ESOPs for Employees: What It Is, How It Works and Advantages

ESOPs for Employees: What It Is, How It Works and Advantages. Recently, the Tata Group gave out 3% of shares of the newly acquired Air India as ESOPs to permanent employees. Not long ago, competing airlines like Indigo and Spicejet have also offered ESOPs to their mid-level employees. In this article, Compliance Calendar brings to you, a comprehensive overview of Employee Stock Option Plan (ESOPs) - covering legal and taxation nuances, while also discussing the risks and advantages associated with ESOPs.
What is an ESOP?
Employee Stock Option Plans (ESOPs) are a type of equity compensation plan that allows companies to offer their employees the option to purchase company stock at a predetermined price. ESOPs are a way for companies to incentivize and reward their employees, while also providing a potential financial benefit to the employees if the company's stock price rises. 
Here's how an ESOP typically works:

The issuing of ESOP is covered under the Companies Act, 2013, and the Companies (Share Capital & Debentures) Rules, 2014.

It involves preparing a basic ESOP document. This includes the company granting the employee the option to purchase a certain number of company shares at a specified price, which is called the "strike price". The strike price is typically set at a discount to the market price.

A board meeting notice with a resolution is prepared.

After establishing the price point, a general meeting needs to be convened to adopt a special resolution for issuing ESOPs. This also includes filing the MGT-14 form with the Registrar of Companies.

The employee has the option to exercise the option and purchase the shares at the strike price at a future date, which is called the "vesting period". These details are to be maintained in the ‘Register of Employees Stock Options” in Form SH-6 and Form PAS (Return of Allotment).

Who is eligible to receive ESOPs?
» Permanent employees
» Directors, excluding an Independent Director
» Employees of holding or subsidiary companies 
Are any categories of employees deemed ineligible to receive ESOPs?
The following two special cases of employees/directors are barred from receiving ESOPs of a non-startup company:

Employees who are either promoters or belong to the promoter group; or

Director who either himself or through his relative or through anybody corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.

However, the above two provisions do not apply to a startup within the first ten years of its incorporation. Hence, a startup can still issue ESOPs to promoter employees and directors holding more than 10% shares.
How does the purchase or sale of ESOPs take place?
If the employee decides to exercise their option and purchase the shares, they can then hold onto the shares while they remain with the company or sell them for a profit if the stock price has risen since the option was granted. If the stock price has fallen, the employee may choose not to exercise the option and instead let it expire.
Employee Stock Option Plans (ESOPs) offer several advantages to both companies and employees. Here are some of the key advantages:
Employee Retention:

ESOPs are a great tool for companies, especially startups, to incentivize and retain talented employees by providing them with an ownership stake in the company.

A peculiar trend in the IT sector, which witnesses a high employee turnover rate, ESOP is a preferred practice to retain employees, as employees work towards the success of the company and ESOPs can motivate them to work towards achieving the company's goals as well as bolster their own investment.

Tax Benefits:

ESOPs can provide tax benefits to both the company and the employees. For example, the company can deduct the cost of the options from their taxable income, and the employees can delay paying taxes on the options until they exercise them.

From Budget 2020-21 onwards, employees receiving ESOPs from ‘eligible startups’ do not need to pay tax in the year they purchase them and can defer them for a period of 48 months.

However, capital gains are taxable when the shares are eventually sold if long term gains are over INR 1 lac.

» Corporate governance and employee loyalty: ESOPs can improve corporate governance by aligning the interests of employees with the interests of shareholders. Employees also feel more responsible for taking ethical actions while performing their jobs. This can lead to more responsible decision-making and better long-term performance.» Reduced working capital for a startup or a cash-strapped business: ESOPs can be a cost-effective way for companies to provide their employees with additional compensation without having to pay upfront cash salaries. This can help startups in conserving cash while still providing their employees with encouraging benefits.» Increased Productivity: ESOPs can lead to higher levels of motivation, engagement, and job satisfaction.» Building wealth over the long term: ESOPs also allow employees to build a corpus of wealth due to appreciation in stock prices over time. The underlying value of shares as well as the dividend can sum up to a rich value, for retirement or emergency use. Overall, ESOPs can be a win-win for both companies and employees, providing a range of benefits that can help to improve employee retention, productivity, and engagement, while also providing tax benefits and reducing cash compensation costs for companies.Understanding risks associated with ESOPs
While Employee Stock Option Plans (ESOPs) offer many advantages, they also come with certain risks that both companies and employees should be aware of. Here are some of the key risks associated with ESOPs:» Stock Price Volatility: ESOPs are tied to the stock price of the company, which can be volatile and subject to market fluctuations. If the stock price falls, the value of the options may be reduced, and employees may lose money. This can trigger massive stock sales or employee turnover, triggering even more volatility in stock prices.» Taxed twice, in the hands of the employee: When an employee purchases the ESOP, the difference between the market price of shares and the exercise price (or price paid by the employee) is taxed under the head ‘Perquisites’ as part of their salary. Further, when ESOP shares are sold, they are subject to long-term or short-term capital gains tax, based on the holding period of the shares.» Risks of losses due to lack of diverse portfolio: ESOPs may encourage employees to hold a significant portion of their wealth in the stock of the company, which can result in a lack of diversification in their investment portfolios. This can increase the risk of a financial loss if the company's stock price falls.» Risk of devaluation: ESOP adds to the risks of the employees, in case the company goes bankrupt or is acquired at a low valuation, the employees may lose money. If the startup fails, all the stock ends up becoming worthless.» Lack of liquidity: ESOPs are not as liquid as other types of investments, which means that employees may not be able to sell their options when they want to. This lack of liquidity can be a problem if employees need cash for other purposes.» Legal and valuation complexities: ESOPs can be complex and difficult to understand, which can lead to misunderstandings or mistakes in managing them, especially during successive valuation rounds, takeovers or mergers. More rounds of funding may also dilute employees’ shares. Companies need to ensure that they have the necessary expertise and resources to manage their ESOPs effectively.
FAQ: What happens to ESOPs if you quit the company?
Most businesses in India offer a vesting period - let’s say five years. If you quit before completing five years in the business, no shares are accused and hence, you have no right to ESOPs.
 
However, if partial rights have accrued (let’s say 20% of stocks for each completed year of service) and you have exercised rights over that portion of stock on which rights have accumulated, you can choose to sell the ESOP to your organization, usually at the fair market value of the company’s shares. This holds true only for listed companies. For a startup, you may have to wait till the company gets acquired or goes public to receive cash in lieu of the share sales.ESOPs can be a valuable tool for companies to attract and retain talented employees, as well as align the interests of employees with the success of the company. However, they can also be complex and require careful drafting to ensure they are structured and implemented effectively.
 
Compliance Calendar, as a leading legal advisor to several startups, can help your business and employees understand the terms and risks associated with an ESOP, drafting documents and filing appropriate compliance forms.

Recently, the Tata Group gave out 3% of shares of the newly acquired Air India as ESOPs to permanent employees. Not long ago, competing airlines like Indigo and Spicejet have also offered ESOPs to their mid-level employees. In this article, Compliance Calendar brings to you, a comprehensive overview of Employee Stock Option Plan (ESOPs) - covering legal and taxation nuances, while also discussing the risks and advantages associated with ESOPs.

What is an ESOP?

Employee Stock Option Plans (ESOPs) are a type of equity compensation plan that allows companies to offer their employees the option to purchase company stock at a predetermined price. ESOPs are a way for companies to incentivize and reward their employees, while also providing a potential financial benefit to the employees if the company's stock price rises.

Here's how an ESOP typically works:

The issuing of ESOP is covered under the Companies Act, 2013, and the Companies (Share Capital & Debentures) Rules, 2014.
It involves preparing a basic ESOP document. This includes the company granting the employee the option to purchase a certain number of company shares at a specified price, which is called the "strike price". The strike price is typically set at a discount to the market price.
A board meeting notice with a resolution is prepared.
After establishing the price point, a general meeting needs to be convened to adopt a special resolution for issuing ESOPs. This also includes filing the MGT-14 form with the Registrar of Companies.
The employee has the option to exercise the option and purchase the shares at the strike price at a future date, which is called the "vesting period". These details are to be maintained in the ‘Register of Employees Stock Options” in Form SH-6 and Form PAS (Return of Allotment).

Who is eligible to receive ESOPs?

» Permanent employees

» Directors, excluding an Independent Director

» Employees of holding or subsidiary companies

Are any categories of employees deemed ineligible to receive ESOPs?

The following two special cases of employees/directors are barred from receiving ESOPs of a non-startup company:

Employees who are either promoters or belong to the promoter group; or
Director who either himself or through his relative or through anybody corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.

How does the purchase or sale of ESOPs take place?

If the employee decides to exercise their option and purchase the shares, they can then hold onto the shares while they remain with the company or sell them for a profit if the stock price has risen since the option was granted. If the stock price has fallen, the employee may choose not to exercise the option and instead let it expire.

Employee Stock Option Plans (ESOPs) offer several advantages to both companies and employees. Here are some of the key advantages:

Employee Retention:

ESOPs are a great tool for companies, especially startups, to incentivize and retain talented employees by providing them with an ownership stake in the company.
A peculiar trend in the IT sector, which witnesses a high employee turnover rate, ESOP is a preferred practice to retain employees, as employees work towards the success of the company and ESOPs can motivate them to work towards achieving the company's goals as well as bolster their own investment.

Tax Benefits:

ESOPs can provide tax benefits to both the company and the employees. For example, the company can deduct the cost of the options from their taxable income, and the employees can delay paying taxes on the options until they exercise them.
From Budget 2020-21 onwards, employees receiving ESOPs from ‘eligible startups’ do not need to pay tax in the year they purchase them and can defer them for a period of 48 months.
However, capital gains are taxable when the shares are eventually sold if long term gains are over INR 1 lac.

» Corporate governance and employee loyalty: ESOPs can improve corporate governance by aligning the interests of employees with the interests of shareholders. Employees also feel more responsible for taking ethical actions while performing their jobs. This can lead to more responsible decision-making and better long-term performance.

» Reduced working capital for a startup or a cash-strapped business: ESOPs can be a cost-effective way for companies to provide their employees with additional compensation without having to pay upfront cash salaries. This can help startups in conserving cash while still providing their employees with encouraging benefits.

» Increased Productivity: ESOPs can lead to higher levels of motivation, engagement, and job satisfaction.

» Building wealth over the long term: ESOPs also allow employees to build a corpus of wealth due to appreciation in stock prices over time. The underlying value of shares as well as the dividend can sum up to a rich value, for retirement or emergency use.

Overall, ESOPs can be a win-win for both companies and employees, providing a range of benefits that can help to improve employee retention, productivity, and engagement, while also providing tax benefits and reducing cash compensation costs for companies.

Understanding risks associated with ESOPs

While Employee Stock Option Plans (ESOPs) offer many advantages, they also come with certain risks that both companies and employees should be aware of. Here are some of the key risks associated with ESOPs:

» Stock Price Volatility: ESOPs are tied to the stock price of the company, which can be volatile and subject to market fluctuations. If the stock price falls, the value of the options may be reduced, and employees may lose money. This can trigger massive stock sales or employee turnover, triggering even more volatility in stock prices.

» Taxed twice, in the hands of the employee: When an employee purchases the ESOP, the difference between the market price of shares and the exercise price (or price paid by the employee) is taxed under the head ‘Perquisites’ as part of their salary. Further, when ESOP shares are sold, they are subject to long-term or short-term capital gains tax, based on the holding period of the shares.

» Risks of losses due to lack of diverse portfolio: ESOPs may encourage employees to hold a significant portion of their wealth in the stock of the company, which can result in a lack of diversification in their investment portfolios. This can increase the risk of a financial loss if the company's stock price falls.

» Risk of devaluation: ESOP adds to the risks of the employees, in case the company goes bankrupt or is acquired at a low valuation, the employees may lose money. If the startup fails, all the stock ends up becoming worthless.

» Lack of liquidity: ESOPs are not as liquid as other types of investments, which means that employees may not be able to sell their options when they want to. This lack of liquidity can be a problem if employees need cash for other purposes.

» Legal and valuation complexities: ESOPs can be complex and difficult to understand, which can lead to misunderstandings or mistakes in managing them, especially during successive valuation rounds, takeovers or mergers. More rounds of funding may also dilute employees’ shares. Companies need to ensure that they have the necessary expertise and resources to manage their ESOPs effectively.

FAQ: What happens to ESOPs if you quit the company?

Most businesses in India offer a vesting period - let’s say five years. If you quit before completing five years in the business, no shares are accused and hence, you have no right to ESOPs.

However, if partial rights have accrued (let’s say 20% of stocks for each completed year of service) and you have exercised rights over that portion of stock on which rights have accumulated, you can choose to sell the ESOP to your organization, usually at the fair market value of the company’s shares. This holds true only for listed companies. For a startup, you may have to wait till the company gets acquired or goes public to receive cash in lieu of the share sales.

ESOPs can be a valuable tool for companies to attract and retain talented employees, as well as align the interests of employees with the success of the company. However, they can also be complex and require careful drafting to ensure they are structured and implemented effectively.

Compliance Calendar, as a leading legal advisor to several startups, can help your business and employees understand the terms and risks associated with an ESOP, drafting documents and filing appropriate compliance forms.