ESOPs are the employee stock options that are direct compensation offered by the companies to their employees, granting them the right to purchase a specific number of company shares at a predetermined price within a specified period. ESOPs allow employees to benefit from the potential growth of the company’s stock over time.
To whom ESOPs are offered
- Employee Incentives: ESOPs are a powerful incentive tool to attract and retain talented employees. By offering a stake in the company through stock ownership, employees are motivated to work towards its success, as their efforts directly impact the value of their shares.
- Aligning Interests: ESOPs align the interests of employees with those of the company and its shareholders. When employees own a portion of the company, they are more likely to focus on increasing productivity, improving efficiency, and driving innovation, contributing to its overall success.
- Retirement Benefits: ESOPs can be part of an employee’s retirement benefits package. As employees accumulate shares over time, they have the potential to build significant wealth if the company performs well, providing a source of savings for their future.
- Tax Advantages: ESOPs can offer tax benefits to the company and participating employees. Companies can receive tax deductions for contributions to the ESOP, and employees might enjoy tax advantages on the appreciation of the shares if held within the ESOP until retirement.
- Ownership Transition: ESOPs can be used for succession planning, especially in closely held or family-owned businesses. They provide a way for the current owners to gradually sell their stake to the employees, ensuring continuity and preserving the company’s culture.
- Employee Engagement and Loyalty: ESOPs can enhance employee morale, engagement, and loyalty. Employees feel a sense of ownership and pride in the company’s success when they have a stake in its ownership, which can positively impact the workplace environment.
Here’s how ESOPs generally work
- Granting Options: Employees can buy a certain number of shares at a set price, known as the “strike price” or “exercise price.” This price is usually the current valued price when the options are granted.
- Vesting Period: There’s usually a vesting schedule, meaning employees must work for the company for a certain period before exercising these options. For instance, a typical vesting schedule might have four years with a one-year cliff, meaning an employee gains the right to exercise 25% of the options after the first year and then the rest gradually over the following three years. Sometimes, immediate vesting for a confident % is also done for the employee who has been working in the past.
- Exercise Period: Employees can exercise their options once vested. Exercising means purchasing the shares at the agreed-upon price. If the current value is higher than the exercise price, employees can buy the shares at a discount and potentially profit from the difference when they sell them at a future price.
- Expiration: Options typically have a limited lifespan. Employees who leave the company or don’t exercise their options within a specific time frame (often 10 years from the grant date) might lose the right to purchase those shares.
- Option to Exit: Employees shall vest their shares on achieving the condition laid down in the contract. They would be allowed to exit or encash the shares just before the IPO, or if a more significant investor is, then a possible cap-table cleanup would be done by exiting the employee shares.
Tax on ESOPs
- Tax to Employees: The difference between the Market Value per share and the Discount at which the employee is offered the share is taxable in the hands of the employee as perquisite, and the employer must ensure the same is paid when the shares are vested. Once the employee sells the share, exercising the exit option, the difference between the market value and the sale price is decided as short and long-term capital gain, and accordingly, the tax rate is applied. Various tax benefits can be applied to the same.
- Tax to Employer: No tax is applied to the employer, and shares given to the employee shall be considered the amount paid and can be claimed as expenses. The employer must ensure that a timely deduction and payment of TDS are made to avoid any penalty.
Key Features for the Company
- A company can issue ESOPs only after six months from the business’s start date of completion.
- A compulsory valuation of the company is done by the SEBI-approved merchant banker at the time of deciding the price.
- Valuation should be a fair market value of the company per the standards in Incometax and SEBI.
- There is no restriction to offer the number of shares for employees, but a minimum of 5 and a maximum of 20% of the Authorised/Issued share capital is provided as ESOPs
- When a prominent investor enters the company and doesn’t want a disruption in the business may wish for the ESOP pool to start if not already done to ensure the talent pool is retained.
- All ESOP compliance is completed under the Registrar of Companies provisions and mandatory for all the companies registered in the Companies Act.
- No LLP / Partnership firm is allowed to offer an ESOP policy.
- The employee and the employer sign a contract to ensure binding terms between the parties. The number of shares is issued to the employee on vesting of shares, which is reflected in their DMAT account.
- For a private limited company shares are not freely tradeable and must be transferred on the approval of the board of directors.
Conclusion
Employee stock options can be a valuable form of compensation as they align the interests of the employees with those of the company’s shareholders. They offer employees the chance to benefit from the company’s success and share in its growth.
However, risks are involved, such as the potential that the company’s stock price might not increase or even decrease, leaving the options worthless. Employees should carefully consider the terms and risks associated with their stock options and may need to consult financial advisors or tax professionals to understand the implications of exercising them.
Also, different companies might have variations in the structure and terms of their employee stock option plans.
At www.cfoangle.com, we help companies structure the ESOP plan and help with execution, tax and ROC compliance. We help draft the plan and then engage in further engagement.
