Corporate Professionals has been in ESOP advisory for over 15 years and we have witnessed the popularity which the Employee Stocks Options and Employee Stock Plans has been gaining over the years. While Information technology companies started the trend of offering share options to employees in India, companies in several other sectors including Financial Services, Diversified Manufacturing, Health, Real Estate & Construction, Life Sciences, Retail
sectors followed suit with a view to creating entrepreneurial spirit and retaining and rewarding employees.
ESOPs have drawn a lot of attention of the employers who are curious to demystify the ESOP machinery to the core. As an ESOP consultant with extensive client interaction and while addressing industry participants in our webinars, we have observed some commonly asked queries related to key attributes of Employee Stock Plans. With a view to help our industry participants, we have compiled these questions with answers.
Frequently Asked Questions
Eligibility
1. ESOPs can be granted to Permanent Employees only. Who is a Permanent Employee?
The term Permanent Employee has not been explained in the enabling legal provisions of ESOP nor has it been defined under the Companies Act per se. Considering the practical aspects, in case of both Listed and Unlisted Companies, an employee who has satisfactorily completed the probation period can be considered to be a Permanent Employee.
2. Companies Act restricts promoters and directors holding more than 10% of capital of the company from participation in an Employee Stock Plan. Is there any relaxation for Startups?
A Startup Company, as recognized by the Department for Promotion of Industry and Internal Trade (DPIIT), is exempted from the restriction of participation in an Employee Stock Plan of the promoters (founders) and directors, holding more than 10% of the capital, for a period ten (10) years from the date of its incorporation or registration with the DPIIT.
3. Can a Private Company, that is not a recognized Startup, issue ESOPs to a person who is an employee and also a shareholder of the Company?
Yes. A Private Company can grant ESOPs to its permanent employee, who is also a shareholder of the Company Further, a Director cannot be made allotment of shares pursuant to ESOPs if he is holding (directly or indirectly along with his relatives) beyond 10% of the paid up capital of the Company.
4. Can ESOP scheme include future employees also?
Yes. The scheme can cover both existing and future employees of the company who join after the approval of the scheme.
5. Can a Company listed in India issue shares through ESOPS to an employee of step down subsidiary which is a foreign Company?
Yes. A Step down subsidiary is also a subsidiary to the extent permissible by law and an Indian Company can grant ESOPs to employees of its Subsidiary Company, in India or outside India.
6. Nowadays, people opt to work as full time professionals as against an employee contract. Are these people eligible for ESOP?
ESOPs can be granted only to permanent employees who are on the payroll of the company. Since a consultant a full time Professionals is not on the pay rolls of the company, they are not eligible for ESOPs.
Vesting Period
7. Is there any minimum vesting period under ESOP scheme for an unlisted Company? Can it be as slow as three months or has to be the same as the minimum period as per the regulatory framework?
The minimum vesting period of ESOPs granted under a scheme is minimum of one (1) year, whether Listed or Unlisted Company. In case of graded vesting, post one (1) year from grant date, vesting can be made systematically on a monthly/quarterly/semi- annual/annual basis.
Exercise Price
8. Can the Exercise Price of ESOP be less than face value?
No. The Company can set Exercise Price below the prevailing market price or at any such discounted price but it cannot be below the face value of the shares.
9. Can the exercise price be different for each employee for the same exercise date?
Yes. The grants may be made to each employee or class of employees at a different exercise price on a discretionary basis.
10. Is there a remedy if the employee does not have enough funds to exercise the vested stock options?
The Company can give loan to employees for exercising the vested stock options.
In case the company does not have sufficient cash reserves or for any other reason decides not to extend such loan, an arrangement of ESOP funding through various agencies can be made.
These agencies extend funds to employees to exercise the stocks and repayment of such ESOP funding is made by the employee to agency.
11. Can a Company give loan to directors and employees to subscribe to ESOP in accordance with the law?
A Company can extend loan to its employees to subscribe ESOP in accordance with Section 67 of the Companies Act, 2013. In accordance with Section 186 of the Companies Act 2013, a Company is prohibited from extending loan to its director or director of holding Company. However, Loans and advances made by the companies to their employees, other than the managing or whole-time directors, are not governed by the requirements of Section 186.Thus the company can freely extend loan to its employees to subscribe ESOPs.
12. Should the exercise price be pre-determined even for a private Company? If so, is there any method to arrive at the exercise price?
Yes, a Company, whether public or private, has to set the exercise price which has to be determined at the date of grant of the options. The Company can freely set exercise price which may be at a discount/premium at the prevailing market price at grant date.
13. Can two differential exercise price offered to employees be incorporated in one scheme?
Quantum
14. Is there any threshold on the quantum of ESOP and the number of employees for issue of ESOP?
There is no minimum or maximum threshold on the quantum of ESOP or the number of employees participating in ESOP. Also, the employees issued shares under ESOP are not counted in the maximum limit of shareholder (200) in case of Private Company in terms of the definition of Private Company under the Companies Act.
15. Can the total shareholding of a director, after allotment of shares under ESOPs, exceed 10% of the paid up capital of the Company?
A director shall not be eligible for ESOPs 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. Thus, a Director a can be granted ESOPs if his holding does not exceed this limit. However, it has to be ensured that his holding on allotment of shares pursuant to ESOPs, does not exceed10% of the paid up capital of the Company.
At present, certain eligible Startups have been extended relaxation regarding grant of ESOPs to its Promoters and Directors where under the Startup Company can make grants to Directors holding more than 10% of the capital of the Company.
Type of Shares
16. Can shares having Differential Voting Rights be issued as ESOP?
Yes. Any form of shares may be issued under ESOP which may be Preference Shares, Equity Shares or Shares with Differential Voting Rights.
17. Can we issue ESOP shares to employees without giving voting rights?
No. A share must always carry a voting right which may be same as the existing shareholders or differential.
Stock Appreciation Rights (SAR)
18. In the case of Stock Appreciation Rights, is it necessary to decide upfront, whether it will be cash settled or Equity settled?
The Company has to decide upfront whether the scheme will be Equity Settled or Cash Settled to ensure compliance with the various legal requirements. However, in an Equity settled scheme, provision of buyback of vested rights by the Company may be added to facilitate settlement of rights in cash instead of Equity if required.
19. What is the difference between SAR and Phantom Stock?
SAR stands for Stock Appreciation Rights which is a form of incentive or deferred compensation that is linked with the performance of the Company’s stock. Under SAR, a right to the monetary equivalent of the appreciation in the value of the shares of the company is given. The appreciation is measured on a specified number of shares over a specified period of time that is settled in the future either by way of Equity allotment or Cash as pre-determined by the company.
A SAR that’s settled in cash is popularly known as Phantom Stock. While SAR may be considered as Equity Settled Scheme, Phantom Stocks are settled in cash only.
20. Can SAR to be settled in Cash be exercised during shut down period?
Employees can get their SAR Vested during shut down period as they are considered to be in continuous service during such period and subsequently exercise the vested rights within the exercise period.
Sweat Equity Shares
21. What is difference between ESOP and Sweat Equity?
Under ESOP an employee has the right to exercise the Option to receive allotment of shares of the Company by paying exercise price upon vesting of an Option which cannot take place earlier than one year from the date of grant of the options. Under Sweat Equity the employee receives immediate allotment of shares without any vesting requirement.
While ESOP is a deferred form of compensation, Sweat Equity shares provide immediate entitlement of the benefit extended.
Restricted Stock Units (RSU)
22. What are the different forms of Restricted Stock Units (RSU)?
Based on vesting conditions RSUs can be broadly categorized as:
a) Loyalty Based
RSU’s are granted with an objective to retain an employee in an organization for a specific number of years.
b) Performance Based
RSU’s are granted with an objective to motivate an employee for achieving a pre-determined performance target. Here the performance targets can be linked with individual performance or organizational performance or combination of both.
23. Can all three types of share based plans i.e. RSU, ESPS and ESOP be implemented in the same scheme?
Yes, a comprehensive scheme can be drafted incorporating different plans, clearly specifying the number of shares attributable to each plan and providing specific provisions for each plan providing common administrative powers with a Compensation Committee.
Impact of Phantom Stocks on Financials
24. What is the impact of issuing phantom stocks on the financials of the company? How are phantom stocks recognized in books of accounts?
Phantom stocks create a financial liability which has to be settled in cash, resulting in impact on the profits and the cash flows of the Company. A provision of the same is recognized with the vesting of the units and such provision needs to be re-measured & revised each year till they are settled.
Trust Related
25. What is the objective of implementing ESOP Scheme through Trust?
A Company is restricted to buy its own shares; however, it may do so by extending finance to a Trust to acquire its shares for the benefit of the employees. Also in case of listed companies, it is mandatory to implement the scheme through Trust as per the applicable SEBI Regulations.
26. Apart from avoiding dilution, are there any other benefits in the Trust model?
Trust is a highly lucrative mechanism through which the Company can extend funding to the Trust to acquire shares of the Company in pursuance of its employee share based benefit scheme. The shares held by the Trust are transferred to the employee upon exercise of their vested rights.
Companies further use trust to create funding arrangement for exercise of options by employees, whereby the employee can pay the exercise price to the trust in installments and to also restrict transferability of shares during such period.
Trust provides another useful feature that is of cashless exercise of options by the employee and facilitating the sale of shares of the employees in both listed and unlisted companies.
27. Can a Company extend interest free loan to the EOSP Trust to acquire shares for the purpose of the Scheme?
Yes, a Company can freely extend loan without interest to the ESOP Trust to acquire shares for extending the share based benefit to employees who are beneficiary of the Trust in accordance with the scheme under Section 67 of the Companies Act, 2013.
28. Is In-Principle Approval from Stock Exchange required for acquisition of shares through Trust?
Where Shares are acquired from secondary market through Trust for transferring shares to employees pursuant to ESOP exercise there is no requirement of In-Principle approval as there is no fresh allotment of shares.
29. Can Company transfer shares to foreign employees using Trust Route?
Yes. The FEMA Regulations allow the issue of shares to foreign employees is in accordance with the SEBI Regulations which per se allow the Trust mechanism.
Price Unattractive
30. How a Company can compensate its employees, in case of the options become unattractive due to fall in market price of the shares?
The Company can re-price the Options, which are not exercised, whether or not they have been vested if the Schemes were rendered unattractive due to fall in the price of the Shares in the stock market. Any change in terms of options and such re-pricing must be in the interest of the grantees and approval of shareholders needs to be taken in this regard.
Corporate action
31. Bonus Issue involves allotment of additional shares to shareholders without payment of any subscription money. Pursuant to Bonus issue how will the adjustment be done, as the ESOPs exercise requires payment of exercise price?
Pursuant to Bonus Issue, the number and price of Options shall be adjusted in a manner such that total value of the options to the employees remains the same after the corporate action and the vesting period and the life of the options shall be left unaltered as far as possible to protect the rights of the employees who are granted options.
Compliance
32. Is MGT-14 required to be filed at the time of approval of scheme by Board of Directors?
Yes. MGT 14 is required to be filed both at the time of passing the Board Resolution and upon passing shareholders resolution.
33. Is it necessary to pass a board resolution when the Stock Option lapses or for cancelling the options?
The unvested options that lapse due to non-fulfillment of the vesting conditions, in accordance with the terms of grant, do not require passing of a Board Resolution.
Tax
34. What is the taxation of ESOP in India on an employee?
ESOPs in India are taxed in the hands of the employee at two instances. First, at the time of exercise as Perquisite that is the difference between the Fair Market Value of the Shares at that time and the exercise price paid for it. Secondly, the capital gain arising of the sale of shares received on exercise of the options is taxable as per the period of holding of the shares.
35. At what time does liability to deduct TDS arise on perquisite income arising from ESOP exercise?
The Company has a liability to deduct TDS from the salary of the employee earned during the month in which allotment/transfer of shares is made to the employee, at the applicable rate of tax on which TDS under the head salary is deducted.
36. ESOPs do not require any cash outlay; will such non-cash compensation cost allowed as tax deductible expenditure?
Yes. The ESOP Discount that is recognized as Compensation Cost by the Company is an ascertained expense and is tax deductible expenditure u/s 37 of the Income Tax Act, 1961. The meaning of the term expenditure u/s 37 does includes not only paying out but also incurring the expense and could also encompass loss, even though no amount is actually paid.
37. What is the timing and quantum of deduction of ESOP expense available under Income Tax?
The Liability towards ESOP expense is incurred during vesting period; hence it is deductible over the vesting period on straight line basis. However, the actual amount of ESOP cost is determined only at the time of exercise of Option; such options may also be unvested or unexercised or lapsed, accordingly a suitable upward or downward adjustment of cost in relation to actual fair market value of shares need to be made at such time.
Insider Trading Law
38. Which price is to be considered for seeing the requirement of 10 lakhs disclosure under SEBI (PIT) Regulations- Is it ‘the market price of the Equity share as on the date of exercise’ or ‘exercise price’?
The market price at the time of exercise is considered for making requisite disclosure of trade under the SEBI (PIT) Regulations.
Valuation & Accounting
39. What is the timing for seeking valuation- is it at grant or at exercise?
For the purpose of accounting, -valuation is required to determine the intrinsic value/ fair value (as the case may be) of the Stock Options at the date of grant of the options. So, the Company must seek a valuation on the grant date to record the cost of the stock options in its books of accounts.
Further, for the purpose of determining income and taxes in accordance with the requirement of the tax laws, an Unlisted Company needs to determine the fair market value of the shares at the time of exercise so it needs to seek a valuation of its shares on the exercise date. The price of shares of a Listed Company is known from the price quoted on the Stock Exchange, so the valuation of shares for taxation purpose is not required by it.
Thus, an Unlisted Company must get valuation both at the time of grant of the options and the exercise of the options. However, a Listed Company needs valuation only for accounting purpose at the time of grant of the options.
40. When does the compensation cost need to be booked for ESOP accounting- at grant date or vesting date?
The value of the Stock Options granted is a compensation cost of the employees that needs to be booked for ESOP accounting. Since this cost is incurred by the company over the vesting period, the estimated cost is measured on grant date and is booked systematically over the vesting period.
41. Whether valuation is also needed at the end of every financial year for the purpose of ESOP accounting?
In case of equity settled grant, the compensation cost is determined by measuring the value of stock options at the grant date which is recognized systematically over the vesting period. There is no requirement to re-measure and revise the value at the end of each financial year; hence, there is no need to get annual valuation done.
42. Whether valuation of ESOP needs to be done by a Merchant Banker or can it be done by a Registered Valuer or Chartered Accountant?
For the purpose of recognizing compensation cost in the books of Accounts, the valuation may be procured from a Registered Valuer or Chartered Accountant but for the purpose of Income Tax the valuation report of a Merchant Banker is required.