ESOP- Way to reward and retain your employees.


We all have read about the acquisition of Indian retail giant Flipkart by US retail stalwart, Walmart for a whopping $16-billion. In that deal the employees of the Flipkart also struck a killing deal, when the Walmart decided to purchase of the shares of the employees of Flipkart by shelling out more than $800 Mn (Approximately Rs. 5670 Crore). That is the beauty of ESOP. In this article I am briefing about ESOP that can be implemented by Unlisted Companies.


Why ESOP?

In order to reduce the brain drain and to have a control over the employee attrition, many Companies are adopting novel and innovative practices. Compensating the employees by allotting them the shares of the company is the most prevalent practice among many companies to arrest the attrition rate and to boost the employee morale. By allotting the shares to employees an ownership feeling will be developed among them and it will help the companies to take them into confidence in many critical areas. Some employers use share-based payments as a part of remuneration package for their employees. Such payments generally take the forms of Employee Stock Option Plans (ESOPs), Employee Stock Purchase Plans (ESPPs) and stock appreciation rights. ESOPs are plans under which an enterprise grants options for a specified period to its employees to purchase its shares at a fixed or determinable price. ESPPs are plans under which the enterprise grants rights to its employees to purchase its shares at a stated price at the time of public issue or otherwise. Stock appreciation rights is a form of employee share-based payments whereby the employees become entitled to a future cash payment or shares based on the increase in the price of the shares from a specified level over a specified period. Apart from using share-based payments to compensate employees for their services, such payments are also used by an employer as an incentive to the employees to remain in its employment or to reward them for their efforts in improving its performance.


Employee Stock Option (ESOP) means a right of an employee to buy shares of a company at a price fixed on the date of the grant. At the same time it is not an obligation for an employee to purchase the shares granted to him.


ESOP works as a motivational tool to the employees and it can form part of the compensation package. It is an effective mechanism to attract and retain talented employees to an organization. It will enable the employees to create wealth by participating in the growth of the company.


An unlisted company can allot shares to its employees under a scheme of employees’ stock option (hereinafter referred to as "Employees Stock Option Scheme") subject to certain conditions.


Rationale behind ESOP.

As mentioned above, ESOP is the right given to the employee to purchase the shares of the company at a predetermined price on meeting certain conditions attached thereto. That means options can be converted into shares by the employees on meeting certain criteria. This criterion is called “Vesting Conditions or Vesting Criteria”. Vesting Criteria can be either continuation in the employment for a certain period or satisfaction of certain goals by the option holder. On attaining the said criteria, the options are said to be vested in the name of the option holder. There shall be a minimum period of one year between the grant of options and vesting of option.


ESOP- How it works

Once the option is vested as above, it gives the option holder an unfettered right to exercise the same and the shares shall be allotted to the employee. But if the employee is terminated for misconduct, then even his vested options may lapse. Exercise of an option is the process by which a vested option is converted into shares by payment of the exercise price. The exercise price is normally determined at the time the option is granted to the employee. In a case where options are granted by a company under its Employees Stock Option Scheme in lieu of options held by the same person under an Employees Stock Option Scheme in another company, which has merged or amalgamated with the first mentioned company, the period during which the options granted by the merging or amalgamating company were held by him shall be adjusted against the minimum vesting period.


Regulatory aspects pertaining to issuance of ESOPs

The provisions of law applicable for an ESOP issuance are listed below:

  1. Companies Act, 2013 and the allied rules

  2. Foreign Exchange Management Act (FEMA), 1999

  3. Income Tax Act, 1961

  4. Department of Public Enterprise (DPE) Guidelines (additional Guidelines for PSUs only)

  5. SEBI (Share Based Employee Benefit) Regulations, 2014 (In case of listed entities only)

  6. ICDR Regulations, 2009 (in case of listed companies only)


Type of Employee Share Based Payments [ESBP].

Some of the ESBPs have been explained briefly below:

  1. Employee Stock Option Plans (ESOPs) . ESOP is a contract that gives employees the right, but not obligation, to purchase or subscribe to a specified number of shares of the company at a fixed price, that is, the exercise price. The exercise price remains fixed even if the market price goes up in future.

  2. Employee Stock Purchase Plans (ESPPs) ESPP is a plan under which the company offers shares to its employees at a discounted price as part of public issue or otherwise.

  3. Stock Appreciation Rights (SARs) SARS are rights that entitle the employees to receive cash or shares for an amount equivalent to the excess of market price on exercise date over a stated price.


ESOP Structures.

There are two prevalence modes for implementation of ESOP. They are (1) Direct Route (2) Trust Route.

  1. Direct Route. In Direct route, the company grants the options to the employees and at the time of exercise fresh shares are being allotted to them, resulting to which the employee will become the shareholder of the company. Most of the unlisted companies prefers Direct route. The major issue in following that route is the availability of the limited options to the employees to monetize their investments. They have to either wait for a buy back or IPO to get an exit from the company.

  2. Trust Route. In this route a separate trust shall be registered, independent of the promoters and management of the company to acquire either through new issue or through the acquisition of shares from the secondary market. The company has an option to provide loan to the trust to enable it to acquire the funds from the secondary market. Section 67 of Companies Act, 2013 read with Rule 16 of the Companies (Share Capital and Debentures) Rules, 2014 allows the unlisted public companies to make provisions of money involving purchase or subscription of its own shares or shares of the company subject to compliance of certain conditions. This route is mainly followed by listed companies, which can purchase the shares from the secondary market.

Provision of Money by Company for Purchase of its Own Shares by Employees or by Trustees for the Benefit of Employees

The company can create provision of money for the purchase of , or subscription for, shares in the company or its holding company, if the purchase of, or the subscription for, the shares by trustees is for the shares to be held by or for the benefit of the employees of the company subject to the following

  1. the scheme of provision of money for purchase of or subscription for the shares as aforesaid is approved by the members by passing special resolution in a general meeting;

  2. such purchase of shares shall be made only through a recognized stock exchange in case the shares of the company are listed and not by way of private offers or arrangements;

  3. where shares of a company are not listed on a recognized stock exchange, the valuation at which shares are to be purchased shall be made by a registered valuer;

  4. the value of shares to be purchased or subscribed in the aggregate together with the money provided by the company shall not exceed five per cent. of the aggregate of paid up capital and free reserves of the company;


Privileges and exceptions to employees

The shares received on exercise of the option shall rank pari passu with the existing shares in the same class. The option holder is not entitled to either dividend or voting rights until he exercises his option and is allotted shares. The company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.


The amount, if any, payable by the employees, at the time of grant of option- (a) may be forfeited by the company if the option is not exercised by the employees within the exercise period; or (b) the amount may be refunded to the employees if the options are not vested due to non-fulfilment of conditions relating to vesting of option as per the Employees Stock Option Scheme.


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. No person other than the employees to whom the option is granted shall be entitled to exercise the option. 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.


Identifying the eligible employees and fixing the compensation package.

It is one of the most critical areas of the entire plan. The ESOP is designed to retain the best talents in an organisation. The employees can be identified based on many factors such as Seniority, Management Position, Criticality etc depending upon the nature of the business of the company.


Accounting Aspects.

An enterprise should recognise as an expense (except where service received qualifies to be included as a part of the cost of an asset) the services received in an equity-settled employee share-based payment plan when it receives the services, with a corresponding credit to an appropriate equity account, say, ‘Stock Options Outstanding Account’.


If the shares or stock options granted vest immediately, the employee is not required to complete a specified period of service before becoming unconditionally entitled to those instruments. In the absence of evidence to the contrary, the enterprise should presume that services rendered by the employee as consideration for the instruments have been received. In this case, on the grant date, the enterprise should recognise services received in full with a corresponding credit to the equity account

If the shares or stock options granted do not vest until the employee completes a specified period of service, the enterprise should presume that the services to be rendered by the employee as consideration for those instruments will be received in the future, during the vesting period. The enterprise should account for those services as they are rendered by the employee during the vesting period, on a time proportion basis, with a corresponding credit to the equity account.


A grant of shares or stock options to an employee is typically conditional on the employee remaining in the employment of the enterprise for a specified period of time. Thus, if an employee is granted stock options conditional upon completing three years’ service, then the enterprise should presume that the services to be rendered by the employee as consideration for the stock options will be received in the future, over that three-year vesting period.


There might be performance conditions that must be satisfied, such as the enterprise achieving a specified growth in profit or a specified increase in the share price of the enterprise. Thus, if an employee is granted stock options conditional upon the achievement of a performance condition and remaining in the employment of the enterprise until that performance condition is satisfied, and the length of the vesting period varies depending on when that performance condition is satisfied, the enterprise should presume that the services to be rendered by the employee as consideration for the stock options will be received in the future, over the expected vesting period. The enterprise should estimate the length of the expected vesting period at grant date, based on the most likely outcome of the performance condition. If the performance condition is a market condition, the estimate of the length of the expected vesting period should be consistent with the assumptions used in estimating the fair value of the options granted, and should not be subsequently revised. If the performance condition is not a market condition, the enterprise should revise its estimate of the length of the vesting period, if necessary, if subsequent information indicates that the length of the vesting period differs from previous estimates.


Typically, shares (under ESPPs) or stock options (under ESOPs) are granted to employees as part of their remuneration package, in addition to a cash salary and other employment benefits. Usually, it is not possible to measure directly the services received for particular components of the employee’s remuneration package. It might also not be possible to measure the fair value of the total remuneration package independently, without measuring directly the fair value of the shares or stock options granted. Furthermore, shares or stock options are sometimes granted as part of a bonus arrangement, rather than as a part of basic pay, e.g., as an incentive to the employees to remain in the employment of the enterprise or to reward them for their efforts in improving the performance of the enterprise. By granting shares or stock options, in addition to other remuneration, the enterprise is paying additional remuneration to obtain additional benefits. Estimating the fair value of those additional benefits is likely to be difficult. Because of the difficulty of measuring directly the fair value of the services received, the enterprise should measure the fair value of the employee services received by reference to the fair value of the shares or stock options granted.


Compliance under FEMA .

If the ESOP is being offered to directors, officers or employees of or joint venture or wholly owned overseas subsidiary/subsidiaries, then in addition to the compliance under the Companies Act, the compliance under FEMA also have to be carried out.


As per consolidated FDI Policy 2018 “Employees’ Stock Option” means the option given to the directors, officers or employees of a company or of its holding company or joint venture or wholly owned overseas subsidiary/subsidiaries, 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.


Issue of Employees Stock Option Scheme (ESOPs) / Sweat Equity

An Indian company may issue “employees’ stock option” and/or “sweat equity shares” to its employees/directors or employees/directors of its holding company or joint venture or wholly owned overseas subsidiary/subsidiaries who are resident outside India, provided that :

  1. The scheme has been drawn either in terms of regulations issued under the Securities Exchange Board of India Act, 1992 or the Companies (Share Capital and Debentures) Rules, 2014 notified by the Central Government under the Companies Act 2013, as the case may be.

  2. The “employee’s stock option”/ “sweat equity shares” issued to non-resident employees/directors under the applicable rules/regulations are in compliance with the sectoral cap applicable to the said company.

  3. Issue of “employee’s stock option”/ “sweat equity shares” by a company where foreign investment is under the approval route shall require prior approval of Government of India.

  4. Issue of “employee’s stock option”/ “sweat equity shares” under the applicable rules/regulations to an employee/director who is a citizen of Bangladesh/Pakistan shall require prior approval of the Government of India.

  5. The issuing company shall furnish to the Regional Office concerned of the Reserve Bank of India under whose jurisdiction the registered office of the company operates, within 30 days from the date of issue of employees’ stock option or sweat equity shares, a return as per the Form-ESOP

Explanation of the terms

  1. Vesting means the process by which the employee is given the right to apply for shares of the company against the options granted to him in pursuance of the employee stock option scheme.

  2. Vesting Period is the period between the grant date and the date on which all the specified vesting conditions of an employee share-based payment plan are to be satisfied.

  3. Vesting Conditions are the conditions that must be satisfied for the employee to become entitled to receive cash, or shares of the enterprise, pursuant to an employee share-based payment plan. Vesting conditions include service conditions, which require the employee to complete a specified period of service, and performance conditions, which require specified performance targets to be met

  4. Exercise means making of an application by the employee to the company for issue of shares against option vested in him in pursuance of the employee stock option scheme.

  5. Employee’’ means-

(a) a permanent employee of the company who has been working in India or outside India; or

(b) a director of the company, whether a whole time director or not but excluding an independent director; or

(c) an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company

but does not include-

(i) an employee who is a promoter or a person belonging to the promoter group; or

(ii) a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.


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