ESOP Advisory Services in Bangalore
ESOP, which stands for Employee Stock Option, is a valuable benefit that companies can offer to their employees. It provides an opportunity for employees to become shareholders in the company, aligning their interests with the company’s success. By granting employees the option to purchase company stock at a predetermined price, ESOPs can incentivize and motivate employees to perform at their best.
ESOPs, or Employee Stock Options are broadly exercised in both startup and large companies. This category offers a range of benefits and serves as a valuable tool for retaining eligible employees. By granting them the opportunity to enjoy privileges and benefits, ESOPs contribute to the growth of the business and the increase in market value of shares over time.
At Chhota CFO we specialize in providing ESOP advisory services in Bangalore. Employee Stock Ownership Plans (ESOPs) are powerful tools for attracting and retaining talent, fostering employee engagement, and aligning employee interests with company growth. By fostering a sense of ownership and empowering employees, they can actively contribute to the growth and success of the organization.
- Meaning and Definition of ESOP
An Employee Stock Ownership Plan (ESOP) benefit the employees by an ownership stake in the company. Each eligible employee is allocated a specific percentage of the company’s stock shares by the employer, without any financial gain. ESOP allocation is determined by factors such as the employee’s pay scale, terms of service, or other criteria set by management.
One important distinction to note is that when shares are issued, the shareholder assumes the role of a startup owner within the company. However, when it comes to ESOPs, employees are granted the opportunity to potentially become owners in the future, provided they meet specific criteria. Employee Stock Ownership Plans, also known as ESOPs, are a common term used to refer to these types of plans.
An ESOP (Employee stock ownership plan) is a type of employee benefit plan that provides employees with the opportunity to have a stake in the organization. Employee stock ownership plans are issued as direct stock, profit-sharing plans or bonuses, and the employer has the sole discretion in deciding who could avail of these options. However, employee stock ownership plans are just options that could be purchased at a specified price before the exercise date. There are defined rules and regulations laid out in the Companies Rules that employers need to follow for granting employee stock ownership plans to their employees.
- Eligible Employees
According to Rule 12(1) of Companies (Share Capital and Debentures) Rules, 2014, companies can issue ESOPs under Companies Act, only to the following:
- A permanent employee of the company – such an employee can work in India or outside India.
- A director of the company can either be a whole-time director or not. However, companies cannot issue ESOPs to an independent director (because it will affect his independence!)
- Any person falling under the definition of (a) or (b) belonging to a subsidiary or the holding company.
The rule also clearly identifies persons to whom companies cannot issue ESOPs:
- A person being a promoter.
- A person belonging to the promoter group.
- A director who holds more than ten per cent of the equity of the company both directly or indirectly
ESOPs in most companies are typically regulated by the Employee Stock Option Scheme (ESOS).
- How does an Employee Stock Ownership Plan (ESOP) work?
An organization offers its employees the opportunity to purchase a set number of company shares at a predetermined price after a certain period of time has passed. In order for an employee to exercise their option, they must complete the predetermined vesting period. This means that the employee must work for the organization until they are able to exercise a portion or all of their stock options.
Employees have the opportunity to leverage their ESOPs and acquire company stock at discounted prices, providing them with a valuable investment opportunity. Employees have the opportunity to sell shares acquired through ESOPs and benefit from their investments
In the event, If an employee departs or retires prior to the completion of the vesting term, the corporation must purchase back the ESOP at fair market value within 60 days.
- Fees and other expenses
Fees such as Legal fees, accounting fees, and administrative expenditures are typically factored into the initial costs of an Employee Stock Ownership Plan (ESOP) in India.
The cost of establishing and sustaining an ESOP varies according to the plan’s size and complexity.
Furthermore, ESOP distributions in India may occur in a variety of ways.
When an employee exercises their stock option to obtain shares, they have the option of selling them immediately or storing them for future appreciation.
If the employee decides to sell the shares, the proceeds, less any taxes due on the gain, will be sent to them. If the employee agrees to keep the shares, they will own a piece of the company and may be eligible for dividends or capital gains if the stock price rises.
- Benefit for the companies towards issuing ESOP to employees
Many organizations utilize Employee stock ownership plans as a strategic method to attract and retain top-tier employees or eligible employees. Organizations typically distribute stocks in a phased manner, following a strategic approach. As an example, a company could provide its employees with stocks at the end of the financial year as a way to encourage them to stay with the organization and receive the grant. Companies that provide ESOPs typically have a focus on long-term goals.
Companies are not only focused on keeping employees around for the long haul, but also want to ensure that they become invested in the success of the company. Many IT companies are facing significant attrition rates, and implementing ESOPs could be a potential solution to reduce this issue. Start-ups often use stock options as a way to attract talented individuals. Many organizations of this nature struggle with limited funds and are unable to provide competitive salaries. By providing a stake in their organization, they ensure that their compensation package remains competitive.
- Benefits of Employees availing ESOP’s from the Company
ESOPs provide employees with the opportunity to acquire company shares at a nominal rate and sell them for a profit after a specified period of time determined by their employer. There are employees achieving great financial success alongside company founders.
- ESOP Taxation
ESOPs have dual tax effects:
When an employee exercises their rights and purchases company stock
When the employee sells the stock after purchasing it
Let’s take a closer look at these examples:
- Tax treatment at the time of buying the shares
Employees can purchase shares after the vesting date at a price less than the share’s Fair Market Value (FMV) on that date. As a result, the difference between the FMV and the exercise price of the share is considered a pre-condition in the employee’s hands and taxed at his income tax slab rate.
However, in the case of new businesses, the government has softened the tax implications of ESOPs.
Employees at the start-up would not have to pay the tax on the perk in the year in which they exercised the ESOP. TDS on ESOPs would be delayed until the sooner of the following dates:
Five years from the date of the ESOP grant
When does the employee sell the ESOP?
Date of departure from the company
- Tax treatment at the time of selling the shares
If the employee sells the shares, the difference between the selling price and the FMV on the date the share was exercised is taxable as capital gains.
If you sell your shares within a year of buying them, you will have to pay a 10% tax on any profits over Rs.1 lakh. If the shares are sold within 12 months, the profits are taxed at 15%.
Taxation of foreign ESOPs in India is also similar, and you would be taxed in India on the perquisites earned from a foreign company.
- Benefits of ESOPs for the employers
Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee to put in his 100%. Although motivation, employee retention and awarding hard work are the key benefits which ESOP brings to employers, there are several other noteworthy advantages too. With the help of ESOP options, organisations could avoid cash compensations as a reward, thus saving on immediate cash outflow. For organisations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.
- Key Terms in ESOPs
Meaning | Description |
Option Pool | Before issuing ESOPs, a startup should first create an option pool. This refers to a set of shares for issuing to early employees. Founders use option pools to attract top talent from the industry when the startup has yet to generate adequate revenues to offer competitive compensation packages. Typically, option pools range from 10-15% of a startup’s initial equity. Companies can create an ESOP pool in two ways: · From the founder’s stock: In this case, the founder has set aside 10-15% of their share ownership towards creating the option pool. · Issue of new stock: In this scenario, an ESOP pool is created by setting aside fresh shares. The existing shareholders’ ownership gets diluted by creating a new stock pool. |
Eligibility | As the name suggests, ESOPs are available only for employees. Promoters, consultants, advisors, freelancers, and contractual employees do not qualify for ESOPs. |
Grant | When an employee fulfils certain conditions, the company grants the ESOPs. These conditions vary from company to company but are linked to achieving certain milestones—revenue, product launch, and market development. Granting options is a pre-requisite for vesting and issuing shares to the employee. |
Vesting | Vesting is the process by which employees “earn” their stock over time. As per the guidelines of ESOPs under Companies Act, a minimum one-year lock-in period must be in place between the grant of the ESOP and the vesting of its option. The vesting could be either: · Time-based: for example, vesting equally over three years · Milestone-based: for instance, fully vested once the employee achieves his sales target of Rs 10 crore. |
Vesting Cliff | A vesting cliff is when the stocks “accrue” to the employee, but the employee cannot exercise it. At the end of the cliff period, the stocks will vest as per the vesting schedule. There are no mandatory guidelines for a vesting cliff for ESOPs under Companies Act. However, a four-year vesting with a one-year cliff is quite common |
Vesting Schedule | When startups offer ESOPs to their employees, they draw up a vesting schedule. This schedule governs the time the employee acquires full ownership of their ESOPs. Often, entrepreneurs have a staggered schedule for granting ESOPs. For instance, it could be 25% in the first year, 50% in the second year, etc. At the end of the vesting schedule, an employee receives the right to exercise their option. |
Exercise | Once the options become fully vested, the employees can convert their “right” (in other words, their ESOPs) to actual shares by exercising their rights. Once the employee exercises the right, they will be issued stocks and have the right to receive company dividends. |
Strike Price | The strike price (also called the exercise price) is the rate employees can purchase the stock options granted to them |
Expiration Date | Once the company announces the grant, employees must exercise their rights and purchase the shares allotted to them within a specific period. If the employee does not exercise the options within this date, the ESOPs will expire. |
- In Simpler Terms, the following steps are generally followed in all types of companies.
Steps | Description |
Grant | The first step in an ESOP process is the grant. Grant is when the company announces that the employee is eligible for ESOPs. Usually, grants are made based on certain conditions, such as: · The employee has completed five years of service; or · The employee has played a significant role in product launch and market expansion. |
Vesting | The next stage is vesting. Vesting is when the employee becomes eligible to exercise his options. Vesting can be time- or milestone-driven and can be immediate or happen over a staggered period. |
Exercise | Exercise is the event when the company allots shares. Once the employee exercises his options, he becomes a shareholder. Until the exercise happens, the employee only has a right to buy company shares |
Exit | Once the employee exercises his right, he becomes a shareholder. Exit happens when the employee decides to sell his shares. The employee can sell the shares: · In the open market · In the IPO · To other shareholders during a subsequent round Many companies have a clause in the employee stock option scheme that the employee cannot sell these shares to direct competitors. There could also be clauses requiring the employee to offer the shares to the existing investors or shareholders before selling to third parties. |
- Legal obligations for ESOP’s under Companies Act, 2013
- Section 62(1)(b) of the Companies Act, 2013
- Rule 12 of the Companies (Share Capital and Debenture) Rules, 2014
