Employee Stock Option/Ownership Plans (ESOPs) have gained significant popularity in India as a means of incentivizing and retaining employees.  ESOPs are a form of compensation that grants employees the right to purchase shares of their employer’s company at a predetermined price. These plans offer a win-win situation, benefiting both employees and the company they work for.  ESOPs align the interests of employees with those of the company and its shareholders, fostering a sense of ownership and responsibility. Thus Employees with ESOPs are motivated to contribute to the company’s growth and profitability, as their financial well-being is directly linked to its success.  ESOPS are quite applauded among startups as they may have budget constraints in offering competitive salaries during their early stages. ESOPs enable these startups to attract and retain exceptionally skilled employees by compensating them with a relatively modest salary package, while the remainder of their compensation is tied to ESOPs. The Tax benefit it offers is also an additional advantage.

Regulatory Framework

ESOPs work in a well-defined legal framework and specific regulations.  ESOPs in India for Private Limited/ Startups are regulated by The Companies Act, 2013, Income Tax Act 1961, Foreign Exchange Regulations and also IFRS to Certain extent. Companies need to adhere to these regulations while implementing ESOPs to ensure transparency and fairness.

Key Terminologies

1. Employee Stock Option: According to Section 2(37) of 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;
2. Grant Date: An grant date refers to the date at which the Company/Startup officially allocates the stock options to an employee.
3. Vesting Period: Vesting period refers to the minimum period required for an employee to earn the right to exercise their stock options or gain ownership of company shares. Typically, there is a vesting schedule that outlines when these rights become available. Under a Law the minimum vesting period is 1 year.
4. Exercise Price: It is also known as the strike price. It is the predetermined price at which an employee can buy company shares when they exercise their stock options.
5. Exercise Period: The exercise period is the duration during which employees can exercise their stock options. This period typically may have specific start and end dates.
6. Exercise Date:  The date on which employees can exercise their stock options.
7. ESOP Policy: Prior to granting ESOP offers, any company should establish an ESOP Policy that details the terms and conditions related to ESOP shares. This policy covers aspects such as the exercise period, pricing, tax implications, provisions for employees who leave the company while holding ESOP offers, and procedures in case of termination. It’s important to note that the issuance of ESOP shares under this policy typically requires approval from the majority of shareholders, typically 51% or more.
8. ESOP Trust: The company may choose to establish an ESOP trust to hold company shares on behalf of its employees, with the employees being designated as beneficiaries of the trust. This approach is typically adopted when the company has a substantial workforce.

How do ESOPs work?

1. An Ordinary resolution seeking approval of shareholders about the issue of ESOP needs to be taken before implementation of the Policy. Detailed information need to be provided to shareholders about class of employees covered under the scheme,  Particulars of Employees, Relationship of trustee with directors and KMP, promoters of Company , benefits derived from said employees etc.,
2. The resolution must be acted upon within 12 months
3. Then the Board of Directors shall sign ESOP agreement with selected employees with a terms and conditions related to ESOP shares like number of shares offered, vesting schedule, Exercise price etc.,
4. Entity grants the ESOP with a vesting period. The minimum vesting period under Guidelines is one year. A longer or graded vesting period may also be provided.
5. After the vesting period, the company has the discretion to either impose or not impose a lock-in period for the equity shares
6. The Employee can exercise the option after the vesting period.  Employees are not obligated to exercise the option however companies are obligated to issue the shares if exercised.
7. Employees who have been granted ESOPs shall not possess the entitlement to receive dividends or exercise any voting rights
8. For those employees who exercise the option, the company credits the underlying shares with applicable rights on the shares
9. Every year the company must disclose the number of ESOP shares offered, exercised and lapsed details in their Annual Report. Necessary cost for ESOP issuance should be accounted for in the Books of Accounts.

Tax implications of ESOP

 When an employee exercises ESOPs, the company is required to get the shares valued  from a SEBI Registered Merchant Banker. The Fair Market Value (FMV) as per Valuation Certificate provided by the Merchant Banker needs to be considered. The difference between the amount of FMV and the exercise price is treated as ‘Perquisite’ which forms a part of employee’s  salary. The employee is obligated to pay income tax at the standard tax rate, while the employer is legally required to deduct taxes at the source. Shares cannot be credited to the employee’s account unless the employees have paid the required tax. Section 192 of the Income Tax Act, 1961 deals with the provisions related to the deduction of income tax at source by employers from the salaries of their employees and the subsequent payment of these taxes to the government.

However, employees working in startup  Companies get additional time lines to pay the taxes.  In the case of eligible startups i.e startup registered under Section 80-IAC of Income Tax Act, 1961, the section specifies that tax shall be deducted from any income considered as perquisites from ESOPs within 14 days of the occurrence of one of the following events, whichever comes first:

1. a) Upon the completion of 48 months from the conclusion of the assessment year in which securities were allocated under ESOPs.
2. b) Commencing from the date when the individual ceases to be an employee of the organisation.
3. c) Starting from the date of sale of securities that were granted under ESOP

Capital gain in case sale of ESOP shares:

Before delving into capital gains, it’s crucial to emphasise that ESOP shares cannot be sold or transferred unless they have been exercised and the requisite taxes have been settled. Having understood that,  let’s move on to Capital Gains. Capital gains occur when an employee sells his shares at a higher price than the exercise price. Capital gains are classified under two categories, Viz Short Term & Long term. If shares are sold within a 24-month period from exercise, they will be classified as a short-term capital gain and typically subject to taxation at a rate of 30% or as per the employee’s applicable tax bracket. If ESOP shares are sold after a 24-month period following exercise, they will be categorised as long-term capital gain, subject to a 20% tax rate.

It’s worth highlighting that if the exercise price and sale price are identical, there might not be any capital gain, and therefore, capital gain tax may not apply.

What key details should an employee be well-informed about before accepting ESOPs?

Employees should be aware about the ESOP policy, terms and conditions relating to vesting period, share valuation method, tax  implications, stamp duty on sale, anticipating any significant corporate event that might trigger the need to exercise the shares within the company,  Understand the consequences of obtaining shares upon leaving the company, the impact of resigning, and the duration of validity for ESOP offers.

What is the fate of ESOPs when the company shuts down?

When a business experiences a decline, the company’s value decreases, consequently affecting the value of ESOP shares. It’s worth emphasising that the value of these shares increases in tandem with the company’s success.

While ESOPs offer numerous advantages to startups, it’s important to note that they also come with administrative responsibilities and potential complexities, including valuation, legal compliance, and communication with employees. Startups should carefully plan and implement their ESOPs in consultation with legal and financial experts like BCL India the best chartered accountant in Bangalore to maximise the benefits while minimising potential challenges.