MEANING (SECTION 2(37) OF COMPANIES ACT, 2013):
“Employees’ Stock Option” means the option given to the directors, officers or employees of a Company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price.
Employees’ Stock Option Scheme helps a company to enter into a strategic and robust relationship with their employees on a voluntary basis and in a gracious manner for their genuine benefit. It has now been accepted internationally that stock options are an effective instrument to align the interest of the employee with that of the company. It also provides an opportunity to employees to participate in the growth of the company, besides creating long term wealth in their hands.
Section 62(1)(b) provides that a company may, at any time, issue shares to its employees under a scheme of employees’ stock option, subject to special / ordinary resolution in the case of a public / private company respectively passed by company and subject to such conditions as may be prescribed.
An employee stock ownership plan gives workers ownership interest in the company. ESOP is usually formed to allow employees the opportunity to buy stock in a closely held company to facilitate succession planning.
ESOPs encourage employees to do what’s best for shareholders since the employees themselves are shareholders and provide companies with tax benefits, thus incentivizing owners to offer them to employees. Companies typically tie distributions from the plan to vesting.
Employee shall have the same meaning as defined in clause (b) of sub-section (1) of section 62 and Rule 12 of the Companies (Share Capital and Debentures Rules 2014). ‘‘Employee’’ therefore means–
(i) A permanent employee of the company who has been working in India or outside India; or
(ii) A director of the company, whether a whole time director or not but excluding an independent director; or
(iii) 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 or of an associate company but does not include–
(a) An employee who is a promoter or a person belonging to the promoter group; or
(b) 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.
ROUTES OF ESOPS:
There are two routes available to companies for the creation and implementation of an ESOP:
- Direct Route; and
- Creation of a Trust
Direct Route:
Under the Direct Route the ESOP is approved of and administered by and/or with the approval of the Company’s Board of Directors. As per the provisions of the Companies Act 2013 an ESOP scheme should be drafted and approved by the shareholders’ by passing a special resolution.
Once the ESOP scheme has been approved by the shareholders, it should be implemented and governed in the manner set forth in the ESOP document so approved. The Board of Directors should issue to their employees a Letter of Grant stating the number of Options being granted to them along with other details such as the Vesting Period and the Exercise Price at which the Employee will be entitled to exercise the Options.
The Direct Route is simpler and is a generally recommended route of ESOP implementation for start-ups. 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).
The Trust Route:
The formation of a trust for the purposes of implementing an ESOP is more complex than implementing an ESOP via the direct route.
For the implementation of an ESOP under the trust route, a trust is formed as per the provisions of the Indian Trust Act 1882. A Trust Deed is executed and has to be registered with the jurisdictional sub-registrar.
Under this route shares and/or options are not allotted directly to the employees. The shares are first received by the Trust by any of the following methods:
- Shares may be allotted to the Trust;
- The Trust may purchase the shares from existing shareholders in the open market;
- The owner of the Company may sell shares of his holding to the Trust.
The Trust arranges for funds to purchase these shares either through a loan from a financial institution or from a seller of shares or even from the issuing company (as permitted under the provisions of section 77(2)(b) and (c) of the Companies Act.
If the Employees decide to exercise their Options the Trust allots the shares to the Employees and the Exercise Price received by the Trust is used by it to repay its loans.
Trust Route is the second method of issuing shares pursuant to an ESOP scheme. In this method, a Trust is specifically created and registered for the purpose of implementing an ESOP Plan. A company drafts a scheme and gets it approved from the members of the company. Simultaneously, a Trust is formed and registered to act as an intermediary between the company and employees. As and when options are exercised by the option holders, Trust is responsible for issuing shares to employees. In this structure, trust is formed and funded by the company itself. The capital of the trust and further funding requirements are fulfilled by the company by way of loan. The funds are then utilized by the trust to acquire shares either by subscribing to the issue of shares by the co. or from the secondary market. Generally, it is observed that shares are transferred by the promoters of the company. Further, as and when options are exercised by the employees, shares are transferred to them in conformity of the ESOP Scheme.
Tax Implication of ESOPs :
Employee stock ownership plan is considered as a perquisite with respect to taxation. On the other hand, for an employee, ESOPs are taxed at two below-mentioned instances :
While exercising – in the form of a perquisite. When an employee exercises his option, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxed as a perquisite.
While selling – in the form of capital gain. An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax. The capital gains would be taxed depending on the period of holding. This period is calculated from the date of exercise up to the date of sale.
Benefits of ESOPs for the employers:
Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee to put in his 100 percent. Although motivation, employee retention and rewarding hard work are the key benefits which ESOP brings to the employers, there are several other noteworthy advantages too.
With the help of ESOP options, organizations could avoid the cash compensations as a reward, thus saving on immediate cash outflow. For organizations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.
Problems related to ESOPs for the employers:
It’s easy to pitch the benefits of ESOPs for the companies considering the liquidity and succession alternatives. However, there are good reasons not to go for ESOPs.
Employee stock ownership plans have complex rules and need significant oversight. Although outsourcing this function to external advisors and ESOP TPA (Third Party Administration) firms could manage it, the ESOP company requires some internal personnel for championing this program. In case a company doesn’t have the staff to do the ESOP work properly, they could risk issues and potential violations.
Once the ESOPs are established, the company needs a proper administration including the third-party administration, trustee, valuation, legal costs. Company owners and the management must be aware of the ongoing costs. In case the cash flow which is dedicated to ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP scheme isn’t a good fit for such a company. For companies requiring significant additional capital for carrying on business operations, they must avoid ESOPs. The ESOP schemes use the cash flow of the company for
funding purchase of shares from its shareholders. In case a company requires the funds for additional working capital or capital expenditures, the ESOP transactions would compete with this necessary requirement, creating a crisis situation for the management.
——–Article Collation Credits: Abiza, Clear Tax & Taxguru———