A Brief Overview of Employee Stock Option Plan (ESOP) By CS Annu Sharma



 

In this write will be discussing about Employee Stock option plan (ESOP), how this impact an organization?, How It gives benefits to organization and employees and what are the regulatory requirements in case of Private Companies Mainly.

Employee Stock Option Plan (ESOP) is the option provided to employees to purchase the shares of the company at a future date at a pre-determined price. ESOPs give the employee a right to purchase the share, but not an obligation, to buy a certain amount of shares in the company at a predetermined price for a certain number of years. Therefore, if the shares of the company are valued at less than the option exercise price, then the employee need not excise the right to buy the shares of the company.

KEY POINTS

·         An employee stock ownership plan gives workers ownership interest in the company.

·         ESOP is usually formed to allow employees the opportunity to buy stock in a closely held company to facilitate succession planning.

·         ESOPs encourage employees to do what's best for shareholders since the employees themselves are shareholders and provide companies with tax benefits, thus incentivizing owners to offer them to employees.

·         Companies typically tie distributions from the plan to vesting.

 


COST OF IMPLEMENTATION OF ESOP TO COMPANY:

Apart from dilution in shareholding of promoters, the company should keep the following expenses in mind:

 
  • Fees payable to Registered valuer and the Merchant Banker for Valuation of shares
  • Fees payable to consultant for implementation  and supervision of ESOP.
  • Administration cost throughout it’s tenure

OPERATIVE ASPECTS OF ESOP (Employee Stock Option Plan)

  1. ESOPs have an exercise period – the predetermined period within which the option must be exercised   by the employee. There must be a minimum period of one year between the grant of option and vesting of option.

  2. Option granted to employees is not transferable to any other person.

  3. ESOPs have a Vesting Period and Vesting Percentage. Vesting period is the amount of time the employee needs to work with the company to be eligible for the ESOP.

  4. It can’t be offered to Promoters or Directors who directly or indirectly hold 10% shares in the company nor can be offered to non-employees.

  5. A typical lifecycle of ESOP can be depicted as under:

  6. Valuation shall be done (Fair value of shares) at the time of “grant of Option” and “exercise of option” by registered valuer as per “Guidance note on accounting for employee share-based payment” and pursuant to the Rule 40D of Income Tax Rules ,1962 which provides that FMV of ESOP shall be as determined by a merchant banker on the specified date Therefore, valuation is to be done every time when the options are granted and /or exercised. Valuation not older than six months will be considered valid.

  7. There is no ready market for shares of a Pvt Ltd Co. unlike listed companies. Marketability of such shares are generally discussed at the time of launch of the scheme and generally promoters come forward with assurances and commitment through scheme document. Employees would have following Exit options for disposal of shares:

  • IPO
  • To Strategic buyer / Investor, etc
  • Company buyback
  • Selling to an external buyer, subject to the Articles of Association

TAXATION IN THE HANDS OF EMPLOYEE CONCERNED:

Taxation takes place at 2 stages i.e. when the option is exercised and secondly when the shares are disposed:

While selling – in the form of capital gain. An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax.

REGULATORY REQUIREMENTS FOR A PVT LTD COMPANY FOR IMPLEMENTING ESOP

  1. Maximum Number of shareholders in   Private Limited Company    is allowed to be 200.  If this limit is breached by ESOP, the company has to be converted into a Public Limited Company.
  2. Articles of Association i.e. Charter of company should   have enabling provisions or allowing the ESOP.  If not, then amendment would be required by convening AGM/EGM.
  3. There has to be sufficient authorized capital to accommodate the ESOP allotments.  If not, then MOA and AOA need alterations.
  4. EGM (Extra Ordinary General Meeting) has to be conducted for ESOP Scheme approval by shareholders by way of a special resolution. Disclosures in the Explanatory Statement (Rule 12(2)) for passing the special resolution should cover following aspects:
  • Total number of stock options to be granted
  • Identification/ Appraisal process for determining the eligibility of employees;
  • Requirements of vesting and vesting period and the maximum period within which the option shall be vested;
  • Exercise Price/Pricing Formula/Exercise Period/Method of valuation;
  • Lock in period, if any;
  • Maximum no. of ESOPs to be granted per employee and in aggregate;
  1. Each year, the Board of Directors in the Directors Report must report the following details of the ESOP plan:
  • Options granted/vested/exercised/lapsed.
  • Total number of shares arising as a result of exercise of options;
  • Exercise Price;
  • Variation of terms of options;
  • Money realized by exercise of options;
  • Total no. of options in force
  • Employee wise details of options granted to:
  1. The company must maintain an ESOP Register (Form SH-6 (Rule 12(10),   giving information about the option granted to employees.

CONCLUDING NOTE:

Once the ESOPs are established, the company needs a proper administration including the third-party administration, trustee, valuation, legal costs. Company owners and the management must be aware of the ongoing costs. In case the cash flow which is dedicated to ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP scheme isn’t a good fit for such a company.

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