Importance of ESOPs to Retain Employees

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Roma Priya, Burgeon Law Firm- Importance of ESOPs to Retain Employees

 

Burgeon Law is a law firm for founders, startups, emerging growth companies, incubators, accelerators, angel investors, family offices and venture capital/private equity funds.

 

Roma Priya is an entrepreneurial lawyer, mentor and startup enthusiast with over the last 8+ years of experience in the industry. With her distinctive perspective and strong market understanding she advises on complex legal issues ranging from business formation to exit including angel investment, venture capital/private equity financing, convertible-debt financing, acquisition, founder compensation, employment, stock option plan and contract negotiation among others. A mentor to entrepreneurs and high growth startups, Roma actively conducts workshops and mentorship programs in collaboration with various organizations and Govt. initiatives such as Invest India.

ESOPs are an incentive tool gaining popularity in India especially in companies that cannot offer high grade salaries to its employees and simultaneously want the employees to work with a sense of ownership in the Company. ESOPs help motivate the employees and encourage them to contribute to the growth and profitability of the Company.

ESOPs can benefit the company along with the employees as it has shown to improve organisational performance of a company to a great extent. Increased organisational performance typically leads to a higher share price and therefore a higher balance in employee ESOP accounts.  ESOP is in the form of Equity shares which implies that if an employee exercises his/her option, he/she will actually own part of the company and if the company does well the value of those shares will also rise.

 

What are Employee Stock Options?

 

ESOP is a type of employee benefit plan which gives the employee of a company the right to purchase a certain number of shares in the company at a predetermined price after the expiration of a predetermined period

Sec 2(37) of Companies Act, 2013 defines “employees stock option” which means, ‘the option given to the directors, officers or employees of the 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 pre-determined price.

 

 

Key Factors to be considered for the structuring of ESOPs 

Sec 2(37) of Companies Act, 2013 is to be read with Rule 12 of The Companies (Share Capital and Debentures) Rules, 2014 according to which, a Company, other than a listed company, shall not offer shares to its employees under a scheme of employees’ stock option, unless it complies with the certain requirements, namely:

1. Sanction by the Shareholders: The issue of the Employee Stock Option scheme needs to be approved by the shareholders of the company.

2. Employees to whom ESOPs may be issued: ESOPs may be issued to the following “Employees”:

  • A permanent employee of the company who has been working in India or outside India; or
  • A director of the company, whether a whole-time director or not but excluding an independent director; or
  • An employee as defined in clause (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-
  • An employee who is a promoter or a person belonging to the promoter group; or
  • A 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.
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3. Disclosures in the explanatory statement annexed to the notice for the passing of the resolution: The company shall make the following disclosures in the explanatory statement annexed to the notice for the passing of the resolution:

  • The total number of stock options to be granted;
  • Identification of classes of employees entitled to participate in the Employees Stock Option Scheme;
  • The appraisal process for determining the eligibility of employees to the Employees Stock Option Scheme;
  • The requirements of vesting and period of vesting;
  • The maximum period within which the options shall be vested;
  • The exercise price or the formula for arriving at the same;
  • The exercise period and process of exercise;
  • The Lock-in period, if any;
  • The maximum number of options to be granted per employee and in aggregate;
  • The method which the company shall use to value its options;
  • The conditions under which option vested in employees may lapse e.g. in case of termination of employment for misconduct;
  • The specified time period within which the employee shall exercise the vested options in the event of a proposed termination of employment or resignation of employee;
  • A statement to the effect that the company shall comply with the applicable accounting standards.

 

4. Pricing: The companies granting option to its employees pursuant to Employees Stock Option Scheme will have the freedom to determine the exercise price in conformity with the applicable accounting policies, if any.

5. Shareholders’ approval by way of separate resolution: The approval of shareholders by way of separate resolution shall be obtained by the company in case of:

  • grant of option to employees of subsidiary or holding company; or
  • grant of option to identified employees, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option.

6. Variation of terms of ESOPS: The company may vary the terms of Employees Stock Option Scheme not yet exercised by the employees provided such variation is not prejudicial to the interests of the option holders.

7. Minimum vesting period: There shall be a minimum period of one year between the grant of options and vesting of option.

8. Lock-in-period for shares issued on exercise of option: The company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.

9. Right to receive dividends: The Employees shall not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to them, till shares are issued on exercise of option.

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10. Forfeiture/ Refund of amount paid by employees under ESOP: The amount, if any, payable by the employees, at the time of grant of option-

    • May be forfeited by the company if the option is not exercised by the employees within the exercise period; or
    • The amount may be refunded to the employees if the options are not vested due to non-fulfillment of conditions relating to vesting of option as per the Employees Stock Option Scheme.

Options not transferable

 

    • The option granted to employees shall not be transferable to any other person.
    • The option granted to the employees shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner.

 

Who can exercise the option?

 

    • No person other than the employees to whom the option is granted shall be entitled to exercise the option. However, in the event of the death of employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.
    • In case the employee suffers a permanent incapacity while in employment, all the options granted to him as on the date of permanent incapacitation, shall vest in him on that day.
    • In the event of resignation or termination of employment, all options not vested in the employee as on that day shall expire. However, the employee can exercise the options granted to him which are vested within the period specified in this behalf, subject to the terms and conditions under the scheme granting such options as approved by the Board.

 

Disclosures in Board of Directors Report:

 

The Board of directors, shall, inter alia, disclose in the Directors’ Report for the year, the following details of the Employees Stock Option Scheme: (a) options granted; (b) options vested; (c) options exercised; (d) the total number of shares arising as a result of exercise of option; (e) options lapsed; (f) the exercise price; (g) variation of terms of options; (h) money realised by exercise of options; (i) total number of options in force; (j) employee wise details of options granted to: (1) key managerial personnel; (2) any other employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year, (3) identified employees who were granted option, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;

 

Register of Employees Stock Options

 

    • The company shall maintain a Register of Employee Stock Options in Form No. SH.6 and shall forthwith enter therein the particulars of option granted under clause (b) of sub-section (1) of Section 62.
    • The Register of Employee Stock Options shall be maintained at the registered office of the company or such other place as the Board may decide.
    • The entries in the register shall be authenticated by the company secretary of the company or by any other person authorised by the Board for the purpose.
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Benefits of ESOPs

 

  1. Offering meaningful stock options both attracts better, more talented employees and helps keep them for the long term.
  2. Granting stock options creates motivation and dedication for all employees involved as they are more invested in the company and the interests of the owners, investors and employees are all aligned.
  3. The flexibility of ESOP transactions allows owners to withdraw slowly over time or all at once, depending upon their needs.
  4. The private ESOP transaction does not require confidential information to be shared with prospective buyers which could have a significant adverse impact on the business.
  5. While other exit strategies can have a negative impact on company culture, the transition to employee ownership ensures the company culture remains intact or even strengthens, as the interests of owners, management, and employees are aligned
  6. The tax advantages:
      • No Tax implications on grant of options by the company.
      • No Tax implications on vesting of options in the employees.
      • When the employee exercises his option of buying the shares, the difference between the market value and exercise value is treated as perquisite and is taxable as per the tax bracket that the employee falls in.
      • When the employee sells the shares, the profit is treated as capital gains. If the shares are sold within one year, 15% capital gains tax has to be paid just like in the usual purchase and sale of shares. However, there is not tax implication if the shares are sold after 1 year.
      • If the capital gains are long-term, 10% tax has to be paid without indexation benefit or 20% tax has to be paid with indexation benefit.

 

Conclusion

 

While established companies use this option as a retention tool for their top assets/brains, startups use it as a tool to hire talent, as they cannot afford to pay salaries as high as large organizations.  ESOPs act as a great incentive for employees to put their heart and soul into an organization. However, it in very important to have an overall idea of the implications/ intricacies involved. Previously ESOPs were not considered part of compensation in many Indian organizations but the potential of wealth creation by incentivizing the employees with the ESOPs have started been considered by organizations of almost all sizes.

 

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