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ESOPs: Frequently Asked Questions

Updated: Sep 4, 2022

Employee Stock Ownership Plans or ESOPs are a favoured option for startups to attract talent. Having a part of equity in the company one works for, makes one more committed to its growth. However, there are many queries one has around the issuance of ESOPs. We bring to you a list of common queries every unlisted private company has about the issuance of ESOPs.

1. Who is Eligible to Issue ESOPs?

The following can issue ESOPs-

  1. Any unlisted company by way of an ordinary resolution

  2. An unlisted company by way of a special resolution

  3. An unlisted company (following SEBI ESOP guidelines) can issue ESOP.

The ESOP has to be compulsorily approved by the shareholders of the concerned company by passing a special resolution accompanied with an explanatory statement.

2. Who is Eligible to Receive ESOPs?

  1. A permanent employee of the company who has been working in India or outside India; or

  2. A director of the company, whether a whole-time director or not but excluding an independent director; or

  3. An employee of a subsidiary, in India or outside India, or of a holding company of the company.

3. Who is not Eligible for ESOPs?

  1. An employee who is a promoter or a person belonging to the promoter group; or

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

  3. Exception: Startups may issue the shares under ESOP to their promoters and directors who hold more than 10% for the first 5 years from the date of their incorporation.

4. What is the Procedure to Issue ESOPs?

A company should undertake a detailed feasibility study, before rolling out an ESOP plan. Based on the study and keeping in mind the financial position of the company, the next steps under this process include –

  1. Draft an appropriate ESOP scheme based on stage of the company and propose the same in a shareholders’ meeting.

  2. Once approved, employees to be granted the stock options in a ‘Letter of Grant’. This will contain information about the options like several granted options, exercise period, vesting exercise period, etc.

  3. After the vesting period is over, the employees can translate this option to shares and thereby become the shareholders of the company. The vesting period is referred to as the period from the date of grant till the date on which such option becomes a vested option, i.e. when the option holder is eligible to exercise the option. Vesting can be based on duration, milestones or performance.

  4. The third and final stage is called exercise. Once an option becomes vested, which means relevant vesting period is over (or milestone is achieved), the employee has the right to exercise the option. The date on which the employee exercises his/her options is called exercise date. Upon exercise of the option by the employee, the company allots the shares to the eligible employee in accordance with the employee stock option scheme.

5. How are ESOPs taxed?

Employee stock ownership plans are taxable as perquisites, meaning thereby that employees are liable to pay tax when they exercise their options. Taxes are applicable in the following cases:

  1. While exercising (Company allots the Shares under ESOP)- The amount of difference between the exercise price and Fair Market Value (FMV) as on the date of exercise is taxable.

  2. While selling (Employee sale the Shares allotted to him under ESOP)- Capital Gains Tax is also applicable in case the employee sells his shares at a price higher than the FMV on the exercise date. The capital gain tax is applicable as per the period of holding i.e. STCG short-term capital gains) or LTCG (long-term capital gains).

6. What are the Compliance Requirements for ESOPs?

  1. Each year the Board of Directors should report about the ESOP plan in the Directors Report. The concerned company should maintain an ESOP Register and thus maintain all the information about ESOP that are granted to the employees.

  2. The company will host a board meeting to discuss the ESOP plan and a general meeting to adopt the scheme with an ordinary resolution. If the grant of options exceeds 1% of the company’s issued capital, a special resolution must be passed at the annual meeting.

  3. The rules governing ESOPs allows companies to amend its ESOP scheme at any time by passing a special resolution approving such amendment. However, the amendment must not be unfavourable to the existing ESOP holders.  

  4. In addition, there will be certain restrictions, such as minimum one-year between the grant of options and their vesting, and non-transferability of options granted. The granted options may not be pledged, mortgaged, or otherwise encumbered or alienated in any way.

ESOPs can be bought back by the company. When employers need to replenish the ESOP pool without diluting it further, employers they may choose to buy back the ESOPs at a price. The employee signs a letter agreeing to give up their vested ESOPs in exchange for a pay bonus equal to the current value of those shares. Any money received by employees as a result of these ESOPs sales forms part of their pay. As a result, it is taxed according to the current income tax rates.

If you have any queries regarding issuance of ESOPs or ESOP documentation, do reach out to us by clicking the button below.

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