Employee Stock Options (ESOP) offered by a company to its employees entitle them to buy shares of the company at a future date and in a pre-determined manner. They provide an opportunity to the employees to acquire a stake in the company and are intended to create an ownership attitude and align their interests with those of the company. ESOPs confers a right and not an obligation on the employees to buy shares of the company at a future date at a predetermined price.
- What is a stock option?
One of the ways a company can reward its employees is by granting them stock options. A stock option is just that – an option, or a choice – to buy shares. The options give employees the opportunity to buy the company’s shares in the future at a price determined at the time of grant. If the share price goes up, employee’s options would be valuable. If the stock price goes down, then the employee simply might not use his/her option – there’s no risk to the employee.
- Can ESOPs be used for improving performance?
Yes, ESOPs help in creating a vibrant ownership culture across the entire organization. Ownership culture is one in which employees are encouraged to think and act like ‘owners’. It is expected that ESOPs will result in improvement of individual and group performance because of the alignment of goals of the employee and the organization.
- Why is an option valuable?
An option is valuable as it gives a right (with no obligation) to purchase the shares at a pre-set price. As a result of which, if the shares increase in value, the employee will be able to purchase the shares at the lower option price provided the options have vested. However, if the share price decreases after the option is granted and vested, the employee may choose not to exercise the options, and thus they are insulated from the risk of downward movement of the company’s share price.
- What is an “option” in ESOP?
An option in ESOP gives a choice – a right but not an obligation – to purchase the shares of the company on the fulfillment of all conditions mentioned in the ESOP Plan, at a price decided at the time of grant of options. The company is, however, under an obligation to issue shares in case the employee decides to exercise their right to purchase the shares underlying the options.
- What is a grant?
The Board/ Compensation/Remuneration Committee (‘Board’) decides the eligibility criteria based on the criticality of the employee’s role and performance. Depending on the criteria set by the Board, the individual’s eligibility options are arrived at and subsequently granted. This is known as a grant of options.
- What is vesting?
Vesting has two components – vesting percentage and vesting period. Vesting percentage refers to that portion of total options granted, which employee will be eligible to exercise. The vesting period is the period on the completion of which the said portion can be exercised.
The following table presents an example of an employee who is granted 1,000 options with the vesting schedule 33%:33%:34% vesting at the end of each year beginning from the date of grant.
|Vesting Details||1st Vesting||2nd Vesting||3rd Vesting|
|Date||July 31, 2021||July 31, 2022||July 31, 2023|
- What is exercise?
The activity of converting the options granted to an employee into shares by paying the required exercise price is known as the exercise of options.
- What is exercise price?
The exercise price is the price that employees have to pay to convert the options into shares e.g. if the options are granted at an exercise price of INR 11 and an employee wants to exercise 300 options then he has to pay INR 3,300 (300 options x INR 11).
- What is the exercise period?
This is the period within which an employee can decide to exercise his/her options. This period starts from the date of vesting.
- What is the effective date of the exercise?
The effective date of exercise is the date on which the employee exercises his/her options and this shall be considered as exercise date for all purposes including his/her individual taxation.
Often companies who have granted ESOP to their employees can prefer to allot the shares only in liquidity or exit events to avoid a situation where a large number of employees having a small portion of shareholding are part of the cap-table which creates unnecessary chaos in shareholding. However, the company also should keep in mind that the investors may feel wary if they are forced to buy a small number of shares from a large number of employees. This can be accordingly discussed with the investors.
- What is lapse of options?
Options lose their validity in certain circumstances i.e. expiry of the exercise period, separation, abandonment etc. These options then cannot be converted into shares and lose their value. Such options are said to have lapsed.
- If an individual has options, does that mean he owns shares?
No. The options are not actual shares, but a right to buy shares. They become shares only when an employee exercises that right.
- What are the general yardsticks for determining the grants?
For determining whom to grant and how much, factors like the past association, the role played by the employee, overall performance of the employee, the value created for the Company, and future potential of the employee are taken into consideration.
- What are the documents that the employee will get at the time of grant of options?
1. Grant letter
2. Notice of Option Grant
3. ESOP guide.
- How can an employee exercise his options?
If an employee wants to exercise options he/she would have to submit to the company a duly filled up exercise form along with the amount required for exercising the options by way of a cheque or draft or any other specified mode. He/she may contact the HR department for obtaining the exercise forms.
- Can an employee pay cash instead of the cheque to exercise the options?
No. The employee has to pay the amount by way of a cheque only or any other mode which may be decided in future by the Board.
- What are the risks associated with ESOP?
The employee stock option gives a right to get shares of the company, subject to compliance of the terms of the Plan. The employee will bear the normal market risk of a shareholder in terms of loss of value due to fluctuations in the market price of the shares once options are exercised. If he does not exercise the options, he does not face any risk, as no money is committed till the options are exercised.
- Are stock options transferable?
Options granted are NOT TRANSFERABLE to any person till they are exercised. Only the employee will be entitled to exercise options granted except in the case of death when nominees would be entitled to exercise options granted to the employee
An employee is not allowed to pledge, hypothecate, mortgage or otherwise alienate in any other manner the options granted.
- What will be the tax liability?
At the time of grant and vesting of options – No tax liability for the employees
At the time of exercise of options by the employee – The difference between the Fair Market Value (‘FMV’) on the date of exercise and exercise price (the price at which the options are granted to the employees by the company) is treated as ‘Perquisite’ in the hands of the employees and the company is required to deduct tax at source as per the applicable slab rate of the employee.
At the time of sale of shares by the employee – In case the shares are of an unlisted company, the difference between the sale price and FMV on the exercise date is taxed as capital gains and the same can be long-term capital gain or short-term capital gain depending upon the period of holding of shares by the employees. If the employees sell the shares after holding them for a period of more than 24 months, then they would be liable for a long-term capital gain tax. If the employees sell the shares after holding it for a period of less than 24 months, then they would be liable for a short-term capital gain tax.
- When can an employee sell the shares?
An employee can sell his shares on obtaining them after exercise of options as per the terms of the ESOP scheme and articles of association of the company.
- Does the Options holder have the same rights as that of a shareholder?
As Options holder, the employee does not have the right or status of a shareholder of the company. The employee will avail all rights pertaining to a shareholder only on exercising of options and becoming a registered holder of the shares of the company.
- What is preferred – Direct ESOP route or ESOP trust route?
Companies having an ESOP scheme or proposing to issue ESOPs in the future should prefer to set forth the agreed number of options to be granted to the employees of the company, in the form of an ESOP pool rather than creating an ESOP trust, which can be used for allotting shares to the employees on a timely basis. On the contrary, if ESOP trust is created, shares are required to be allotted to the trust immediately.
The ESOP pool in the cap-table will depict the number of shares and the % that it constitutes in the whole shareholding pattern on a fully diluted basis of a company that is reserved for granting under the ESOP scheme without any actual allotment of shares. Investors would want the company to create an ESOP pool prior to the investment so as to avoid any dilution impact to them on account of creation or increase of pool size after the investment is made.
- What is an eligible start-up?
Under the Start-up India Action Plan, start-ups that meet the definition as prescribed under G.S.R. notification 127 (E) are eligible to apply for recognition under the program. The Start-ups have to provide support documents, at the time of application. The following conditions must be fulfilled by the companies in order to be eligible as Start-up-
- The Start-up should be incorporated as a private limited company or registered as a partnership firm or a limited liability partnership
- Turnover should be less than INR 100 Crores in any of the previous financial years
- An entity shall be considered as a start-up up to 10 years from the date of its incorporation
- The Start-up should be working towards innovation/ improvement of existing products, services, and processes and should have the potential to generate employment/ create wealth. An entity formed by splitting up or reconstruction of an existing business shall not be considered a “Start-up”
- Can ESOPs be given to promoters/founders of start-ups?
The founders/promoters of the Department of Promotions of Industry and Internal Trade (DPIIT) recognized start-ups are eligible to receive ESOPs for up to 10 years from the date of incorporation.
For any ESOP related query or assistance in structuring, implementing or managing your ESOP plans, reach out to us at: [email protected]
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