ESOP: Employee Stock Option Plan - In Simpler Words

What are ESOP’s?

From being given to acknowledge and remunerate senior employees to using it as a consideration in the beginning to retain employees, since employers cannot afford to shed lakhs of money for remuneration, ESOP’s became essential for startups.

Employee Stock Option Plans are the plans in which employees get the right to purchase a number of shares in the company at a discounted price (less than the market price). Companies provide their employees with stock ownership at a discounted price. These shares are a part of employees remuneration for work performed.

Following terms are to be kept in mind for a better understanding of ESOP’s:

Grant of Options: It’s the issue of the right provided by the company to its employees to buy shares of the company.

Vesting: Vesting is earning the right to exercise the options.

Vesting Period: It’s the period that an employee has to wait to exercise his options.

Exercise Price: A price that is paid to convert the options into share.

Exercise Period: A period after the vesting period within which the employee has to exercise his/her options.

For example, ‘XYZ’ company employed ‘A’ with a yearly package of Rs. 20 Lakhs. It was decided that half of the salary will be in the form of ESOP. In such a case, A will wait for a certain time period (Vesting Period) before he can exercise his right to purchase those specifies number of shares.

How does ESOP work?

The company sets up a trust that accepts tax deductible contributions from the company to purchase company stock.

An ESOP scheme should be drafted. The shareholders must approve the scheme. After the scheme is approved, a Letter of Grant must be issued to the employee informing him about his options, what the vesting period would be and how the exercise price will be determined. The amount of stock issued to the employee may vary according to the pre decided rules.

The employees may cash out after the vesting period, which means, he has to continue to work for the company for a minimum number of years before any options can be exercised. If the employee dies, his/her beneficiaries receive the vested portion of the deceased ESOP account right away.

An ESOP employee who has at least ten years of participation in the ESOP, when reaches the age of 55 years, he or she must be given the option of diversifying his/her ESOP account up to 25 % of the value. This option continues up to the age of 60.

What is the difference between ESOP’s and Sweat Equity Shares?

People usually confuse Employee Stock Option Plans with Sweat Equity Shares. It should be kept in mind that both the concepts are very different from each other. Sweat Equity Shares, as per the Companies Act 2013, are those shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing know-how, or IPR, or value additions, by whatever name called while, an ESOP on the other hand is an option given to the employees to buy certain number of shares of the company at a pre-determined price.

Sweat Equity can be issued for consideration other than cash while ESOP has to be issued only in lieu of cash.

Advantages of ESOP’s to employers

If the company cannot afford to pay high salaries to employees, ESOP’s can be used to hire good talent.

ESOP’s give the feeling to the employees that their position is somewhat equal to that of the partners in a company and hence they are motivated to perform good which will automatically help in the growth of the company.

Disadvantages of ESOP’s to employers

When the ESOP’s are exercised, the shareholdings of the founders of the company gets diluted.

Advantages of ESOP’s to employees

There are chances for Employees to earn a really good amount if the company turns out to be a huge success in the future.

Disadvantages of ESOP’s to employees

Accepting ESOP is like buying a lottery ticket. There are chances of both winning and losing.

Thus ESOPs are a really good tool for startups to attract and retain talent, but at the same time it’s a bet for the employees. Employees should be convinced about the growth of company and should see if proper documentation is in place.

What all should be kept in mind before accepting ESOP’s?

Before accepting ESOP’s from a startup, you need to keep the following things in mind:

1. The first and the foremost thing you need to do is to evaluate whether startup has a scope to survive in this market for a considerable period or not. It is very important to know the growth potential of the startup before accepting ESOP’s from them.

2. ESOP’s are very different from shares. One cannot avail the option to buy shares, in ESOP’s, before the pre-decided vesting period. In case the employment ends before the vesting periods, ESOP’s are lost.

3. ESOP’s are considered as a part of an employee’s perks and taxed accordingly. As per the current tax laws, Income tax is payable on exercise stock options as follows: Taxable Value = Number of options exercised * [(Market price on exercise date) – (exercise price)].

4. The amount is taxed at the normal tax slab rates. The company shall recover this tax amount from you at the time you exercise options.

5. You need to be aware of all the chances before accepting ESOP’s. There are chances of cashing out before the company goes public. You need to make a wise decision.

6. You need to make a smart choice between the two options available: A good CTC or CTC plus ESOP’s. Both the options have their pros and cons.

7. You need to read the agreement terms thoroughly before signing and agreeing to them.

Example of an Employee Stock Option Plan

On 1st January, 2017 XYZ company employs Steve and offers him Rs. 10,00,000 and an option to acquire 10,000 shares of XYZ at Rs. 10 per share (market value of a share of XYZ at the time of grant).The options are subject to a four-year vesting period, which means that Steve has to stay employed with XYZ for four years before he gets the right to exercise his options. Under the Company Rules, there is one year cliff period, which means that vesting will not commence till 1st January, 2018. If Steve leaves XYZ or is fired before this period, he doesn’t get any of the options. After his options are vested, he has the option to buy the stock at Rs. 10 per share, even if the share value has gone up drastically. On 1st January, 2022, all of his option shares are vested if he has continued to work for XYZ. XYZ becomes successful and goes public. Its stock trades at Rs. 100 per share. Steve exercises his options and buys 10,000 shares for Rs. 1,00,000 (1000*Rs. 10). Steve turns around and sells all 10,000 shares for Rs. 10,00,000 (1000*Rs. 100), making a profit of Rs. 9,00,000.

FAQ’s on Employee Stock Option Plan

What happens after the death/ retirement of the employee before the Vesting period?

After the employee retires or leaves the company or dies before the vesting period is over, the shares are then either bought back by the company for redistribution or voided.

What happens after the death of the employee after the Vesting Period is over?

If the employee dies after the vesting period is over, his/her beneficiaries receive the vested portion of the deceased ESOP account.

Are all employees eligible for ESOP’s?

According to statutory provisions, following are not eligible for ESOP:

1. An employee who is a promoter or belongs to the promoter group.

2. A director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.

Apart from these, organizations can have their own eligibility criteria for the purpose of this plan.

Do you need experts to help you with your Employee Stock Option Plans?

There are a few corporate and legal compliances associated with ESOP’s. The laws that plan an important role while making or implementation of ESOP’s are:

Companies Act

SEBI (ESOP guidelines)

Income Tax Act

Accounting Guidelines (ICAI, IFRS, US GAAP)

Foreign Exchange Management Act

Apart from these legal compliances, an ESOP also requires different accounting procedures and different methods for allocating stocks and other investments among the employees than other types of plans. For this reason the plan should be designed by an ESOP specialist in order to avoid any difficulties.



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