March 27, 2023

ESOPs: Company Law Compliance

Employee stock option plan (ESOPs) is an old method of rewarding hardworking employees of the company by giving them shareholding in the company at a nominal rate. ESOP strives for employees to work hard for the enhancement of the value of the company so that the value of their own investment can enhance.

Now, ESOPs are extensively used by startups to retain their employees. Startups are short of funds and therefore they offer ESOPs to retain their higher management. However, the issuance of ESOPs by companies is subject to guidelines issued by SEBI, in the case of a listed company, and subject to provisions of the Companies Act, 2013, in the case of an unlisted company.

In this article, a detailed discussion is carried out about provisions of Companies Law on the ESOPs.

1. Definition

As per Section 2(37) of the Companies Act, 2013, “employees’ stock option” means the option given to the 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 predetermined price.
Under ESOP, existing shares are not offered to the employees. Rather, the company proposes to increase its subscribed share capital by issuing further shares to its employees at a predetermined rate.

2. Who is eligible for ESOPs

Provisions related to the issuance of ESOPs are given under the Companies (Share Capital and Debentures) Rules, 2014.
As per Rule 12(1) of Companies (Share Capital and Debentures) Rules, 2014, the following employees are eligible of Esops-
1. A permanent employee of the company, whether working in India or outside India.
2. A Director of the company, including a whole-time or part-time director but not an independent director.
3. A permanent employee or director of a subsidiary company in India or outside India, or a holding company.

However, the following employees are not eligible for ESOPs:
1. An employee who is a promoter of the company or who belongs to the promoter group.
2. A director who either himself or through anybody corporate or through his relative holds more than 10% of the outstanding equity shares of the company, whether directly or indirectly.
3. Independent Directors

However, exclusions given in clause © above shall not apply to startups, for a period of 10 years from the date of its incorporation or registration. Therefore, start-ups can issue ESOPs to promoters. A Start-up company means a private company incorporated under the Companies Act, 2013, and recognized as a “start-up” in accordance with the notification issued by the Department of Industrial Policy and Promotion.

3. What’s The Procedure to Issue ESOPs

Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of The Companies (Share Capital and Debentures) Rules, 2014 governs terms of issuance of ESOPs by a Company, other than a listed company.

An unlisted company is required to follow the below-mentioned procedure before issuing ESOPs:

Prepare a draft of the Employee Stock Option Scheme according to which shares are issued to employees under ESOP.
Make amendments in the Memorandum of Association (MOA) if authorized share capital is falling less for issuing shares under ESOP.
In the case of a Private company, issuance of ESOPs must be authorized by Articles of Association. Therefore, if AoA does not authorize the issuance of ESOPs then the Company is first required to amend AoA to obtain the necessary authorization.
Board Meeting:
1. Prepare notice for the board meeting along with the draft resolution to be passed in the board meeting.
2. Send the notice of the board meeting to all the directors.
3. Approve ESOP Scheme and determine the price of shares to be issued pursuant to ESOP.
4. Finalize the time and date for calling the Extraordinary general meeting to pass a special resolution for issuing ESOP.
5. Approve draft of notice to be issued to convey ESOP.
6. Authorize any person to send the notice of the Extra-Ordinary General Meeting to all the members of the company

Send the draft minutes of the board meeting to all the directors within 15 days of its conclusion and file the MGT-14 form with the Registrar of Companies for passing the board resolution.
Extra-Ordinary General Meeting:
1. Send notice of the EGM to all the directors, auditors, shareholders, and secretarial auditors of the company at least 21 days prior to the date of the meeting.
2. The explanatory statement to the Notice of EGM Shall contain the following information:
  - the total number of stock options to be granted;
  - identification of classes of employees entitled to participate in the Employees Stock Option Scheme;
  - the appraisal process for determining the eligibility of employees to the Employees Stock Option Scheme;
  - the requirements of vesting and the period of vesting;
  - the maximum period within which the options shall be vested;
  - the exercise price or the formula for arriving at the same;
  - the exercise period and process of exercise;
  - the Lock-in period, if any ;
  - the maximum number of options to be granted per employee and in the aggregate;
  - the method which the company shall use to value its options;
  - the conditions under which option vested in employees may lapse e.g. in case of termination of employment for misconduct;
  - the specified time period within which the employee shall exercise the vested options in the event of a proposed termination of employment or resignation of the employee; and
  - a statement to the effect that the company shall comply with the applicable accounting standards.
3. Pass the special resolution for the issuance of shares under the ESOP to the employees, directors, and officers of the company in the general meeting.

File the MGT-14 form with the Registrar of Companies within 30 days of passing the special resolution in the general meeting along with the documents.
Send options to the employees, directors, and officers of the company for purchasing shares under ESOP.

4 Terms and Conditions of issuance of ESOPs

As per Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014, An unlisted company shall not offer shares to its employees under a scheme of ESOPs unless it complies with the following requirements:

Grant Price:
1. The companies shall have the freedom to determine the exercise price in conformity with the applicable accounting policies, if any

Approval by Separate Resolution:

The company is required to obtain the approval of shareholders by way of separate resolutions in the following cases:

ESOPs are granted employees of a subsidiary or holding company; or
grant of an option to identified employees, during any one year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of the option.

Amendments in terms of ESOPs:

The company may vary the terms of the ESOP Scheme, which is not yet exercised by the employees, provided such variation is not prejudicial to the interests of the option holders. Such variation shall be approved by shareholders through Special Resolution.
The notice for passing a special resolution for variation of terms of the ESOP Scheme shall disclose:
1. full of the variation,
2. the rationale therefore, and
3. the details of the employees who are beneficiaries of such variation.

Vesting Period:
1. There shall be a minimum period of one year between the grant of options and the vesting of options:
2. However, where options are granted by a company under its ESOP Scheme in lieu of options held by the same person under an ESOP 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 required.
3. The company shall have the freedom to specify the lock-in period for the shares issued pursuant to the exercise of the option.

The Employees shall not have the right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to them, till shares are issued on exercise of the option.

The amount payable by employees for ESOP:
1. The amount, if any, payable by the employees, at the time of the grant of the option may be forfeited by the company if the option is not exercised by the employees within the exercise period; or
2. Further, such amount may be refunded if the options are not vested due to non-fulfillment of conditions relating to the vesting of option as per the Employees Stock Option Scheme.

Transfer of option to other employees or persons:
1. ESOPs offered to employees shall not be transferable to any other person.
2. The option granted to the employees shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner.
3. no person other than the employees to whom the option is granted shall be entitled to exercise the option.
4. However, in case of the death of the employee during employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.
5. 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.
6. 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 of the ESOP Scheme.

Disclosure in Board report:

The Board of directors shall disclose the following details about ESOPs in the Directors’ Report:

options granted, vested, and exercised;
the total number of shares arising as a result of the exercise of option;
options lapsed;
the exercise price;
variation of terms of options
total number of options in force;
employee wise details of options granted to;
- key managerial personnel;
- any other employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year.
- identified employees who were granted an option, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;

5 Register of ESOP

The company shall Maintain a ‘Register of Employee Stock Options in Form No.SH-6 and enter the particulars of the ESOP granted to the employees, directors, or officers of the company.
Such Register shall be maintained at the registered office of the company or such other place as the Board may decide.
The entries in the register shall be authenticated by the company secretary of the company or by any other person authorized by the Board for the purpose.

DISCLAIMER: The views expressed are strictly of the author and VJM & Associates LLP. The contents of this article are solely for informational purpose. It does not constitute professional advice or recommendation of firm. Neither the author nor firm and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any information in this article nor for any actions taken in reliance thereon.

Layering Restrictions on Formation of Multiple Subsidiaries

Accordingly, a holding company is allowed to have only up to two layers of subsidiaries excluding one layer of wholly-owned subsidiaries. Parallelly, the restriction on investment through not more than two layers of investment companies also applies.

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