Understanding Employee Stock Option Plan (ESOP):
Updated: Sep 5, 2019
The Employee Stock Option Plan (ESOP) or Employee Stock Option Scheme (ESOS) is the option or a right which is being offered by a Company to its employees to purchase its shares at a pre-determined price in the future. ESOP is not an obligation rather it is a right of the employee to purchase certain amount of share of the Company as pre decided price.
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ESOP is basically a tool used by a Company to retain its employees and get them awarded for being associated with the Company. As a part of an employee's compensation ESOP creates a sense of ownership in the mind of employees and their interest in the organization remains intact. ESOP plays vital role to attract employees at the growing stage of the Company.
As defined under the provisions of section 2(37) of the 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.
Persons Eligible for ESOPs:
Under the provisions of the Companies Act, 2013 read with the Companies (Share Capital and Debentures) Rules, 2014, following class of persons are not considered as employee to be eligible for ESOP:
An employee who is a promoter or a person belonging to the promoter group; orA director who either himself or through his relative or through any Body Corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the Company.
However, in order to promote startups, the Ministry of Corporate Affairs vide Notification3 dated 19.07.2016 issued the Companies (Share Capital and Debentures) Third Amendment Rules, 2016 wherein it was provided that Startups may issue the shares under ESOP to their promoters and directors who hold more than 10% for the first 5 years from the date of their incorporation. The restriction on issuing shares under ESOP to promoters and such directors continues for Companies which do not fall under the category of startups.
Objective of issuing ESOP:
The primary objective of issuing ESOP is to:
§ Provide incentive to retain and reward employees of the Company based on their contribution.
§ Motivate employees to contribute to the growth and profitability of the Company in future as well.
Important Terms and flow of actions:
a. OPTION: a right but not an obligation – to purchase the shares of the Company on the fulfillment of the conditions mentioned in the ESOP plan at the price decided at the time of grant of options.
b. GRANT: The eligibility of a particular employee (depending on the criteria set) for grant of stock options based on his role and performance is known as grant of option.
c. VESTING: Vesting has two components – Vesting percentage and vesting period. Vesting period is the period on the completion of which the said portion can be exercised. Vesting percentage refers to that portion of total options granted, which the employee will be eligible to exercise.
d. EXERCISE: The activity of converting the options granted to an employee into shares by paying the required exercise price is known as exercise of options.
e. The effective date of exercise is the date on which the Company allots the shares.
f. The companies have freedom to determine the exercise price in conformity with the applicable accounting policies, if any.
g. There shall be a minimum period of one year between the grant of options and vesting of option.
h. The Company shall have the freedom to specify the lock-in period for the shares issued.
ESOPs typically are issued by the Company directly or are done through the trust route. Each of the structures are explained below:
a. Direct Route
In case of direct route, the Company grants the option and at the time of exercise, fresh equity issuance is undertaken to allocate equity to the eligible employees. In case the employee decides to exercise the option, the employee also becomes the shareholder of the Company.
Direct route is preferred by unlisted companies. 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). Trust route brings in several complexities in the ESOP structures.
b. Trust Route
In the trust route structures, the Company creates a trust specifically for the purpose of running the ESOP schemes. Where the employees decide to exercise the option to acquire the shares, the trust would first acquire the shares from the secondary market and the transfer the shares in the name of the employees.
Under the trust route, the Company does not have to dilute its existing capital base and the structure is largely preferred by listed entities for secondary market acquisition of the shares.
Procedure for issuance of ESOP under Companies Act, 2013:
Once a Company has identified employees who shall be eligible to avail the benefits under ESOP schemes, the Company needs will carry out the following:
1. Prepare an ESOP Scheme
2. *Approval of the Scheme by Nomination and Remuneration Committee (where a Company has one) (*N.A. for Startups))
3. Convene a Board meeting to approve the scheme and decide time, date, venue for calling a Members’/ shareholders’ meeting.
4. Convene the shareholders meeting for approving the scheme
a. The notice to the shareholders meeting shall give out details with regard to the scheme. Some of these details are specified in Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 and include:
i. Total number of stock options to be granted;
ii. Identification of classes of employees who shall be eligible under the scheme
iii. Appraisal process for determining the eligibility of employees
iv. Details of vesting and vesting period
v. Determination of exercise price and the process of exercise
vi. Lock-in period
vii. Maximum number of options to be granted per eligible employee and in aggregate etc.
b. A separate shareholders‟ resolution is required where:
i. Grant of option to employees of subsidiary or holding Company
ii. 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
5. Grant letter of option to eligible employees.
6. Once the option is accepted by the eligible employees, execute the ESOP agreement with each eligible employee.
7. On expiry of vesting period, where an employee has exercised the option to acquire shares, allot shares.