Understanding Employee Stock Option Plans as a Form of Remuneration

Introduction:

An employee stock option plan is a type of incentive mechanism, used by organizations for their employees and directors. For startups that are not being able to pay the salary of an employee regularly, having an Employee Stock Option Plan (ESOP) is a good measure. At times, when companies find that several of their employees are performing well, they tend to offer ESOPs as bonuses for those employees as compensation.

An ESOP has been defined under Section 2(37) of the Companies Act, 2013 as ”Employees’ stock option means the option given to 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 pre-determined price”[1]. Furthermore, Section 62 acts as an enabling provision for a company to issue stocks to employees under the Employee Stock Option Plan provided that a special resolution needs to be passed by the company and subject to any other condition as prescribed by the Companies Act or the SEBI Regulations.[2]

In the ESOPs, rather than granting shares of stock directly, the organizations tend to offer derivative options on such stocks instead. However, ESOPs should not be confused with Employee Stock Purchase Plans (ESPP), which is a process wherein an employee reserves the right to purchase the company’s stock for a specified discounted price for a limited amount of time.

There are many benefits to granting ESOPs to employees. It is a way of keeping the employees motivated and ensuring that they are working with the utmost efficiency, thereby leading to the success of the organization. ESOPs also create a sense of belonging and ownership in an employee thereby further ensuring their long-term retainership and maximum effort.

Eligibility Criteria & Procedure to Grant ESOP

As mentioned earlier, organizations can grant ESOPs as per Section 62(1) (b) of the Companies Act, 2013. However, certain criteria need to be fulfilled before an organization can grant ESOPs, which are mentioned in the (Share Capital and Debenture) Rules, 2014.

Rule 12 of the (Share Capital and Debenture) Rules, 2014

As per this rule, ESOPs can be granted/issued only to the “employees” of a company. Clause (c) of Rule 12 defines the term “Employee”[3]. However, this definition shall not apply in the case of a Start-Up Company up to 5 years of the date of their registration.[4] One of the conditions mentioned under the said Rule is that in the case of Private Companies, ESOPs can only be granted if there has been a special resolution passed by the shareholders of the company in question. Wherein the Private Company concerned is listed, the ESOPs shall have to be issued considering compliance with the SEBI Regulations.

Once, the number of employees who are to be granted the ESOPs are identified, a company must comply with the following steps to successfully grant the ESOP:

1. The ESOP should be approved by the shareholders of the company.
2. A company is required to make certain disclosures prior to the issuance of ESOPs, which are mentioned hereinunder:
   1. The total amount of stocks to be granted.
   2. The classes of the employees that are to be subject to the grant of ESOPs.
   3. The procedure of appraisal for determining the eligibility of the employees.
   4. The requirement and period of vesting.
   5. The period within which the options should be exercised.
   6. The exercise price of the options.
   7. The process of exercising the options.
   8. The lock-in period in case any.
   9. The minimum and maximum number of stocks to be allotted to the employees.
   10. The conditions for lapse of ESOP, for instance, termination or misconduct of the employees.
3. The company can also make changes to the existing ESOP, provided that such changes are not made with bona fide intentions or hurt the interests of the employees already holding the options.
4. The company can forfeit the ESOP of an employee if such employee fails to exercise the ESOP within the given period.
5. The options granted to the Employees under the ESOP is not transferable to any other person.
6. In case of termination or resignation of an employee, all such options which were not granted to him shall be forfeited. The employee however can exercise those options which have already been issued to him.
7. The Employees do not have any right to claim dividends w.r.t to the options granted to them.

Other Compliances to be Followed

In addition to rule 12, there are other rules that the company must follow. For instance, the Board of Directors have to turn in an annual disclosure report wherein the following heads must be mentioned:

• Total number of options issued.
• Total number of options forfeited or lapsed.
• The exercise prices.
• Variation in the ESOP.
• Class of Employees to whom the options have been issued.
• The company shall maintain an Employee Register under Form SH.6 and shall mention all the given details in the form.

Taxation Policies Regarding ESOPs

The Income Tax Act has laid down two stages of taxation w.r.t to employees and the shares allotted to them under ESOP.

FIRST STAGE (PREREQUISITES): As soon as the shares are allotted to the employees. When the employee exercises his options before the vesting period, the employer will have to account for the prerequisite value of tax to be applied on the ESOP and shall deduct that amount. Such deduction of tax shall be accounted for via Form 16 and Form 12BA of the employee.

SECOND STAGE (CAPITAL GAINS): If the company is listed in the National Stock Exchange and the shares under ESOP has been held for more than 12 months, it will be considered as a long term capital gain and therefore will be taxed under Section 112A at 10% when it exceeds Rs. 1,00,000 at CG. However, if shares are held for less than 12 months, it shall be considered as a short-term capital gain and therefore shall be taxed under Section 111 of the Income Tax Act.

Conclusion

The main question that arises with this transaction is whether an employee should accept the options under the ESOP? The author here believes that “two heads are better than one”. Therefore, two heads of income are better, and the employees should consider taking up the options under the ESOP. It is also good for the employers as it helps in curbing the outward flow of cash and keeps the employees motivated and interested in working for that company.

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References:

[1] See, https://www.mca.gov.in/SearchableActs/Section2.htm. (Aug. 19, 2020, 4:34 PM)

[2] See, https://www.mca.gov.in/SearchableActs/Section62.htm. (Aug. 19, 2020, 4:39 PM)

[3]  See, https://www.sebi.gov.in/sebi_data/attachdocs/apr-2017/1492085873402.pdf. (Aug. 19 2020, 5:02 PM)

[4]See,http://www.dhc.co.in/uploadedfile/1/2/1/Companies%20(Share%20Capital%20and%20Debentures)%20Third%20Amendment%20Rules%202016.pdf. (Aug. 19, 2020, 5:04 PM)