Meaning of ESOP

It is a system by which a company allows its employees to purchase shares of the company. In certain cases, a foreign holding company provides the employees of an Indian subsidiary with such an option. Under this scheme, employees are granted options, which allows the employee to buy the stock at a rate below the prevailing market value of the stock or the employee is provided a certain percentage of his/her remuneration in stocks of the company.

ESOP is a contract that gives employees the right, but not obligation, to purchase or subscribe to a specified number of shares of the company at a fixed price, that is, the exercise price. The exercise price remains fixed even if the market price goes up in future.

Employee Stock Option Plan

Why Company offers Employee Stock Option?

The trend of giving ESOPs is more prevalent in start ups, which cannot afford to provide large compensation packages to its employees. By providing an employee with an ESOP, the employer gets the employee vested in the interests of the company and provides the employee with a sense of ownership, thereby, motivating the employee to perform a task with an actual vested interest in the company. Some companies provide ESOPs to employees which can be exercised on a future date, to provide incentive for a long term commitment by the employee to the company.

What benefits does the company enjoy by providing ESOPs?

1. Acquiring the shares of a departing owner: The owners of private companies can use the ESOP to sell their shares. Companies are allowed to make tax deductible contributions to the ESOP to buyout the shares or the company can use the ESOP to borrow money to buy the shares.

2. Borrowing money at lower after-tax cost:Cash borrowed under ESOP is used to buy company shares and shares of existing owners. Contributions to the ESOP are tax deductible as they are made to repay the loan amount. Both principal and interest are tax deductible.

3. Creates an employee benefit:A company can issue treasury shares or new shares to an ESOP and deduct the value from the taxable income. Companies sometimes contribute cash to the ESOP to buy shares from existing public or private owners. In public companies, ESOPs are often used in conjunction with the employee savings plan. Rather than matching the employee’s savings through cash, the employers can match the employee’s savings through stocks from an ESOP, and usually the employers will match the savings at a higher level through stocks.

What are the disadvantages of ESOPs?

1. Options can become an obligation for the company. ESOPs do not have an option premium and the only compensation a company can hope for is indirectly through increased liquidity and sometimes through a tax advantage. The risk for the exercise remains the same as it is for normal stocks. This can make options riskier than normal stocks.

2. Only when the exercise on the options is executed does it generate liquidity for the company and the amount of liquidity is uncertain till the date of the exercise. The liquidity benefits with ESOPs is highly uncertain.

3. There are still various unclear guidelines for the valuation and accounting procedure for ESOPs in a company.

Criteria for eligible employees 

The intent of granting ESOPs is to keep employees motivated and also to let them be a part of the progress of the company. ESOPs will not be offered to all employees of the company. The company will be carving out a selection criteria basis which it will determine who will be eligible employees for availing the scheme.

The extant regulations pertaining to ESOPs lays down some criteria for who eligible employees could be. For instance, Explanation to Rule 12 (1) of Companies (Share Capital and Debentures) Rules, 2014 states that –

“For the purposes of clause (b) of sub-section (1) of section 62 and this rule „„Employee‟‟ means-

(a) a permanent employee of the company who has been working in India 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) 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.” Over and above the regulatory requirements, a company may set down certain criteria subject to which eligible employees will be identified. Most companies offer ESOPs to employees above a particular grade, number of years of service. In case of start-ups, the employees who joined the founders at the early stage of running the company may be offered ESOPs.

Step by Step Process for issue of ESOP

1. Preparation of list of eligible employees for ESOP

This is the first step and basic step required for ESOP scheme. Employees should be carefully selected for participation in ESOP scheme after considering his/her experience, roles and responsibility etc.

2. Preparation of ESOP policy

It is the most important step for Companies. Following are essential things that must be kept in mind while drafting ESOP policy:

  • Quantum of ESOP pool;
  • Employees Selection and evaluation criteria for participating in the scheme;
  • Rights of option holders;
  • Rights of shareholders like Tag along, Drag along and pre-emption rights;
  • Exit mechanism;
  • Tax liabilities.

3. Board Approval

After preparation of list of eligible employee, quantum of options, drafting of ESOP scheme, next step is to convene a Board Meeting for final board approval. Board have to approve list of employees participating in the scheme, draft ESOP scheme, notice of general meeting for approval of shareholders.

4. General Meeting

General Meeting of members of the company will have to convene for their approval of ESOP scheme by Special Resolution. However, Only Ordinary Resolution in required for issue ESOP by Private Limited Company.

5. Filing of Form MGT-14

E-form MGT-14 must be filled by all the companies (Except Private Limited Company) attaching Special Resolution for approval of Scheme, Explanatory Statement, Notice of GM, and approved ESOP policy.

6. Preparation & Dispatch of Grant Letter

After approval of shareholders, Company need to send Grant Letter to all the eligible shareholders to participate in the scheme mentioning their entitlement, vesting schedule, date of vesting, last date upto which exercise can be made, exercise price, manner of exercise of options and other terms and conditions.

7. Vesting of ESOPs

There must be minimum 1 year time gap in between granting of option and vesting of option. For e.g: If you grant the option on 01st April, 2019, it can’t be exercised before 01st April, 2020.

8. Exercise of ESOPs

After completion of vesting period, employees can apply for shares or further wait upto the last date on which exercise can be made or not apply for the shares. ESOP grants only right and not obligation to employees for purchase of shares.

9. Allotment of Shares

If shareholders apply for shares, companies need to allot the shares and file e-form PAS-3 for allotment of shares by attaching Special or Ordinary Resolution for approval of ESOP, Resolution for allotment of shares, list of allottees etc.

10. Issue Share Certificate & Payment of Stamp Duty

Company need to issue share certificate to the shareholders within 30 days after allotment. Companies need to pay stamp duty on issue of shares according to the stamp rates prevailing in the state.

ESOP structures

ESOPs typically are issued by the company directly or are done through the trust route. Each of the structures are explained below:

Direct Route

In case of direct route, the company grants the option and at the time of exercise, fresh equity issuance is undertaken to allocate equity to the eligible employees. In case the employee decides to exercise the option, the employee also becomes the shareholder of the company.

Direct route is preferred by unlisted companies. The only issue with direct route structures is as and when the employee intends to monetize the shares, the company may have to buy-back the shares, specifically so in case of private limited companies or wait for the company to go for a public offering to get an exit from the company (as a shareholder).

Trust route brings in several complexities in the ESOP structures.

In the trust route structures, the company creates a trust specifically for the purpose of running the ESOP schemes. Where the employees decide to exercise the option to acquire the shares, the trust would first acquire the shares from the secondary market and the transfer the shares in the name of the employees.

Under the trust route, the company does not have to dilute its existing capital base and the structure is largely preferred by listed entities for secondary market acquisition of the shares.

These employee welfare trusts are funded by the company to acquire the shares in the secondary market to be transferred to the employees upon exercise of the options. In essence, the company is indirectly funding the acquisition of the shares of the company for the employees.

When the employees leave the company, the employees have the option of selling back the shares to the trust or in the secondary market and monetizing the wealth creation by way of subscribing to the shares. The exit route is far easier in case of trust mechanism than in case of direct route structures.

In case of trust route of issuance of ESOPs, the trust on its own will not have funds to be able to acquire the shares from the secondary market as the trust is not a business trust and is a specifically created with the objective of issuance of ESOPs to the employees.

The Companies Act, 2013 facilitates the company to on-lend to the trust for it to acquire shares from the secondary market to be allocated to the employee shareholders.

Section 67 of Companies Act, 2013 read with Rule 16 of the Companies (Share Capital and Debentures) Rules, 2014 allows the unlisted public companies to make provisions of money involving purchase or subscription of its own shares or shares of the company subject to the fulfilment of the conditions specified below.

Conditions (1)

(a) the scheme of provision of money shall be separately passed by special resolution in a general meeting;

(b) In case of listed Company, the Trust shall purchase the shares from the secondary market.

(c) In case of unlisted Company, valuation of the shares purchased by the trust shall be done by an Independent Registered valuer.

(d) the total value of shares in the trust shall not exceed 5%. of the aggregate of paid up capital and free reserves of the company;

Conditions (2)

The explanatory statement to be annexed to the notice of the general meeting to be convened pursuant to section 102 shall, in addition to the particulars mentioned in sub-rule (1) of rule 18, contain the following particulars, namely:-

(a) the class of employees for whose benefit the scheme is being implemented and money is being provided for purchase of or subscription to shares;

(b) the particulars of the trustee or employees in whose favor such shares are to be registered;

(c) the particulars of trust and name, address, occupation and nationality of trustees and their relationship with the promoters, directors or key managerial personnel, if any;

(d) the any interest of key managerial personnel, directors or promoters in such scheme or trust and effect thereof;

(e) the detailed particulars of benefits which will accrue to the employees from the implementation of the scheme;

(f) the details about who would exercise and how the voting rights in respect of the shares to be purchased or subscribed under the scheme would be exercised;

Who can be the trustees?

In the trust structures, the law prohibits the following people from being trustees in the company:

1. The directors, KMPs and their relatives of the company, its holding, subsidiary or association company;

2. Any person beneficially holding more than 10% of the paid-up share capital of the company.

 Taxation: At the Time of Sale of ESOPs by Employee

The gains that arise out of the sale of ESOPs are considered as Capital Gains and thus, the Capital Gains Tax is levied on ESOPs and it is to be paid in the year in which such sale has been made. Capital Gain is computed as the difference between the price at which the ESOPs are sold by the employee and the price at which it was awarded by the Employer.

Further, the Capital Gains treatment depends upon the holding period of the ESOPs. For instance, if such shares are held for a period of less than 12 months or on year, the Short Term Capital Gains Tax@15% is levied and if such shares are held for more than 12 months, the Long Term Capital Gains Tax is levied. This Long Term Capital Gains tax is currently NIL. In other words, if the employee sells his shares given to him through ESOPs, the sale is effectively exempt from Tax.


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Location: New delhi, New Delhi, IN
Member Since: 22 Jan 2020 | Total Posts: 6

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  1. Jai says:

    The understanding on tax is wrong. The beneficiary of ESOP will have to pay tax twice. First event will be on receiving (exercise) of the stock. Income accrued will be computed as difference between market price and price charged by trust and normal slab rates will apply on this. When beneficiary sells the stock, cap gain will be paid on difference between sale price and Market price used at time of exercise of shares .

  2. AMIT S says:

    “This Long Term Capital Gains tax is currently NIL. In other words, if the employee sells his shares given to him through ESOPs, the sale is effectively exempt from Tax.”

    Is LTCG nill for Esops?

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