relating to vesting of option as per the ESOP.

F. The option granted to Employees shall not be transferable to any other person.

G. The option granted to the Employees shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner.

H. In the event of the death of Employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased Employee.

I. In case the Employee suffers a permanent incapacity while in employment, all the options granted to him as on the date of permanent incapacitation, shall vest in him on that day.

J. In the event of resignation or termination of employment, all options not vested in the Employee as on that day shall expire. However, the Employee can exercise the options granted to him which are vested within the period specified in this behalf, subject to the terms and conditions under the scheme granting such options as approved by the Board.

VALUATION ASPECTS

As per provisions of the Rules Company is free to determine the exercise price under the ESOP, accordingly, valuation of shares is not required in case of ESOP.

VARIATION OF TERMS OF ESOP:

As per the SCD Rules, Company by passing special resolution, can vary the terms of ESOP which is not yet exercised by the Employees, however, such variation shall not be prejudicial to the interests of the option holder (i.e. Employees).

Disclosure in explanatory statement

Following disclosures required to be made in Explanatory Statement:

(a) The total number of stock options to be granted;

(b) Identification of classes of Employees entitled to participate in the ESOP;

(c) The appraisal process for determining the eligibility of Employees to the ESOP;

(d) The requirements of vesting and period of vesting;

(e) The maximum period within which the options shall be vested;

(f) The exercise price or the formula for arriving at the same;

(g) The exercise period and process of exercise;

(h) The Lock-in period, if any;

(i) The maximum number of options to be granted per Employee and in aggregate;

(j) The method which the Company shall use to value its options;

(k) The conditions under which option vested in Employees may lapse e.g. in case of termination of employment for misconduct;

(l) The specified time period within which the Employee shall exercise the vested options in the event of a proposed termination of employment or resignation of Employee; and

(m) A statement to the effect that the Company shall comply with the applicable accounting standards.

DISCLOSURE IN DIRECTORS REPORT

The Board of Directors, shall, inter alia, disclose in the Directors’ Report for the year, the following details of the ESOP:

(a) Options granted, Options vested, Options exercised, The total number of Shares arising as a result of exercise of option, Options lapsed, The exercise price, Variation of terms of options, Money realized by exercise of options, Total number of options in force;

(b) Employee wise details of options granted to;-

(i) Key Managerial Personnel;

(ii) Any other Employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year.

(iii) Identified Employees who were granted option, during any one year 1% or more of the issued capital (excluding outstanding warrants and conversions) of the Company at the time of grant;

TAXATION ASPECT

ESOP is taxable in hands of Employee at two stages:

(a) First when the Company allots the Shares under ESOP; and

(b) Second when Employee sale the Shares allotted to him under ESOP.

Taxability of ESOP at the time of allotment of Shares:

Where Shares allotted to Employee under the ESOP, free of cost or at concessional rate, than difference between fair market value and exercise price of option, on the date of exercise of option, is taxable under the head salary.

How to calculate fair market value?

As per Rule 3(8)(iii) of the Income Tax Rules fair market value of unlisted shares, on the date of exercise of option, shall be determined by the Category I Merchant Banker registered with SEBI.

TAXABILITY OF SHARES ISSUED ALLOTTED UNDER ESOP AT THE TIME OF SALE

The sale of Shares by Employee issued to employee under ESOP is taxable under the head capital gain. The difference between sale price and exercise price will be treated as capital gain/ loss, and period from the date of exercise of option till the date of sale of Shares, will be treated as period of holding. If Shares held for more than 24 months than the gain will be treated as LTCG, if not than it will be STCG.

Internationally, Singapore offers a dedicated equity remuneration incentive scheme (ERIS) for startups which provides a tax incentive to employees who derive gains from ESOP granted by their employers. According to the scheme, one can enjoy tax exemption of 75% of the gains arising from ESOPs. Tax exemption is available for each year of assessment over a period of ten years, subject to qualifying criteria. The cumulative gains on which the tax exemption applies are capped at $10 Million over the ten-year period and the gains must be derived on or before December 31, 2023, according to the Inland Revenue Authority of Singapore.

WHY FOUNDERS DO NOT TRANSFER SHARES DIRECTLY INSTEAD OF ESOP SCHEME

Transfer of shares by existing members to employee is one of the reasonable option to give shares to the employee instead of ESOPS, though, in transfer as well as ESOP holding of the Existing Shareholders dilutes but in first case compliance requirement is less and process of issue is quite simple, however, startups prefer ESOP with the agenda to retain the employee for a specific period, therefore, start-ups tend to put forth the condition of minimum tenure of employment for exercising the option of stocks. Nevertheless, ESOP tends to become the part of employees total salary structure, therefore, total remuneration offered to employee sustains in book, this not only justifies the salary schedule of employee but also assist as a tool to attract Multi National Investors. Further, ESOPS encourage the key managerial person to remain in the organization for long tenure which resonate the sense of trust among potential or interested investors.