Understanding Employee Stock Option Plans (ESOP)

In the recent era, companies are adopting many employee-friendly policies in order to retain good employees who is up the ante when it comes to company performance and growth. From providing extended maternity leave and women-friendly policies to adopting flexi timings, corporate organizations are leaving no stone unturned to be the leaders and trendsetters in their field of work.

Startups have set a certain benchmark when it comes to providing employees with more than just a salary. One such policy that has caught the attention of all is ESOP or the Employee Stock Option Plans.

ESOPs were never as popular until a few years back. Traditionally, these stock options were awarded to senior employees by companies to acknowledge their loyalty and performance. However, in the era of startups, ESOPs are being used as candy to attract good talent at affordable salaries. They are a way of keeping employees focused on company performance and share price appreciation.

ESOPs are not as simple as they seem. Most employees who are given this option believe that they have unlocked a treasure chest! Let us highlight some basic concepts behind this scheme and dispel misnomers.

What are ESOPs?

An ESOP is a qualified, defined employee benefit plan that allows employees to purchase a specific number of shares in a company at a predetermined discounted price in lieu of salary. They are in strict compliance with the Companies (Capital and Debenture) Rules, 2014. There is a vesting period (a waiting period) before they can actually exercise their right to purchase the shares. If an employee leaves the organization during this lock-in period then the ESOPs get lapsed and the benefits stand null and void.

Who is entitled to ESOPs?

As per the Companies Rules, 2014, ESOPs can be given out to the following.

– A permanent employee working in or outside India

– A whole-time or part-time director of the company

– An employee of a subsidiary in India or abroad, holding a company or an associate firm A promoter or a director holding more than 10% of the share equity of a company will not be entitled to participate in this scheme.

The trend was in fact set by software firms like Infosys and Wipro who presented these options to even their clerical staff. There are known examples of even drivers, office assistants, and personal secretaries employed by these IT companies, who turned millionaires, thanks to this scheme.

A motivating sense of ownership:

Offering stocks of the company to employees instills a sense of pride and partnership in them. It keeps them motivated to give their best to the organization thereby building a better value for the company. The participants often push their limits as the growth of the company translates to their own.

Saving on cash:

  For startups, it is a good tool to maintain liquidity. In the early days, ESOPs were smartly presented by small companies to their employees as part of their compensation package to make the overall pay look more attractive without actually affecting the company’s cash reserves.

The tax deal:

How the Indian tax department looks at ESOPs has changed in the past two decades. When ESOPs are issued, the benefits arising out of the scheme are taxed as perquisites and form a part of the employee’s salary. The perquisite value is calculated as the difference between the market value of the stock and the exercise price (ie, the price at which the Company shares are purchased by the employee through the ESOP scheme).

If the employee sells these shares subsequently, then Capital Gains Tax is applicable on the proceeds of sale of stock options. The capital gain is calculated as the difference between the sale price and the price of issue of stocks. The tax applicable also depends on the period for which ESOPs are held. Gains arising out of stocks that are held for more than 12 months from the date of issue are exempted from Capital Gains Tax.

A word of caution Both as an employer and an employee, care must be taken while handling ESOPs. As a company, you have to do the following.

– First, create an ESOP pool and allocate the number of shares that you would like to give out as part of this scheme. Then draft an ESOP scheme, get it approved by the shareholders through an ordinary/special resolution, and file with the Registrar of Companies (ROC).

– While handing over this offer to an employee, a Letter of Grant must be issued in his name, clearly specifying the number of options being granted to him, the vesting period, and other terms and conditions. Remember, when employees exercise their option, the company’s share holding gets diluted.

As an employee, take care to of the following points.

– Ask your employer for a copy of the scheme while accepting the stock options.

– Present an Exercise Application to the employer in case you wish to exercise the option.

– Look for the vesting period clause carefully. There is also an exercise price that is to be paid to the employer in order to exercise the vested options.

The options will not be converted into equity in case you do not wish to pay a price. It is safer to look at ESOPs as an added bonus and not as a part of the salary component. Even though ESOPs are a great incentive for employees, the best rewards can be reaped as part of high growth companies or big multinationals.

VenturEasy can help you with issuing ESOP to your employees. Get in touch with us at ventureasy.com

Nikita Bhatia is the co-founder of VenturEasy, an online platform for Company registration, book-keeping, accounting, tax consultancy and legal compliances in India. A Chartered Accountant and company secretary by profession, she has wide experience in the fields of audit, accountancy, taxation and corporate governance.