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Employee Stock Option Plans (ESOPs)- An Overview

Prabhat Nigam

| Updated: Dec 04, 2021 | Category: Company Registration, Company Share Transfer

Employee Stock Option Plans (ESOPs)

In the saturated labour market, there is always a dearth for skilled men and hence the business organizations invest a lot of their resources in hiring, retaining and training them. But it is not always easy for those business organisations which do not have enough capital to run their operations and still want the services of highly skilled men. Therefore, these organisations in order to retain these skilled employees offer a handsome remuneration containing a good portion of equity in the business. This scheme of remuneration to pay the employees in the form of equity stake in the company is called Employee Stock Option Plans (ESOPs).

This article lists down the

  • Regulatory aspect of ESOPs,
  • Benefits that both the employees and employers receive because of ESOPs,
  • Taxation aspect of ESOPs.

What are ESOPs?

Employee Stock Option Plans [ESOPs] refers to a scheme of remuneration wherein the employees of the company are remunerated not in the form of money but in the form of equity stake in the company in order to make the interests of the owners align with the interests of the employees resulting in increased productivity and eventually overall success of company. ESOPs are given in order to incentivize the employees to remain with the company for longer periods by making the employees part owners of the company without forcing the company to part with the cash.

Regulatory aspect of ESOPs in India

Section 2(37) of the Companies Act, 2013 clearly defines “employees stock options” as the option given to the employees, directors of the company or its holding company or any of its subsidiary company or companies which gives the employees and directors, officers the benefit, right to purchase, subscribe for shares of the company at a future date at pre determined prices.

This provision of the Companies Act has to be read conjointly with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014[1].

Life Cycle of ESOPs

Stage I: Framing of the ESOP policy and Granting of letters by the company: At this stage the company begins with framing a scheme of ESOPs with granting of letters which means that the company decides as to which category of employees is eligible for the grant of shares based on their role and their performance.

Stage II: Vesting of Options: means the method by which the employee is given the right to apply for the shares of the company. Here the procedure is delineated regarding the procedure by which the grant holder can apply for the shares according to the scheme provided in the policy by the company. It can be based on the serving a duration of tenure with the company, performance based etc.

[Note: Stage I and Stage II combined represent the vesting period of ESOPs]

Stage III: Exercise of options: At this point the grant holder makes an application to the company for the purchase of shares he/she is eligible according to the ESOP policy. Here the company on receiving the application of the grant holder sells the shares to the grant holder after receiving the exercise price which was pre decided and not according to the fair market value. Usually, the exercise price is less than the Fair market value of the shares.

Stage IV: Sale of shares by the grant holder: Now the grant holder has the total rights over his share of the equity of the company and it depends on his/her wish to sell the shares or hold and receive dividends.

Benefits of Employee Stock Option Plans

  1. High Employee retention rate: It is the human resource that is the backbone of any business organization. These organizations invest a lot of resources in hiring employees and subsequently in training them. And once a skilled and valuable employee leaves the organization, it means not only a loss of skilled workforce but again the company has to shell out more resources in hiring a new employee and its training. Some industries such as IT, construction etc. has high attrition rates causing a huge loss to these organizations. In order to prevent the company from becoming a training ground for people to come, learn and move out, it was necessary that a certain scheme of remuneration be devised which lowered the high attrition rates and employees stick with the organization for longer periods. In response to this ESOPs were designed with the aim of increasing employment retention ratio. It is seen that organizations that grant ESOPs have higher rate of retaining employees compared to the organizations not extending ESOPs to their employees.
  2. Productivity and sense of belongingness with the organization increases: Giving equity stake in the company to the employees makes the employees feel being part of the organization. With ESOPs they have become part owners of the business and better performance of the business means better returns in the form of higher prices of their holding. The employees begin to realise that their performance in a way affects the overall success of the company and indirectly value of their holding in the company. This results in the aligning of interests of the employee with those of the company and keeping this in mind the employee works as if it is his/her company and tries to increase the productivity of the company. This becomes a bonus for the company where the not only employee does not want to leave the organization but also increases productivity.
  3. Better corporate practices: Granting ESOPs to the employees and making them part owners of the company comes across as part of good practices in corporate governance wherein employees behave in an ethical manner which is very important for the growth and success and overall environment of the company. When the employees feel that it is their own company and any unethical act on their part or on the part of the others may indirectly affect the value of their holdings, so they starting acting ethically and more responsibly. This ethical conduct of the employees results in less and less of malpractices and financial irregularities in the company and ultimately contributes to the overall growth of the company.
  4. Boon for cash strapped organizations or startups: ESOPs is a great tool for those business organizations that are cash strapped and do not wish to give away with the profits made by the company. Similar is the case with the startups who do not want to give too much money away during the initial stages of the business and those organizations in their phase to scale up their operations.
  5. Wealth creation for employees: It is a means for the employees to create long term wealth. The ESOPs vested in the employees have the potential to be exercised at a later point of time when the value of their shares must have gone up giving the employees huge returns. This way both the business organisation and the employee lands up in win-win situation where the company does not have to part with money. On the other hand employee also gets a piece in the profits of the company.

Taxation aspects of ESOPs

There are two scenarios for the levy of tax in case of ESOPs:

  • When the employee exercises the right to buy the equity shares: Since the equity shares provided come under the ambit of non-cash benefits given by the employer to the employees, so ESOPs are considered as perquisites which are taxable according to the tax slab of the assessee.

ESOP calculator at the time of exercise of shares (purchasing the shares as per the stock option agreement)

Date of exercise1st  January 2021
Exercise priceRs. 100/ share
Fair Market ValueRs. 200/ share
Taxable value of perquisite200-100= Rs. 100
No. Of shares exercised100
Total taxable value100 shares*  Rs. 100= 10,000
Tax Payable (Assuming tax slab of 30%)30% of Rs. 10,000=  Rs. 3000

However, in the case of employees of startups, tax implications have been relaxed by the government. Now the employees of startups are not supposed to pay the tax in the year they exercise buying of shares but shall be deferred to the following dates whichever is earlier:

  1. After five years of completion from the date ESOPs were granted.
  2. Selling date of ESOPs by the employee.
  3. The date on which employee leaves the company.
  • When the employee exercises the right to sell the shares:  When the employee decides to sell the shares, capital gains tax would be applicable on the taxable value in the following manner:
    1. The difference between selling price of the shares and Fair Market Value (FMV) at the time of exercising shares.
    2. If the capital gains earned exceed Rs. 1 lakh after selling the shares after a period of 12 months, then 10% capital gains tax will be imposed. However, if the capital gains earned after selling the shares within a period of 12 months then the tax payable would be 15% of the taxable amount.

Date of Exercise

1st January 2021

FMV on 1st January 2021

Rs. 200

Situation 1: shares sold on 1st July 2021

FMV on 1st July 2021

Rs. 300

Difference between FMVs

300-200= Rs. 100

Number of shares

1000

Total amount of Short term capital gains

1000 shares* Rs. 100= 100000

Short term capital gains tax payable

15% of 100000= 15000

Situation 2: Shares sold on 2nd January 2022

FMV on 2nd January 2022

Rs. 250

Difference between FMV on date of exercise and FMV on date of sale

Rs. 250-200= Rs. 50

Number of Shares

1000

Total amount of Long term capital gains tax

1000 shares* Rs.50= Rs. 50,000

Long term Capital gains tax

Nil (since the taxable amount is less than Rs. 1 lakh)

Conclusion

The scheme of ESOPs as remuneration for the services rendered by the employees, management and directors has resulted in the lower attrition rates in the workforce, better productivity in the business, wealth creation source for the employees and overall improvement and infusion of ethical business practices in the business organizations. Therefore it is advisable for the business organisations to adopt the scheme of ESOPs for the purpose of remuneration of their employees in order to realise the same results within their respective organizations. However, devising this scheme involves securing and managing the interests of a lot of shareholders. This requires careful planning and expert guidance and services of professional with years of experience in framing the scheme of ESOPs.

Read our article:Procedure to Issue Shares through ESOP (Employees Stock Option Plan)

Prabhat Nigam

Prabhat has done his BA LLB (Hons) and has been writing research papers since his law school days. His interest in content writing made him pursue a career in legal research and content writing. His core areas of interest are indirect taxes, finance and real estate.

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