[2021]

130 taxmann.com 88 (Article)

[2021] 130 taxmann.com 88 (Article)

Date of Publishing: September 6, 2021

Employee Stock Option Plan (ESOP) - the concept

and its benefits, issue procedures and other
related details

PROF R. BALAKRISHNAN
FCS, FICW

Employee Stock Option Plan (ESOP) –meaning

1. Employee stock option plan simply means a system by which a

companies could allow its employees to purchase the company's
shares. Some of the foreign holding companies also provide the
employees of an Indian subsidiary with such an option in certain cases.
Under the employee stock option plan, the employees are granted
options, which allows the employee to buy the stock at a rate below the
prevailing market price / value of the stock or the employee is provided
a certain percentage of his/her remuneration in stocks of the company.

Employee stock option plan is of a contractual nature which gives

employees the right, but not obligation, to purchase or subscribe to a
specified number of shares of the company at a fixed price, that is, the
exercise price. The exercise price remains fixed even if the market
price goes up in future.

Reason for providing ESOP by companies

2. Many of the startup companies are not in a position afford to provide
large compensation packages to its employees at the initial stage and
hence the startups prefers to offer employee stock option plan to its
employees. When the employee stock option plan is offered to the
employees, the employer gets the employee vested in the interests of
the company and provides the employee with a sense of ownership,
which in turn, motivates the employee to perform a task with an actual
vested interest in the company, being a part owner.

Some of the companies provide the employee stock option plan which
could be exercised on a future date in order to provide incentive for a
long term commitment from the employee to the company.

Benefits available to employer (company) by providing ESOPs

3. The following are the benefits for the company by providing

employee stock option plan to its employees.

1 Acquiring The owners of private companies could use the

the shares employee stock option plan to sell their shares.
of a Companies are allowed to make tax deductible
departing contributions to the employee stock option plan to
owner: buyout the shares or the company could use the
employee stock option plan to borrow money to buy the
shares.

2 Borrowing Cash borrowed under employee stock option plan is

money at used to buy company's shares and shares of existing
lower owners. Contributions to the employee stock option
after-tax plan are tax deductible as they are made to repay the
cost loan amount. Both principal and interest are tax
deductible.

3 Creates A company could issue treasury shares or new shares

an to an employee stock option plan and deduct the value
employee from the taxable income. Companies sometimes
benefit contribute cash to the employee stock option plan to
buy shares from existing public or private owners. In
public companies, employee stock option plans are
often used in conjunction with the employee savings
plan. Rather than matching the employee's savings
through cash, the employers can match the employee's
 savings through stocks from an employee stock option
plan, and usually the employers will match the savings
at a higher level through stocks
Governing regulations on ESOP

4. Sub-section (1)(b) of section 62 of the Companies Act, 2013 and Rule

12 of Companies (Share Capital and Debentures) Rules, 2014 ("Rules")
governs the issuance of ESOP. The procedure for issuance of ESOP
under the Rules is similar to that of the procedure under the Securities
and Exchange Board of India Employee Stock Option Scheme
Guidelines for listed companies.

4.1. The following chart shows at a glance the governing regulations

for ESOP for different types of companies.

S Type of Governing regulations

no company

1 Listed (i) Companies Act 2013 read with Companies

company (Share Capital and Debentures) Rules, 2014.
(ii) Income Tax Act 1961
(iii) SEBI (Share Based Employee Benefits)
Regulations, 2014
(iv) SEBI (Substantial Acquisition of Shears and
Takeovers) Regulations, 2011
(v) SEBI (Prohibition of Insider Trading)
Regulations, 2015
(vi) ICDR (Amendment) Regulations 2021

2 Unlisted (i) Companies Act 2013 read with Companies

company (Share Capital and Debentures) Rules, 2014
(ii) Income Tax Act 1961

3 Foreign (i) Companies Act 2013 read with Companies

company (Share Capital and Debentures) Rules, 2014
(ii) Income Tax Act 1961
(iii) Foreign Exchange Management Act, 1999

Accounting standards IndAS-102 would be applicable in case of

ESOPs in all the above cases
Mode of structuring the ESOPs

5. The companies could structure their employee stock option plans in

one of the following modes / methods.

1 Employee Stock Option Plan (ESOP)

2 Employee Stock Purchase Plan (ESPS)

3 Restricted Stock Units (RSU)

4 Stock Appreciation Rights (STR)

5.1 Employee Stock Option Plan (ESOP)

The Employee Stock Option Plan (ESOP) is an employee benefit plan. It

is issued by the company for its employees to encourage employee
ownership in the company. The shares of the companies are given to
the employees at discounted rates. Any company can issue ESOP. The
steps involved in this plan is, firstly (i) grant of options; followed by (ii)
vesting of options; then (iii) exercise of vested options and finally (iv)
the (iv) allotment of shares.

5.2 Employee Stock Purchase Plan (ESPS)

An employee stock purchase plan (ESPP) is a company-run program in

which participating employees can purchase company stock at a
discounted price. Employees contribute to the plan through payroll
deductions which build up between the offering date and the purchase
date. In this case, the company would announce the details of
enrolment for the scheme would be communicated upon determining
the eligibility conditions, during the enrolment period followed by
payroll process and then the purchase process involving (i) purchase
allocation; (ii) communication; (iii) purchase reports and finally (iv)
share movement.

5.3 Restricted Stock Units (RSUs)

Restricted stock or restricted securities, is nothing but a stock of a

company that is not fully transferable (from the stock-issuing company
to the person receiving the stock award) until certain conditions
(restrictions) have been met. Upon satisfaction of those conditions, the
stock is no longer restricted, and becomes transferable to the person
holding the award. In this plan also the steps involved are similar to the
one involved in the ESOP i.e. firstly (i) grant of options; followed by (ii)
vesting of options; then (iii) exercise of vested options and finally (iv)
the (iv) allotment of shares. Underlying condition arerequired to be
fulfilled after grant of option and before vesting of options.

The plan of restricted stock units are not much popular in India.

5.4 Stock Appreciation Rights (SARs)

Stock appreciation rights (SARs) are a type of employee compensation

linked to the company's stock price during a predetermined period.
Stock appreciation rights are profitable for employees when the
company's stock price rises, which makes them similar to employee
stock options. However, employees do not have to pay the exercise
price with stock appreciation rights. Instead, they receive the sum of
the increase in stock or cash.

For example, let us assume the share price is Rs.50 at the time of grant
– later upon vesting of shares, one exercises the option during which
time, the share price moves to Rs.90. ( share of Rs. 50 and increase of
Rs.40 thereby making it Rs.90). In this case, the employee received the
increase in stock or cash which is Rs. 40.

This plan is not implemented by many corporates, however, few

corporates have implemented this plan.

ESOP issues

6. Sub-section (37) of section 2 of the Companies Act, 2013 defines

employee's stock option as the option given to the directors, employees
or officers of the company or of its holding or subsidiary company, the
right to purchase or benefit or subscribe for the shares of the company
at a predetermined price on a future date

6.1 Eligible employees for ESOP

Rule 12(1)of Companies (Share Capital and Debentures) Rules, 2014

states that ESOP can be issued to the following employees.

(i) A permanent employee of the company who is working in

India or outside India
(ii) A Director of the company, including a whole-time or part-time
 director but not an independent director
(iii) A permanent employee or director of a subsidiary company in
India or outside India, or holding company, or an associate
6.1 Employees not eligible for ESOP

A company cannot issue ESOP to the following employees.

(a) An employee who is belonging to the promoter group or is a

promoter of the company.
(b) A director who either himself or through anybody corporate or
through his relative holds more than ten per cent of the
outstanding equity shares of the company, whether directly or
It may be notes that however, the above two conditions do not apply to
start-up companies for a period of ten years from the date of its
incorporation.

Pricing criteria

7. The companies are free to decide the ESOP exercise price and the
exercise price shall never go below the par value of the shares. ESOP
can be issued at discount or at a premium. Difference pricing also can
be done for different category of employees.

The base price is determined in case of unlisted public companies /

private companies based on the price calculated by the valuer on the
valuation done upon grant. In case of listed companies the base price
could be based on the market price, a day before the day of grant.

8.Valuation aspects

In any Stock Option Plan, the valuation aspects plays a very important
role. The value of stock options is needed upon grant, during interim
periods and at the final payment date to facilitate the calculation of the
benefit extended to the employees.

For ESOPs, there are two types of valuations as stated below:-

1 Accounting Accounting valuation is required to amortize the

valuation employee compensation cost during the vesting
period. Accordingly, the compensation value is
computed initially i.e. at the time of Grant and at the
 end of each reporting period till the liability in respect
of options granted gets settled. It can be performed by
any valuer.

2 Perquisite The perquisite valuation would be conducted only in

valuation case of unlisted companies, at the time of exercise of
options by the employee to know the value of the
perquisite to be added in the employee's salary for the
month in which he makes the exercise of the option. It
is performed by Merchant Banker.
Routes under ESOP issue

9.ESOPs could be issued by the company either directly or through the

trust route. The issue of ESOP under direct route and trust route both
are explained below:

Direct route

9.1 Whenever, the company issues ESOP under direct route, the
company grants the option and at the time of exercise, fresh equity
issuance is undertaken to allocate equity to the eligible employees. In
case the employee decides to exercise the option, the employee also
becomes the shareholder of the company.

Unlisted companies prefer to issue ESOP under the direct route. The
only issue with direct route structures is as and when the employee
intends to monetize the shares, the company may have to buy-back the
shares, specifically so in case of private limited companies or wait for
the company to go for a public offering to get an exit from the company
(as a shareholder).

Trust Route

9.2 In the trust route structures, the company creates a trust

specifically for the purpose of running the ESOP schemes. ESOP Trust
which is a private trust formed as a separate entity, but not being a
charitable trust under the Indian Trust Act 1882.Under the trust route,
the company does not have to dilute its existing capital base and the
structure is largely preferred by listed entities for secondary market
acquisition of the shares.

Whenever the employees decide to exercise the option to acquire the

shares, the trust would first acquire the shares from the secondary
market and the transfer the shares in the name of the employees.

The trusts are funded by the company to acquire the shares in the
secondary market to be transferred to the employees upon exercise of
the options. In essence, the company is indirectly funding the
acquisition of the shares of the company for the employees. The
Companies Act, 2013 facilitates the company to on-lend to the trust for
it to acquire shares from the secondary market to be allocated to the
employee shareholders.

When employees leave the company

9.3 Whenever the employees leave the company, the employees have
the option of selling back the shares to the trust or in the secondary
market and monetizing the wealth creation by way of subscribing to the
shares. The exit route is far easier in case of trust mechanism than in
case of direct route structures.

Trustees

9.4 In case of ESOP trust route, the company can have the trustees
selected internally or trustees selected externally. A trustee is the
person or institution that normally has the formal responsibility to
make sure the ESOP plan is operated for "the exclusive benefit of ESOP
plan participants."

The law prohibits the following people from being trustees in the
company:

1. The directors, KMPs and their relatives of the company, its

holding, subsidiary association company;
2. Any person beneficially holding more than 10% of the paid-up
share capital of the company.
Secretarial checklist for the issue of ESOP

10. The following is the checklist for the procedure and process of
issue of employee stock option plan.

S. Particulars Action Remarks

No required
A. Issue of Notice for Committee / Board Meeting
1 Issue of notice calling for Nomination Remuneration Committee
/ Compensation Committee board meeting

Issue of notice calling for Issue of notice As per Secretarial

Board Meeting in 7 days in standard -1
advance

In case of Listed At least two SEBI (LODR)

companies:- working days Regulations&
before the SEBI ESOP
Intimation to the Stock notice guidelines
Exchange(s) where
securities of the Company
are listed

B. Committee / Board Meeting

2 Approval of the draft

employee stocks option plan
by the Nomination and Draft scheme
Remuneration / approval by
Compensation Committee committee

2(a) At the Board meeting

Approval of ESOP plan

Approval of Notice calling

for General meeting in order
to pass special resolution of
approval of members for the Approval to be
ESOP plan given at the
Appointment of Merchant board meeting
Banker

Appointment of Scrutinizer

Appointment of Agency for

e-voting

C. Action arising out of the Board Meeting

3 Intimation of the outcome of Within 30 SEBI (LODR)

 the Board Meeting to Stock minutes Regulations &
Exchange (s) SEBI ESOP
guidelines

4 Notice of the General 21 days' notice

Meeting to the shareholders

5 Notice of the General Simultaneously SEBI (LODR)

Meeting to the Stock when notice Regulations &
Exchange(s) by the listed sent to SEBI ESOP
companies shareholders guidelines

6 Updation of notice of Upon issue of SEBI (LODR)

general meeting at the notice Regulations &
website of the company SEBI ESOP
guidelines

D. General Meeting

Issue of notice calling for general meeting with explanatory statement

containing the following disclosures:-
The total number of stock
options which is to be The lock-in period, if any,
granted,

The identified class of

The grant of the maximum number
employees who can
of options for an employee
participate in the ESOP
Requirements of vesting The methods used by the company
period of ESOP to value its options
Maximum period within
The conditions of lapsing of the
which the options can be
options vested in employees
vested
A statement that the company will
The exercise price and
comply with the applicable
process of exercise
accounting standards.

7 Approval of ESOP scheme By special Companies Act &

resolution by SEBI ESOP
members guidelines
 Approval of Scrutinizers Approval
report

8 Submission of Scrutinizers After the As per LODR

report to Stock Exchange(s) conclusion of
by listed companies the general
meeting

Display of scrutinizers Website As per LODR

report at the company's display
website

9 MGT 14 form filing with Within 30 days Sec.117(1) of Co's

ROC of the meeting Act

E. Grant date / intimation

(Grant means the issue of stocks to the employees which is –
informing the employee that he / she is eligible for ESOP. The
company have the freedom to determine the exercise price while
option providing the ESOP to the employees.)

10 Hold meeting of the Decision of

Nomination &Remuneration Grand of
/Compensation Committee option date
for deciding grant date

11 Intimation to the stock Intimate Stock SEBI (LODR)

exchanges regarding grant Exchange(s) Regulations &
of options by listed SEBI ESOP
companies guidelines

12 Issue of Grant letter and Issue of Grant Required under

make disclosure to the letter Regulation 16(2)
grantees. of the SEBI
(SBEB)
Regulations,
2014.
Documents to be
issued:

1. ESOP Plan
2. Documents
 stating the
overview of
the Scheme
along with
T&C.
3. ESOP
Agreement.
4. Nomination
form
5. Draft Grant
Letter

13 Merchant Banker Certificate To obtain

Required under
Auditor Certificate To obtain
Regulation 10(b)
Application seeking in- Application to of the SEBI
principle approval from be made for (SBEB)
Stock Exchange(s) along listing Regulation
with applicable fees

14 In case of grant being made to Non Resident Indian (NRI)

employees,

Filing of Form-ESOP with Within 30 days As per FDI policy

Reserve Bank of India of grant 2016

15 Issue of vesting letter to the Preparation of

employees. list of option to
be exercised
by the
employees

In case of NRI employees check the mode of payment whether

through NRO account/ NRE account or remittance through
overseas bank.

F. Vesting and Exercise of option

(Vest means the right of the employees to apply for the shares
granted to them. There shall be a minimum of one year between the
grant of option and vesting of option for ESOP scheme)

G. Application money / allotment of securities

16 Receive application form Receive
along with the application application
money along with
application
money

17 Hold Board Meeting for Allotment of

allotment of securities securities
As per the stamp
Issue of share certificate to Within 30
rates prevailing
the shareholders days' time
in the state
Payment of stamp duty on
issue of shares.

When allotment made to NRI employees

18 Funds are received from Receipt of

NRE a/c or through application
overseas bank towards money through
application money NRE a/c or
overseas bank

Allotment of securities Allotment to

NRI employees

Filing of FG-GRP form with Within 30 days As per FDI Policy

Reserve Bank of India of allotment of 2016

19 Allotment of securities Intimation to

intimation to Stock Stock
Exchange(s) Exchange(s)

The same is required to be Website

updated on the company's updation
website

H. Other compliance

20 MGT-14 (resolution) form Within 30 days Sec.117(1) of Co's

filing with Registrar of Act
Companies

21 PAS-3 form filing for Within 30 days Sec. 39(4) and

allotment of securities 42(9) of Co's Act
 2013 read with
rule 12 and 14
Companies
(Prospectus and
Allotment of
Securities) Rules,
2014

21 Preparation of Corporate Action Form for NSDL & CDSL

Payment of fees for Payment of

Corporate Action through fees to NSDL /
Demand Draft in favor of CDSL for
NSDL/CDSL as the case may corporate
be. action

Send the scanned Documents

documents to submission for
NSDL/CDSL/RTA for corporate
corporate action. action

22 Disclosure under SEBI Insider Trading Regulation.

Submission of form C of To Stock

Insider Trading Exchange(s)

I. Listing of Securities

23 Preparation of Listing Listing

Application for the stock application
exchanges along with the submission
necessary annexures and
submission

Receiving confirmation for Confirmation

the listing application filed. to be obtained

24 Stock Exchange Intimation to

confirmation to be sent to NSDL / CDSL
NSDL/CDSL.

Receipt of trading approval Trading

from the Stock Exchange. approval

J. Disclosures
 25 Ensuring quarterly
accounting, annual
accounting

Required disclosure in the

Director's Report

Disclosure at the company's

website.

26 Obtaining of Auditor's Required under

Certificate on compliance Regulation 13 of
and place it before the the SEBI (SBEB)
Shareholders at every AGM Regulations.
after ESOP Scheme's
approval

K. Record Maintenance

27 SH-6 Register of Employee

Stock Options to be
maintained showing the
particulars of ESOP granted
to the employees / directors
or other officers of the
company
Taxation aspects

11. Employee stock option plans are taxed at two instances as

explained below:-

1 At the At the time when theemployee exercise the option

time of (basically agreed to buy) the difference between the
excising fair market value (FMV) on the exercise date) and the
the option exercise price would be taxed as perquisite. This
– as a amount would be featuring in the employee's form 16
perquisite issued by the employer as part of total income from
salary in the tax return. The required tax is deducted at
source on this perquisite.

2 At the The employee may choose to sell the shares once these
time of are bought by him. If the employee sells these shares,
sales by another tax event happens. The difference between the
 employee sale price and the fair market value on the exercise
– as a date is taxed as capital gains.
capital Depending upon the holding period of securities, the
gain capital gain tax would be levied on the basis of short
term (holding less than a year) or long term (more than
12 months and above).

Taxation aspects in case of start-up unit employees

11.1 It may be noted that in the budget 2020 amendment, from the
financial year 2020-21 onwards, an employee receiving employee stock
option plans from an eligible start up need not in the year of exercising
the option and the tax deducted at source on the perquisite stands
deferred to earlier of the following:-

(a) Expiry of five years from the year of allotment of employee

stock option plans
(b) Date of sale of the employee stock option plans by an
employee
(c) Date of termination of employment
Taxation in the hands of employers

11.2 From the company's point of view, the company has no tax
liability. It has to book compensation Cost in its P&L Account at the
point of calculation of grant and the period of booking would be over
vesting period.

ESOP funding

12. The ESOP funding is a loan facility offered against shares which
have been granted / allotted to employees by their employer. One may
choose the ESOP financing option based on the market price of the
shares and the grant price offered by the company. Very often
employees are constrained from exercising the options because they do
not have funds to pay for the exercise price and perquisite tax. So, they
can opt for ESOP funding.

Conclusion

13. As discussed, elsewhere in this article, for start-ups, ESOPs are a

really a good tool in order to attract and retain and reward the talented
people in the best interest of the business. However, the employees
planning to take up a job in start-ups should be convinced about the
growth of the company and also the company needs to ensure that
proper documentations are in place to take care of the ESOP. Is attract
the best talent and retain the talents of the industry. ESOP is being
used more by startup companies since at the initial stages, the startups
are unable to make a high remuneration to its employees. ESOPs are
the best option for startups to attract and retain talents since
employees can feel ownership rights and they would definitely do their
best to grow up the startups.

The stocks are never vested immediately since the founders of the
startups wants the talented peopleto stick around for a reasonable
amount of time such as 4 to 5 years and the employees becomeentitled
to the benefits. Therefore, immediate value of the stocks is just an
indicative number and the startup needs to be massively successful
before those numbers become meaningful and of any real cash value.

We can conclude in saying that more than the stocks themselves, the
employees need to do a lot of hard work to find more about the
company, founders and their vision. Very few startups go on to become
big names. ESOPs would only make sense with growth oriented
successful companies, otherwise, the ESOP would remain as good as a
piece of paper.

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