Employee Stock Option Plan (ESOP): Full Form and Working

What is Employee Stock Option Plan (ESOP) ?

As per section 2(37) of the Companies Act, 2013, An Employee Stock Option Plan (ESOP) allows employees, directors, and officers to own shares in the company they work for. It is a type of employee benefit scheme that enables the organisation’s employees to have shares of the same organization at a price below the market price, i.e., discounted price. Employee Stock Option Plans (ESOP) are awarded to the employee based on their tenure.

Employee Stock Option Plans (ESOP) help the company make its employees more committed to the organization. In this way, employees can feel a sense of belongingness towards the company and will be motivated to stay with the company for a longer period and further can take ownership of the company.

The thing that employees can take ownership of the company suggests that employees will be the shareholders of the company, so they will work towards the overall growth of the company in all aspects like financial stability, expansion, and modernization, more and better investment attraction and opportunities.

What is Vesting Period ?

Vesting Period can be defined as the minimum duration for which the employees have to wait to claim the benefits of ESOPs. (The vesting period of different companies can vary as per their rules.)

Benefits of Employee Stock Option Plan (ESOP)

A. Benefits of ESOPs to Employees

1. Motivation: It acts as a source of motivation for employees. ESOPs work as bait for employees that they will be the shareholders of the company and can avail all the benefits related to it. Participation in management, voting rights, dividend rights, etc., comes under the same.

2. Benefits of Share Prices: Employees get benefitted when there is a hike in the prices of the shares. It adds additional financial benefits to the employees besides costs to the company.

3. Ownership Interest: ESOPs provide ownership interest to the employees. Employees feel motivated and there develop a sense of belongingness in their minds when they see that they can be owners of the company they work for.

4. Retirement Saving Tool: ESOPs can serve as a source of retirement-saving tools for employees. Besides provident funds and other retirement benefits, ESOPs provide financial security to employees.

5. Tax Benefits: Some ESOPs provide tax benefits, allowing employees to have more financial incentives.

B. Benefits of ESOPs to Businesses

1. Attraction and Retention of Personnel: It helps the business to retain and attract motivated employees. Having experienced employees always play an essential role in the overall growth of the company.

2. Efficient and Effective Personnel: Employees having ESOPs are more efficient, effective, and productive because they feel connected to the organisation which in turn contributes to the overall growth of the business.

3. Tax Benefits: Some ESOPs may provide tax benefits to businesses too, which can help improve cash flows and reduce tax liabilities.

4. Financial Growth: ESOP companies tend to have better financial growth than non-ESOPs companies, potentially due to heightened employee motivation and engagement.

5. Succession Planning: ESOPs provide Succession Planning to businesses to ensure stability and continuity as shareholders tend to leave/retire/die.

How does an Employee Stock Option Plan (ESOP) work ?

The company first set up ESOP trust. In that trust, the company can either contribute to buying the existing shares from the current shareholders at the fair market price (not more than that) or buy the newly issued shares if the current shareholders do not want to sell their shares. If the company does not have enough cash to operate this procedure, the concerned trust takes the loans for the same and buys either the existing or/and newly issued shares and the company pays the trust to repay the loan.

Employees get shares according to their relative pay and employment period as and when they retire. The company must buy back the shares given to employees within a stipulated period at a fair market price. Thus employees receive the value of their shares in the form of cash.

Procedure for the Issue of ESOPs by Private Companies

ESOPs can be issued by all listed companies in compliance with the Companies Act, 2013 and the Companies Rules, 2014, and the other laws and rules applicable from time to time. A normalised procedure for issuing ESOPs is stated below:

1. To pass an ESOP in a shareholders’ meeting, one should first prepare a draft of the ESOP in accordance with the Companies Act, 2013 and the other laws and rules applicable from time to time.
2. Preparation and sending of required notice about the discussion of ESOP along with the draft to all the concerned directors at least 7 days before the meeting.
3. Pass the resolution for the issuance of shares through ESOP, determine the price of shares to be issued under the ESOP plan, and fix a time and date and approve for calling the general meeting to pass a special resolution for issuing ESOP.
4. Send the minutes of the meeting to the directors within 15 days of the meeting and file the MGT-14 form with the registrar of the company.
5. Send notice of the general meeting to all the directors, shareholders, and auditors of the company.
6. Pass the special resolution for the issuance of shares under the ESOP plan.
7. File the MGT-14 form with the registrar of companies within 30 days of passing the special resolution along with the necessary documents.
8. Send options to the employees, directors, and officers of the company for purchasing shares under ESOP.
9. Prepare a register of ESOPs in form SH-6 and enter the necessary details of the ESOPs granted to the employees, directors, or officers of the company.

Note: If a private company wants to issue the shares under ESOP plan, it must check that the Article of Association (AoA) allows the allotment of shares under ESOPs. If not, then first the company should hold a meeting to alter the AoA and then proceeds with the procedure stated above.

What are the Tax Implications of ESOPs ?

ESOPs are taxed under the following two circumstances:

1. At the time of exercising ESOP: When the employee has exercised the option, the difference between the fair market value (on exercise date) and the exercise price is taxed as perquisite under income from salary.
2. At the time of selling ESOP: The employee may choose to sell the shares once these are bought by him. If the employee sells these shares, another tax event happens. The difference between the sale price and fair market value (on the exercise date) is taxed as Capital Gains.

Governance of Employee Stock Option Plan (ESOP)

Employee Stock Option Plan (ESOP) is governed by many acts and regulations. Some of them are:

• Companies Act, 2013
• Company Rules, 2014
• Income-tax Act, 1961
• Security and Exchange Board of India (SEBI) regulations, 2014
• Issue of Capital and Disclosure Requirements (ICDR) regulations, 2009
• Foreign Exchange Management Act (FEMA), 1999
• International Financial Reporting Standards 2