ESOP- A Modern technique to retain an employee in the company

An employee stock ownership plan (ESOP) is a type of employee benefit plan that gives employees an ownership interest in the company. An ESOP gives an employee the right to apply for the company's shares at a pre-determined price at a future stage[SM1] [A&A2]. The employee may at his sole discretion participate and subscribe to ESOPs of a company.

Through ESOP, employers can attain several benefits such as tax benefits, which incentivizes owners to offer such ESOPs to their employees and in turn aids in employee retention resulting in better productivity. Employees can further enjoy ownership in the company as ESOPs provide employees with the right to own some share capital in the company.

Additional Resource: EPF – Everything A Business Needs To Know

Understanding ESOPs

ESOP comes with several benefits to both employees and employers. They could very well be claimed as the most important form of remuneration to the employees of any company. From a company’s perspective, these could be useful in maintaining the liquidity of the company and from an employee’s standpoint, it is a reward for their loyalty towards the company.

The present article discusses the procedure of granting ESOPs as well as their advantages. Before diving further into the topic and its legality, let us first understand what kind of employees are actually entitled to ESOPs. As per the Companies (Share Capital and Debenture) Rule, 2014, which govern the grant of stock options, only three kinds of employees are entitled to ESOPs, namely: (i) Permanent Employees working in or outside India; (ii) Director (Whole-time or Part-time) of the company and (iii) An employee of the subsidiary (could be in India or abroad), holding company or an associated company.

It is imperative to note that neither promoter nor a director holding more than 10% of the equity shares of the company can be entitled to take part in the ESOP scheme. For ESOP a company is required to draft various documents such as ESOP policy, grant letter or add the provisions of ESOP in the employee agreement of the prospective employee. ESOP allows employees to acquire a set number of company’s shares at a set price when the option period expires (a certain number of years). [SM3] [A&A4] Before an employee may exercise his option, he must first complete the pre-determined vesting period, which requires the employee to work for the company until a portion or all his stock options are exercised.

Why are ESOPs granted to employees?

There are a variety of reasons why employees are awarded stock options. Stock options are more common in start-up organizations that can't afford to pay high wages to their employees but are prepared to let employees partake in the company's future success. Employees are granted stock options as part of their remuneration package in such instances. Furthermore, in certain situations, the employees are granted stock options that they can exercise at a later date/s in order to ensure the employee's long-term commitments. So, in addition to providing monetary benefits to employees, ESOP also helps to foster a sense of connection and ownership amongst them.

How do ESOPs work?

Employee stock option plans, that explain the process for granting stock options and the criteria tied to them, are typically used to issue ESOPs to employees. ESOP specifies the grant price or the price at which an employee can purchase a share of the company, which is usually set and is significantly lower than the current market price of the shares.

Employees get a grant letter with respect to the options granted, which includes terms and conditions for exercising the options, as well as vesting criteria, vesting time, and exercise price. After a specific lock-in period, which is usually more than a year, the employee's options could be exercised. The employee's right to exercise the option may vest in him at a later period.

The "vesting date" is the date on which an employee becomes eligible to exercise his right to buy shares and the 'exercise date' is the date on which an employee exercises his option to purchase the shares. However, it is not obligatory for the employee to exercise the option just because it is presented as an option, the employee may also refrain from acquiring the ESOP. The employee is given a certain amount of time to implement his options, after which his vested rights may end.

ESOP allotment

Primarily, there are three points that are concerned with the timing of issuing of shares to employees through an ESOP:

1. Grant

The first step involved in ESOP is a Grant Letter. The term "Grant" refers to the distribution of shares to employees. It involves alerting the employee of his ESOP eligibility. The company will have complete control over the exercise price, while employees will have the option of participating in an ESOP.

2. Vesting Period

The right of employees to apply for shares that have been awarded to them is referred to as vesting. As per law for the ESOP plan, there must be a minimum of one year between the issuance of the option and vesting of the option. The reason behind the vesting period is that if the employee leaves the company before the vesting period ends, the company’s obligation to issue ESOP to the employee also ends, as he has left the company before the vesting of the ESOP granted to him.

3. Exercise Period

Employees can exercise their option to purchase shares throughout the exercise period. The company will have complete control over the lock-in period for any shares issued (if any) once the option is exercised. Employees will not be able to receive a dividend, vote, or enjoy the benefits like that of a shareholder in the ESOP until the shares are issued as a result of his option being exercised. Once the shares are issued to the employee, he is entitled to all rights and obligations provided under the law to any shareholder.

Legal Structure for ESOP in India

ESOPs in India are mainly regulated under the following laws:

1. Indian Companies Act,2013

The Companies Act,2013 particularly prohibits the granting of options to promoters or members of the promoter group, as well as directors, who directly or indirectly own more than 10% of the company's outstanding equity shares.

2. Foreign Exchange Management (Non-debt Instrument) Rules, 2019

Foreign Exchange Management (Non-debt Instruments) Rules, 2019 and the Indian Companies Act, 2013 allow an Indian company to award options to its directors, officers, and permanent employees working in the country or outside India, and to its holding company, subsidiary companies, or joint ventures in India or abroad.

3. Companies Share and Capital and Debenture Rule,2014

The Companies (Share Capital and Debentures) Rule, 2014 specifies the rules and conditions under which an Indian unlisted firm may structure and operate ESOPs.

4. Securities and Exchange Board of India Regulations, 2014

The Securities and Exchange Board of India (Employee Share Based Payments) Regulations, 2014 apply to ESOP plan offered by publicly traded firms.

Advantages of ESOP

1. Advantage to Employees

(i) Shares at Nominal Rate

Employees often pay a nominal amount to acquire the shares assigned to them while exercising their ESOPs. As a result, they can invest in the firm at a discounted rate.

(ii) Ownership

Employee Stock Ownership Plans (ESOPs) allow employees to hold a portion of the company's share capital, hence a big advantage for an employee.

(iii) Dividend Income

Dividends are paid to shareholders from a portion of the company's profits. Employees can thereby receive additional dividend income while also benefiting directly from their contributions to the company's performance.

2. Advantage to employer

(i) Increase in Productivity

Individual employees will immediately benefit from a firm's success and will experience a feeling of ownership since an ESOP provides employees with a share of the company, hence they will gain confidence and work more effectively towards the growth of the Company, which will in return benefit the company/ employer.[SM5] Companies with employee stock plans may see an increase in productivity and overall performance as a result of this. Employees' general morale and trust in the company may improve when they have a financial interest in the company.

(ii) Employee Retention

ESOPs could serve as a potential source of employee retention for any company. ESOPs provide employees with certain ownership in the company which could motivate them to stay with the company longer so as to obtain maximum profits.

(iii) A Way to Attract New Talent

ESOPs are supplemental compensation schemes that assist firms to recruit and in retaining top talents. Indeed, ESOPs assist start-ups attract top employees in their early setup days when releasing higher salary packages may not be a very feasible option for them.

Tax involvement

The taxation of ESOPs happen in a pattern that follows two levels of taxation, wherein the first stage is when the employee option to purchase shares at the Exercise Price is exercised and the second stage is when the shares are eventually sold. In the first stage when the ESOP option is exercised, the difference between the Exercise Price and the market value of the security is considered as a prerequisite in the employee's hand. The employer must deduct tax from the employee who exercises the option at source, recognizing it as a prerequisite. In the second stage when the employees sell the shares owned by them, the difference between the selling price of the share and the fair market value on the day the share was exercised is liable to capital gains tax upon the sale of the shares by the employee. If a foreign company grants an ESOP to an Indian Resident, it will be taxed in India. Further, the tax regulations of the company's home country, as well as the agreement for the avoidance of double taxation (DTAA), must be investigated in order to determine the actual tax implications.

Conclusion

ESOPs have always been considered as a brilliant option by many companies, start-ups and established companies alike, majorly as a means of employee retention which in turn benefits the employees and as well as employers. But while choosing an ESOP plan, every company must consider all factors in relation to how the ESOPs need to be distributed, to which employees and the tax implications involved in the same, prior to providing the ESOP option to its employees. The employees must also keep themselves abreast with the knowledge about what ESOPs are, how they function, the advantages they provide and the tax ramifications they have. Employees should also keep in mind that ESOPs have a vesting time before they may be exercised. ESOP may appear to be a desirable part of the employee compensation package, but employees must first fully comprehend them in order to realize their full potential. To conclude, ESOP could be a beneficial plan for both employees and employers if it is implemented well while considering all the factors including legal formalities involved in it.

FAQ’s

1. Is ESOP good for employees?

Employee stock option plans, or ESOPs, are possibly the most important form of employee compensation. From the standpoint of a start-up, it helps to retain liquidity, and from the standpoint of an employee, it is a reward for loyalty.

2. What happens to ESOP if employee leaves the company?

When an employee quits the firm, he is entitled to the percentage of the ESOP retirement plan that has been vested, the remainder is given to the business.

3. How much ESOP should a company give?

Over the course of a company's life, most companies allocate 10% to 25% of their capital to the ESOP Pool. This is usually determined by the amount of money you raise, the valuations you achieve, and the size of the team you need to assemble. You'll have to refresh the pool and dilute often if you give away too much equity too soon.

4. What is vesting period in ESOP?

The vesting period is the time between when the options or shares are first granted and when the participant can exercise all of the rights that come with them.

5. When ESOP is not good for a company?

ESOP generally is not considered as a good option for struggling companies with both financial and management issues. Providing an ESOP under struggling companies can hamper the top management and decision-making power hence creating more problems for an already struggling company.