Everything you need to know about ESOP

Employee Stock Option Plan, popularly known as “ESOP” has gained a lot of attention in recent times. Since the fashion of startups is on the boom, employers are using ESOPs as a tool to retain them in their companies. As ESOP gives an employee a direct ownership stake in the company at minimum prices, it is a win-win situation for both employer and employee. 

As per Section 2(37) of the Companies Act, 2013, ESOP is an option or right given to the employees of a company to purchase or subscribe for the shares of the company at a predetermined price on a future date. It is kind of a reward given to the employee for their service to the company and used as a retention tool to retain them for a longer period. It is a scheme where a proposal is given to the employees of a company to subscribe to its share capital by issuing further shares to its employees at a predetermined rate.

It encourages employees to give their best and be committed as the company’s success translates into financial rewards. They also help staff to feel more appreciated and better compensated for the work they do. Often instead of granting shares of stock directly, the employer issues derivative options on the stock which come in the form of regular call options and give the employee the right to buy the shares of the company at a specified price for a specified period. The terms of ESOPs are generally specified in the ESOP agreement.

There are many other versions of employee stock options including direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.

• Restricted Stock Grants: These give employees the right to acquire or receive shares once certain criteria are attained, like working for a defined number of years or meeting performance targets.
• Stock Appreciation Rights (SARs): SARs provide the right to the increase in the value of a designated number of shares; such an increase in value is payable in cash or company stock.
• Phantom Stock: This pays a future cash bonus equal to the value of a defined number of shares; No legal transfer of share ownership usually takes place, but they are converted into actual shares on the occurrence of an event. 
• Employee Stock Purchase Plans: These plans give employees the right to purchase company shares, usually at a discount.

The objective behind Issuing ESOPs

There are certain main objectives behind issuing ESOP to an employee:

1. Making the employees responsible towards the company by issuing stock options which will help the company to obtain better performances from them. It acts as a source of motivation for the employees after making them shareholders of the company. 

2. The thought of ownership in the company ensures retention of the employees and better performance for their work, an added advantage to the organization.

3. The scheme generally helps to motivate the employees to contribute to the growth and profitability of the company.

A company's ESOP is beneficial to both its employees and the company as a whole. A public company can reward its employees after going public and keep them as an option as long as the company remains a start-up. 

Benefits Offered

1. An opportunity to share directly in the company’s success through stock holdings
2. Offers the potential for tax savings upon sale or disposal of the shares depending upon the nature of the ESOP plan.
3. A key tool to recruit the best and the brightest in an increasingly integrated global economy where there is worldwide competition for top talent.
4. Boosts employee job satisfaction and financial well-being by providing lucrative financial incentives.
5. Incentivizes employees to help the company grow and succeed because they can share in its success.
6. As a potential exit strategy for owners, in some instances

Types of ESOPs

There are two main types of ESOPs:

1. Incentive Stock Options (ISOPs): Also known as statutory or qualified options, these are generally only offered to key employees and top management. They receive preferential tax treatment in many cases, as the IT authorities treat such gains as long-term capital gains.

2. Non-qualified stock options (NSOPs): These can be granted to employees at all company levels, including the board members and consultants. 

Generally, stock options are often associated with start-ups which are issued to reward the early employees for their retention in the company and it is beneficial when it goes public. These ESOPs also serve as incentives for the employees to stay with the company as they can be canceled if the employee leaves the company before they vest. 

Some Important Concepts

ESOPs come with certain important concepts which are significant for everyone to know to understand the functioning of ESOPs.

Grant of options

The employer grants the options to the employees depending upon the eligibility criteria determined by the Board at its absolute discretion. The employee who wishes to accept the grant must deliver the documents duly completed and executed within the stipulated period from the date of the letter of offer of such ECOP scheme

Vesting period

There is a vesting period of ESOPs for an employee, during which an employee has to wait before claiming their rights for an ESOP. It is an incentive to perform well and remain with the company for a longer duration. The vesting period is determined by the Company in their ESOP Scheme and is shared with the employee as and when decided by the Company.

Vesting

ESOPs are considered vested when the employee is allowed to exercise the options and purchase the company’s stock. However, the stock may not be fully vested when purchased with an option in certain cases, despite exercising the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company.

The Vested options and the unvested options of the employee may be canceled at the absolute discretion of the company if the employee had been suspended from the service of the company, or to whom a show cause notice has been issued, or against whom an inquiry has been initiated because of misconduct, violation of company’s policies, code of the Company, or has been charged with commitment of any illegal or unlawful activity. Such canceled options may be made available for future employees.

If the employee has received the grant of the option, he or she must go through the documents thoroughly to determine the rights available and restrictions applied to employees. All the information regarding the ESOPs is captured in the ESOP plan of the company. The options agreement will provide the key details of the option grant such as the vesting schedule, how the ESOPs shall vest, shares represented by the grant, and the strike price. As a key employee or executive, he may be allowed to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or at a lower exercise price. 

Exercise Period

The exercise period is when the employees can exercise the option of buying the shares. The company will have the freedom to specify the lock-in period for the shares issued (if any) after the exercise of the option. The employees will not have the right to receive any dividend or to vote or enjoy the advantages of a shareholder in respect of the ESOP granted to them until the shares are issued on exercise of his option. The letter of offer mentions the number of shares to be offered under ESOPs, their price, and the beneficiary employees depending upon their eligibility. Whenever an employee leaves the company or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.

Eligibility of the persons to whom the ESOPs be issued

Rule 12(1) of Companies (Share Capital and Debentures) Rules, 2014 states that ESOPs can be issued to the following employees -

a) A permanent employee of the company who is working in India or outside India.

b) A Director of the company, including a whole-time or part-time director but not an independent director.

c) A permanent employee or director of a subsidiary company in India, outside India, a holding company, or an associate company.

Disclosures to be made while issuing ESOPs

An ESOP Scheme should contain information regarding the following:

a. The total number of stock options which is to be granted,

b. The identified class of employees who can participate in the ESOP,

c. Requirements of vesting period of ESOP,

d. Maximum period within which the options can be vested,

e. The exercise price and process of exercise,

f. The lock-in period, if any,

g. The grant of the maximum number of options for an employee,

h. The methods used by the company to value its options,

i. The conditions of lapsing of the options vested in employees,

j. A statement that the company will comply with the applicable accounting standards

Tax implications

The ESOPs are taxed indifferent manner for employees mainly in the following two instances:

1. At the time of exercising ESOP: It is considered as a Perquisite under the income head ‘Salary’. Hence, when an employee exercises his option, the difference between the Fair Market Value (FMV) as on the date of exercise and the exercise price is taxable as a perquisite.

2. At the time of selling ESOP: Considered a Capital Gain, it is imposed after the employee sells his/her shares after buying them, if he/she sells these options at a price higher than FMV on the exercise date, they would be liable for capital gains tax.

When an employee exercises the stock option, it is taxable income. The shares are credited to the Demat Account of an employee once shares are purchased.