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Introduction to Employee Stock Option Plan (ESOP)

The Employee Stock Option Plan (ESOP) is an employee benefit scheme that allows employees to acquire ownership in their company by purchasing shares at a discounted price. This scheme is designed to encourage employee participation in the company’s growth and align their interests with the organization’s long-term objectives.

In India, ESOPs are governed by the Companies Act, 2013, and Companies (Share Capital and Debenture) Rules, 2014 for unlisted companies, whereas listed companies must comply with SEBI (Share-Based Employee Benefits) Regulations, 2014.

Section 2(37) of the Companies Act, 2013 defines ESOPs as the option given to employees, officers, or directors of a company or its subsidiaries to purchase or subscribe to shares at a future date at a predetermined price.

This article provides a comprehensive guide on ESOPs, including eligibility criteria, issuance procedures, statutory requirements, taxation, and compliance under the Companies Act, 2013.

Key Terminologies in ESOPs

1. Grant

The grant refers to the formal issuance of ESOPs to eligible employees. It indicates that employees are eligible to receive ESOPs at a pre-determined exercise price.

2. Vesting

Vesting is the process by which employees gain the right to exercise their stock options. The minimum vesting period is one year between the grant date and the vesting date.

3. Exercising

Once the vesting period is complete, employees can choose to exercise their ESOPs and purchase shares. Until exercised, employees do not have shareholder rights such as voting or dividends.

4. Option Pool

Startups create an option pool, a reserved percentage of shares, to attract and retain employees with stock-based compensation.

5. Strike Price

This is the price at which employees can purchase company shares under the ESOP scheme.

6. Expiration Date

ESOPs have an expiration date, by which employees must exercise their options; otherwise, they will lapse.

Eligibility Criteria for ESOP Issuance

According to Rule 12(1) of the Companies (Share Capital and Debenture Rules), 2014, ESOPs can be issued to:

1. A permanent employee of the company (working in India or abroad).

2. A director (excluding independent directors).

3. A permanent employee or director of a subsidiary, associate, or holding company working in India or abroad.

Who Cannot Receive ESOPs?

1. Employees belonging to the promoter group or promoters of the company.

2. Directors holding more than 10% equity in the company, directly or indirectly.

Exceptions: Startups are exempted from these restrictions for 10 years from their incorporation date.

Process of Issuing ESOPs

The issuance of ESOPs is governed by Section 62(1)(b) of the Companies Act, 2013 and follows these steps:

1. Drafting of ESOP Scheme

A detailed ESOP scheme must be prepared in compliance with the Companies Act, 2013, and Companies (Share Capital and Debenture) Rules, 2014.

2. Board Meeting

1. A board meeting must be conducted with at least seven days' notice to all directors.

2. The board resolution approving the ESOP scheme must be passed.

3. A general meeting must be scheduled for shareholder approval.

3. Shareholder Approval

1. A special resolution must be passed in a general meeting.

2. The company must file MGT-14 with the Registrar of Companies (ROC) within 30 days.

4. Granting ESOPs to Employees

• Employees are notified about their ESOP grants, including vesting schedule, exercise price, and expiration date.

5. Vesting Period

1. The minimum vesting period is one year.

2. Employees must complete the vesting period before exercising their options.

6. Exercise of ESOPs

1. Employees pay the exercise price to purchase shares.

2. Shares are transferred, and employees become shareholders.

7. Maintaining ESOP Register

The company must maintain a Register of ESOPs (Form SH-6) containing details of issued ESOPs.

Statutory Requirements Under Companies Act, 2013

1. Section 2(37)

Defines ESOPs but does not cover Phantom Stock or Stock Appreciation Rights (SARs).

2. Section 62(1)(b)

Requires companies to pass a special resolution before issuing ESOPs.

3. Rule 12 of Companies (Share Capital and Debenture) Rules, 2014

Requires the special resolution to include:

• Number of ESOPs issued

• Eligibility criteria for employees

• Vesting schedule

• Lock-in period

• Methodology for valuation

• Conditions for lapse of ESOPs

SEBI Regulations for Listed Companies

Listed companies must comply with SEBI (Share-Based Employee Benefits) Regulations, 2014, which include:

• ESOP Trust Mechanism: Companies can transfer shares to a trust that manages ESOPs.

• Compensation Committee: A compensation committee must oversee ESOP implementation.

Disclosures in Board Report

The board report must disclose:

• Total number of ESOPs granted

• Eligible employee categories

• Vesting schedule and lock-in period

• Valuation methodology

• Lapse conditions

• Compliance with applicable accounting standards

Taxation of ESOPs in India

ESOP taxation occurs at two stages:

1. At the Time of Exercise

Employees are taxed on the difference between the fair market value (FMV) and exercise price as perquisite income under Section 17(2) of the Income Tax Act, 1961.

2. At the Time of Sale

When employees sell their ESOPs, capital gains tax applies:

• Short-term Capital Gains (STCG): If sold within 12 months, taxed at 15%.

• Long-term Capital Gains (LTCG): If sold after 12 months, taxed at 10% if gains exceed ₹1 lakh.

Administration & Governance of ESOPs

A trustee or ESOP committee ensures smooth administration, compliance, and record-keeping.

Conclusion

ESOPs are an excellent tool for companies to attract, retain, and incentivize employees. However, strict compliance with the Companies Act, 2013, and SEBI regulations is crucial. Understanding the eligibility, process, taxation, and statutory requirements can help employees and employers maximize benefits.

ESOP stands for Employee Stock Ownership Plan. An employee stock ownership plan gives workers ownership interest in the company. Employee Stock Ownership Plan is a benefit scheme for the employees. The company or organization gives the benefit to the employees of buying the shares after a certain period of time. An employee must provide service or work for a definite period of time before receiving the benefit of Employee Stock Ownership Plan. 

There are two types of Employee Stock Ownership Plan-:

Selective Plans 

The facility of owning some shares of the company is made available only to the senior executives. 

All Employee Plans

The facility of owning some shares of the company is made available to all the employees of the company 

Why do the Companies offer Employee Stock Ownership Plan? 

The companies offer stocks to the employees in order to attract and retain skilled and experienced talent. They offer stocks to the employees in a phased manner, which is a form of an incentive for the employees to work with the company for a longer duration. Many a times start-up companies or companies which cannot provide high salaries provide Stock Options to their employees. 

Tax Implications

The Employee Stock Ownership Plan has tax implications. It is very important to understand this before exercising the option. ESOPs are taxed at two different stages-:

While exercising – in the form of a perquisite

In this option the difference between the Fair Market Value and exercise price is taxed 

While selling – in the form of capital gain.  

The employee can sell the shares received however there is a certain amount of time period after which the employee can buy and then sell the shares. At the time of selling if the employee gets money higher than that of Fair Market Value then he will be liable to pay the Capital Gains Tax. The amount of Capital Gains Tax is determined on the period of holding, i.e. from the date of exercise to the date of sale. 

Benefits of Employee Stock Ownership Plan to the Employers

When the employees are rewarded with stocks, they would by default give in their 100 percent of hard work and efforts as they themselves will also benefit when the prices of their company’s shares soar up. Rewarding the hard work and dedication of the employee’s work is necessary, by giving them stock would also remove the necessity of providing cash incentives to the employees at the same time giving them incentives. 

Challenges of having an Employee Stock Ownership Plan for the Employers

Employee Stock Ownership Plan has complex rules and regulations. Companies which provide Stock Ownership benefit to the employees must have a proper administration system which works towards providing of Stock ownership to the employees. If a company does not have proper staff to look into the administration of Employee Stock Ownership Plan then it could invite certain risk issues. Upon establishing Employee Stock Ownership Plan the company must have proper administration, staff, including third party administration, legal costs, trustees. It must be aware of the costs that will include while providing this facility. 

Disadvantages of Employee Stock Ownership Plan for the Employees 

Many times under this scheme the employees invest a large part of their savings in one investment scheme, which is not advisable. Any person saving more than 10 percent of his/her salary is warned by the investors. Ideally, it is not logical to save a large amount of savings in the company’s stocks, as if at any point the company fairs poorly or runs into losses then a huge amount of savings of an employee will be lost. 

An ESOP plan is one of the best ways for a startup to attract and retain talent. In order for the company to grant ESOPs to its employees, it needs to be registered as a Private Limited Company.