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Employee Stock Option Plans, or commonly referred to as ESOPs, were once assumed to be a simple corporate incentive. However, lately ESOPs have featured prominently across media: from the Enforcement Directorate issuing summons to Senior Advocates for providing legal advice over ESOP structuring, former Managing Director of BharatPe levying allegations regarding the unlawful grant of ESOPs to certain managerial-level individuals or scrutiny undertaken by Securities Exchange Board of India (“SEBI”) on Paytm for the alleged illegal grant of ESOPs, ESOPs seem to have attracted immense regulatory and public attention. Further, the recent announcement made by Flipkart regarding its intention to buyback ESOPs worth USD 50 million which ultimately benefits 7500 employees is also garnering a lot of attention. These legal issues, though unconnected, reflect one thing: that ESOPs are now high-stakes legal and strategic tools for corporates and that it makes it imperative to understand the underlying concept and the legal intricacies behind them.
ESOPs are structured initiatives designed for employees of a company to purchase the shares of the company at a discounted price from its market value. ESOPs were first coined back in the year 1956 by an Economist and Lawyer from San Francisco called Louis O. Kelso with a motive to transition the ownership of the company from the founders to their successors along with their employees. While many companies used to work on the concept of employee ownership company prior to 1956 as well, however, the term ESOPs was specifically coined by Kelso as he used a different tax-qualified stock bonus plan as a tool for business succession. ESOPs, in India, were first introduced by Wipro back in 1985, but the news only gained momentum and publicity when Infosys in 1990s used them to hire and retain talent which eventually resulted in many of such employees becoming millionaires.
In this article, we will breakdown everything that companies, employees, and legal practitioners need to know about ESOPs including their origin, purpose, relevance, impact on startups and international application.
What Are ESOPs?
Well, in the most basic sense, it is a tool used by companies to attract, retain and incentivise employees by giving them a right (option) to purchase the shares of the company at a later stage at a pre-determined price so that eventually they can also become owners of the company. It not only acts as a recognition towards the employee’s efforts but also creates a sense of belonging towards the company. It benefits the company in the sense that the company can lower their turnover rates and retain talented people who are crucial for business development.
Legal Framework Governing ESOPs in India
The Companies Act, 2013 (the “Act”) defines “employee stock option” as an option given to employees, officers, and directors of a company or of its holding company or subsidiary which will give them right to purchase the securities at a future date at a predetermined price. Under Section 62 of the Act, a company can issue ESOPs to the employees, prescribed under the rules, through a properly approved scheme. The Act must be read with the Companies (Share Capital and Debenture) Rules, 2014 (“SCDR”) when private limited companies issue ESOPs. It lays down the criteria for startups for issuing ESOPs and provides comprehensive explanation on who can be termed as an “employee” for issuance of ESOPs under Rule 12 of SCDR. It further lays down the requirements in relation to grant, vesting and exercise of the options.
Further, for listed companies, the governing law for ESOPs is the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. These regulations govern the companies which are listed on Indian stock exchanges and have an ESOP scheme.
Further, if any resident individual is willing to acquire securities through ESOPs from a foreign company, then the Foreign Exchange Management Act, 1999 (“FEMA”) read with Foreign Exchange Management (Overseas Investment) Rules, 2022 (“OI Rules”) and the Foreign Exchange Management (Overseas Investment) Regulations, 2022 and Master Directions on Liberalized Remittance Scheme (“LRS”) have to be taken into consideration. Such an issuance falls under capital account transaction and according to OI Rules, such shares or equity interests can only be acquired by way of ESOPs by Indian employees. ESOPs will form Overseas Portfolio Investment (“OPI”) only if it is 10% or less than the total equity capital of the company otherwise it will be termed as Overseas Direct Investment (“ODI”).
LRS permits an Indian employee remittances without RBI approval up to $250,000 per financial year. There exists no sub limit on the amount of remittance made, they are still reckoned towards LRS limit.
Under the FDI Policy, an Indian Company can issue ESOPs to foreign directors or employees of its holding, join venture and subsidiaries outside India but it must comply with the Indian regulations. It should further comply with the sectoral cap applicable on the company. Additionally, it will require prior government approval if the foreign investment is under the approval route.
Phases of ESOPs
An ESOP is not a one-step transaction, but rather is a structured journey conducted in phases which ranges from granting the option to its vesting and concludes at exercising. This phased journey ensures alignment with the long-term goals between the company and the employees. A detailed understanding of these phases is provided below:
Grant Phase: As a first step, the company identifies the employees who are eligible for stock options based on various criterion such as their expected contributions, tenure, skill set etc. Upon identification, the employees are granted the stock options upon executing grant letters/ stock option agreements. During this process, the employees are informed of the terms and conditions of ESOPs including the vesting schedule and the exercise price as may be determined by the company.
Vesting Phase: Granting of ESOPs does not directly give the right to the employee to purchase the shares of a company, and the employee must rather earn the right during a certain time period for undertaking the said purchase. Vesting is actually the cliff period during which the employee is required to stay employed with the company, fulfil targets basis certain milestones and earn the right to purchase the shares of the company. Once this period ends, the shares are said to be vested in the employee.
Exercise Phase: In this phase, the employees can exercise their right to purchase the vested shares at the pre-determined price and become the shareholders of the company. Unless the rights are exercised within the exercise period, the employee cannot be entitled to either derive the dividend or voting rights. Sometimes, companies also impose a lock-in period and/or share transfer restrictions once the options are exercised to restrict the sale of shares.
Routes of Implementation of ESOP Scheme
Generally, the two recognised routes for implementation of ESOP Scheme are:
Trust Route: An ESOP trust is created and incorporated under the Indian Trust Act. The trust is then granted a loan by the Company for the purpose of acquisition of shares through private placement. When an employee becomes eligible and wants to exercise his/her option, he/she can simply apply to the trust by paying the exercise price and the trust will then repay the loan to the Company. In this route, secondary transfer of shares happens from the trust to the employee and the requirement to file return of allotment is done away with. Hence, this is a widely used method of ESOP issuance.
Direct Route through virtual pool: Unlike the secondary transfer under the Trust route, here the Company directly issues the shares to the employees when they chose to exercise their option. Whenever an employee exercises his/her rights, Company is bound to allot fully paid-up shares and file a return of allotment. This method is usually used by small private companies.
Tax Implications on ESOPs: Dual Incidence
ESOP taxation arises at two key stages: First when the employee exercises their option and second when they eventually sell such shares. In both these stages, the tax implications are distinct under the Income Tax Act, 1961.
First Stage: At the time of exercise:
When employees decide to exercise the option to own the vested shares, they have to pay exercise price which is the pre-determined price of the share which is different from the fair market value of the shares. The difference between the exercise value and fair market value is liable to be taxed as a perquisite and taxation is done based on the tax slab of the employee under the head of “salaries.”
Second Stage: At the time of Sale:
Upon exercise of the ESOPs and allotment of shares to the eligible employees, they can sell their shares to any third party subject to the restrictions imposed under the shareholders agreement read with the charter documents of the company. In the event, the employee sells its shares to any third party, the difference between the selling price of the shares and the fair market value shall be liable to be taxed as the same shall be held as “capital gains.”
This tax treatment further depends on two factors:
- Whether the shares are listed or unlisted, and
- The holding period of the shares.
Listed Shares: If the shares are listed and are sold within 12 months of date of exercising the option, it falls under Short Term Capital Gains (“STCG”) and taxed at 15%. If held for more than 12 months and then sold, it will be called as Long-Term Capital Gains (“LTCG”) and if it exceeds Rs.1 Lakhs in a financial year then it will be taxed at 10% without any indexation benefit.
Unlisted Shares: If the shares are unlisted and are sold within 24 months from the date of exercising the option, it will be called as STCG and the same shall be taxed as per the slab rate of the employee and if held and sold after 24 months then it will be called at LTCG which will be taxed at 20% after indexation of cost.
Why Startups Swear by ESOPs
ESOPs are fairly popular among startups as they serve as an optimum incentivisation structure in relation to employee benefits considering that they have fixed resources and need to hire and retain employees for a long period without offering huge packages. Further, through ESOPs employees get ownership in the companies they are working in, which boosts their morale and encourages performance while fostering loyalty even when the salary package is modest.
Many startups are rapidly growing and have been on the path of continued progress by successfully implementing ESOPs. For example, Ola, an online cab booking company has issued ESOPs to more than 3,000 employees which is nearly 3 percent ownership of the company. Many of the employees have earned handsome benefits from selling their ESOPs. Zomato, a food delivery company has given ESOPs amounting to 6.5 % of the ownership which resulted in many early employees is making huge benefits worth millions of dollars.
Additionally, the government of India has also recognised the role played by startups in implementation of ESOPs and therefore, in furtherance to the same, the government of India has introduced targeted tax relief provisions under the Startup India Initiative. Startups that are not more than 10 years old, involved in the development or innovation of products or services, and have a turnover of INR100 crore or below annually, can be exempted from deferred taxation on ESOPs.
Conclusion
Considering its trajectory from being a means of business succession to becoming a defining pillar of India’s startup ecosystem, ESOPs have operated in deeply transformative ways to empower companies to attract, retain, and reward talent and have become an integral part of the growth stories of some of the most successful businesses on the planet.
But ESOPs now do not exist in a regulatory vacuum. They are now regulated by a multi-layered framework of legal and compliance obligations under the Companies Act, FEMA, SEBI regulations, and income tax enactments. Further, ESOP structuring is not merely a strategic human resource choice anymore but a vital legal imperative that needs careful design and careful implementation.
For startups, the dilemma shall be to find the appropriate balance, between legal compliance and empowering employees, between cost-efficient short-run and value-creating long-run, and between preserving capital and granting substantial ownership. Further, considering the transitioning trajectory of the regulatory landscape of India, the ESOPs are anticipated to be more comprehensive, formalized, and subject to stringent governance and therefore, it becomes imperative for both the employees and the employers to learn about the legal, financial and strategic intricacies of the ESOPs.
About the Author:
Shramona Sarkar, Senior Associate at Ahlawat & Associates.
Shramona is a qualified lawyer, having extensive years of experience in the field of ‘Corporate & Commercial’ and ‘Transactional Advisory’. Her broad practice areas in Ahlawat and Associates involve dealing in strategic and financial transactions related to ‘Private Equity’ and ‘M&A’. In addition to this, her expertise spans across several other legal domains, encompassing advisory services concerning labour and employment issues, as well as corporate and commercial law, and she has been closely working with a wide array of clients, both private and government entities, across sectors like sports & gaming, manufacturing, health technology companies, and education.
