Employee Stock Option Plan (ESOP) is one of the old methods of acknowledging the contributions of employees in the company by giving them certain ownership in the company. Traditionally, ESOPs were issued to the senior employees of the companies to acknowledge their contribution in building companies.
However, the concept of ESOPs is emerging again with startups. Apart from the in-hand salary, startups have found ESOPs as an attractive incentive to retain experienced employees in the company. ESOPs not only allow employers to sweeten the pot, especially if they can’t offer a very high compensation package right off the bat, but they also encourage a sense of ownership in the employee.
However, ESOPs can’t be issued on an Adhoc basis. In the case of unlisted companies, It needs to be issued in compliance with provisions of the Companies Act, 2013, and Companies (Share Capital and Debentures) Rules, 2014. Further, in the case of listed companies, it needs to be issued as per the Securities and Exchange Board of India (SEBI) Employee Stock Option Scheme Guidelines.
In this article, a detailed discussion is carried out about various aspects of ESOPs:
1. What is an Employee Stock Option Plan (ESOP)
- ESOP is a type of employee compensation plan in which equity of the company is offered to the employees. These shares are available to the employees at a discounted rate or at free of cost.
- This term is also defined under Section 2(37) of the Companies Act, 2013 which says employees’ stock option as a right granted to directors, employees, or officers of a company or its holding or subsidiary company to purchase or avail or subscribe for shares of the company at a predetermined price on a future date.
- Employees have to serve a minimum period of time, known as the vesting period, to become eligible for ESOPs. They can exercise this option after the expiry of the vesting period.
- This method attached employees to the company by giving them a share of the company’s net worth. This strives for employees to work harder toward enhancing the value of the company as it increases their own value of the investment.
Say ABC Pvt. Ltd. offers its employees the following ESOP-
- 100 shares @Rs.100
- Option/vesting period – 5 years
This implies, after serving employment of 5 years, employees shall have the option to buy 100 shares at Rs.100 each, irrespective of the market value of the company’s stock.
- Small businesses and startups allow a shorter vesting period.
2. Features of ESOP
- ESOPs are given free of cost or at a discounted price to the employees. Therefore, the value of ESOPs or values waived forms part of the employee’s CTC (Cost to company) structure.
- ESOP is a right, not an obligation. Therefore, employees are not mandatorily required to exercise this option. Further, This option can be exercised partially as well.
- ESOPs are offered to the employees as per the recruitment strategy of the company.
- The vesting date is the date when the vesting period expires, i.e., when the employee can exercise his ESOPs and convert it into shares of the company. On the other hand, the grant date is the date the ESOP is granted through a formal agreement between the employer and the employee.
- Further, ESOPs also be exercised in a phased manner, i.e. in installments over a specified period.
- The price at which ESOPs are offered to the employees is called the exercise price or grant price.
3. Benefit of ESOP
ESOPs have benefits for both employers as well as employees. The following are different benefits:
For employers, ESOPs can be a deal-breaker in talent acquisition. This way –
- ESOPs have the following twofold benefits for the company:
- retention, it helps in retaining the deserved employees in the company as ESOPs can be exercised after the vesting period and
- motivation, as it acts as a source of motivation for the employees to work toward enhancing the value of the company.
- Acquiring top talent: When funding is often short during a company’s early years, The Purpose of an ESOPs to bridge the gap in compensating employees. If employees believe in the company’s growth potential, they accept ESOPs as part of their compensation package to acquire shares of the company at lower rates. It helps in getting good talent at a low initial cost.
- Reduced cash outflow: ESOPs also help in preventing a significant cash outflow from the company. Therefore, this method is extensively used by new startups because of their constraint of limited funds.
For the employee, ESOPs has the following benefits:
- Valuable investment at a reasonable price: Employees are well informed about the condition of the company as they are an internal part of the company and they can make a wise decision about exercising options of ESOPs. Therefore, they can make valuable investments at Free of Cost or at a nominal price.
- Additional Income Source: By becoming shareholders, employees have a voice in the management of the company. They also get dividends on their stockholding which act as additional income.
- Job Stability: Due to the vesting period, employees also get job stability which, in turn, increases employee satisfaction.
4. Terms used in ESOPs
- Grant date: The day on which the employer and employee enter into an agreement that the employee will be given the option to own a share at a future date.
- Vesting Date: The day on which the vesting period expires, i.e., the date on which employees become entitled to the ESOPs of the Company which has appointed him/her on mutually agreed T&C.
- Vesting Period: The minimum duration that an employee is required to serve in a company to become eligible for ESOPs.
- Exercise Period: Period after vesting of shares, when an employee is eligible to buy the same shares
- Exercise Date: The day on which an employee exercises the option of ESOPs.
- Exercise Price: it is the price at which ESOPs are offered to the employees. The Exercise price is usually very less as compared to the current Fair Market Value (FMV) of the share.
5. Types of ESOPs Plan
- Employees Stock Option Schemes (ESOS): ESOS is a part of the salary structure of the employee and forms part of the CTC of the employee. ESOPs are offered to employees as compensation to work hard in the company for a specified period. Under ESOPs, all ancillary conditions like vesting period, terms, and conditions are pre-determined. Under this plan, employees can purchase stocks at a given price after the vesting period expires. This plan doesn’t obligate the employees to invest in the shares of the company.
- Employee Stock Purchase Plans (ESPP): ESPP also offers shares of the company at a discounted price but these shares are offered under the stock purchases program run by the company, These shares are available to every employee irrespective of their terms of employment. Generally, the Discount offered in this plan is far less than ESOPs.
In an ESPP, employees can choose to participate via payroll deduction to purchase company stock at a discounted price. Employees designate a percentage of income to be set aside and used to purchase company stock at a discount, at specified intervals.
- Restricted Stock Unit (RSU): RSU is an ESOP with the only difference of additional conditions. Under RSA, the employee does not become an owner of the stock until a specified condition, period-based or performance-based, is met and the stock is actually issued to him.
Usually, employees are granted RSUs in exchange for a particular amount of time spent working with the company or when certain performance milestones are achieved. However, since RSUs are not unlocked or cannot be liquidated until the stipulated conditions are met, an employee should not rely on them for financial support in case of an emergency.
- Stock Appreciation Rights (SARs): is technically not an ESOP plan, but we can use it as one of them. The company opts for this method when it does not want to dilute its shareholding and this benefit allows immediate cash benefits.
Under SARs, employees are offered value appreciation in the stock of the company over a period of time. This value appreciation is given to them in the form of cash. No shares are actually allotted to any employee. Therefore, it gives employees the benefit of increasing the value of shares without exposing them to any downside risk. SARs do not have the same tax advantage as other ESOPs. However, they are beneficial to employees who have a long-term view of their company and who want to enjoy increased profits when the company stock rises.
- Phantom Equity Plan (PEP): Under these plans, employees are allotted token shares of the company at a predetermined rate. The grant or exercise price is recorded in the company’s books but is not actually paid to the employee.
On the vesting date, the employee is paid the profit he would have earned if he exercised the shares. Thus, the employee does not actually get possession of shares but earns profit by the token purchase of shares at a discounted price.
6. Eligibility for ESOPs
Every employee is eligible for ESOP, except directors and promoters of the company holding more than 10% equity in the company. However, an employee must meet any of the following criteria.
- Full-time or part-time Director of the Company.
- Current employees of the Subsidiary, Associate, or Holding company located anywhere in India, or abroad.
- A permanent employee was working in the Indian or Foreign office of the company.
The existence of an ESOP plan in an organization is a great way to motivate the staff members and keep their interest in the overall success of the company.
Before deciding to set up an ESOP, a business should do a comprehensive analysis of its current situation. The goal of the research is to determine whether setting up an ESOP is appropriate for the company and its shareholders.
The tricky part is that ESOP is a customized solution that is not equally suitable for every business. Thus, before getting started, it is best to consult a professional well-versed about the potential of this model.
Click here to read about Company Law compliance for ESOP.
Click here to read about Income Tax implications on ESOPs.