Learn about the Employee Stock Option Plan (ESOP) Meaning in a Detail

If you want to learn about the nitty and gritty of the Employee Stock Option Plan then you must read this piece of blog curated by us just for you to make you understand about it in detail. So, let’s not waste time and move further. 

Employee Stock Option Plan 

The Employee Stock Option Plan is also known as the ESOP, an ESOP is an employee benefit plan which are issued by the company to their employees in order to encourage the ownership of the employee in the organisation. 

ESOPs are defined under the Section 2(37) of the Companies Act as an option issued to the employees, directors, or officers of the company or the subsidiary, or holding of the parent company to purchase or subscribe to the issue of the shares at a predetermined price on a future date. 

With the help of this scheme, the shares are issued to the employees by the organisation at a discounted rate and such companies other than the listed companies are required to comply with the provisions as specified under the Companies Act, 2013 and the Companies (Share Capital and Debenture Rules), 2014. 

On the other hand, the listed companies are required to abide by the guidelines specified under the Securities and Exchange Board of India Employees Stock Option Scheme guidelines. By this scheme, the company is proposed to increase their subscribed share capital with their issue of further shares to their employees. 

Employee Stock Option Plan Key Terms 

There are some key terms that are related to the ESOPs which are very important for any person to understand beforehand in order to understand the ESOPs in true detail. So, let’s quickly understand as to what these terms hold for the ESOPs: 

• Vesting: Vesting is the right of the employees to apply for the shares granted to them by their organization. Usually, the lock-in period for the employees who hold the ESOPs is one year between the grant of the option and the vesting of such option. 

• Exercise: The vesting Period of the ESOPs is one year and the exercising period for such shares is where the option holder can exercise their option of buying the shares but the lock-in period is at the will of the company which is applicable after the employee exercises their option of buying the shares. During this period the employees will not have the right to enjoy any advantages of a shareholder be it the Right to Vote, or to receive any dividends.

• Grant: Grant stands for the issue of the shares. In simple words, it is about informing the employees that they are eligible to hold the ESOPs and their company has the final wording to determine the exercise price at the time of providing the option of the ESOP to the employees. 

• Strike Price: This is the rate at which the employees can purchase the stocks granted to them. 

• Option Pool: This option is usually used by the start-ups before issuing the ESOPs which means that a set of the shares is created for the early employees. This Option Pool is used by the founders to attract top talent to their organisation as the Start-Up has not generated a decent amount of revenue to provide competitive compensation packages to these employees. 

• Expiration Date: As soon as the Grant is announced by the company the employees are required to exercise their rights and purchase the shares within the specified period.  If the employees fail to exercise such an option within such period the ESOP will expire after the completion of this period. 

Eligibility Criteria for the issuance of the Employee Stock Option Plan 

Rule 12(1) of the Companies (Share Capital and Debentures Rules), 2014 states the eligibility criteria for the issuance of the Employee Stock Option Plan (also known as ESOP)

• A Permanent Employee of the Company working in India or outside India

• A Permanent Employee or a Director of the Subsidiary Company, Associate Company or Holding Company working in India or outside India 

• The Director of the Company also includes a Part-Time and Full-Time Director though it excludes an Independent Director. 

• If the ESOP issuing company is a Private Limited Company then it is an essential condition that the Articles of Association of such company shall authorise the issuance of the shares through the ESOP. But if in case the Articles do not authorise such issuance of the shares then in such a circumstance the company is required to hold an Extraordinary General Meeting to alter their Articles of Association for the inclusion of a provision for such issue and besides a Board Meeting is to be held for passing of the resolution in this behalf and obtaining of the approval of the shareholders. 

Disqualification for the issuance of the Employee Stock Option Plan 

• If an employee belongs to the promoter group or is a promoter of a company then such a person will be disqualified from obtaining the ESOP 

• A Director who by himself or through their relatives or through any body corporate holds more than 10% of the outstanding equity shares of the company either directly or indirectly. 

Benefits of the Employee Stock Option Plan

Benefits to the Employees 

• Ownership in the Company: As we have already discussed the most important advantage of the ESOP to an employee is getting a share of the ownership in the companies as employees. 

• Dividends: As the company earns profits which are distributed amongst the shareholders in the form of dividends. The Employees can earn additional income as dividends and get the benefit of their efforts that they had put in earning the profitability of the company. 

• Buying of the Shares at a Discount Rate: The employee usually pays a very nominal amount of the money to buy the shares allocated to them which in turn allows them to invest in a company at a preferential rate. 

 

Benefits to the Employers 

• Attracting Talent: With the help of the ESOP, the employers offer additional compensation plans which in turn help the employers attract and retain talented employees. Even start-ups may lure good talent in their initial days when they are unable to pay for high packages. 

• Retention of the Employees: With the help of the ESOP an employer can easily retain the employees as the employees are required to wait for the vesting period of the ESOP in order to exercise their right of redemption. 
• Productivity: As the Employees are getting their share of the profits earned by the company the ESOP increases the productivity of the employees. 

How Employee Stock Option Plan Works? 

• Deciding upon the number of ESOPs: The first step in the process is the company deciding upon the number of ESOPs to be offered to the employees and their prices. After deciding upon these the ESOPs are granted to the employees with a grant date. 

• Formation of the ESOP Trust: As soon as the ESOPs are granted to the employees ESOPs remain in a trust fund for a specific period which is known as the Vesting Period. The Employees are required to stay with the company till the completion of the vesting period to exercise the ownership of the stock. As soon as the vesting period expires the employees get their right to exercise the ESOPs.

• Vesting Date: As we have already discussed the date on which the employee exercises their right of the vesting is known as the Vesting Date where the Employee can buy the shares of the company at the allotted price which is lower than its market value. If in case the Employee retires or exits the company before the vesting date the company must buy back the ESOP at a fair market value within 60 days. 

Employee Stock Option Plan Distribution and Initial Costs 

Initial Costs 

The Initial Cost of the ESOPs includes the accounting fees, administrative costs and any legal fees. The initial cost of the ESOPs also includes the cost of maintaining and creating the ESOP which depends and varies based on the complexity and the size of the plan. 

Distribution of the ESOP 

There are so many methods of distributing the ESOPs in India. It is when an employee exercises their stock option to acquire the shares where they have the option to either sell the shares or retain them for any further appreciation. 

If in case the employee exercises their option of selling the shares right away the share proceeds will be sent to them by deducting any taxes owing to them, and if the employee decides to keep the shares then they will have a stake in the company and in such a case they will be eligible to receive the dividends or capital gains if the price of the stock rises up. 

Statutory Requirements to be Fulfilled for the Issuance of the Employee Stock Option Plan 

• Section 2(37) of the Companies Act: As we have already discussed this Section defines Employee Stock Options as the options provided to the employees, directors, or officers of the company to purchase or subscribe to the issue of the shares at a predetermined price on a future date. However, this Section is silent upon treating the Employee Benefit Schemes such as the Phantom Stock or the Stock Appreciation Rights. 

• Section 62(1)(b) of the Companies Act: This Section governs the issuance of ESOPs to the employees because an ESOP is issued when the company passes a special resolution and fulfills the terms and conditions associated with such shares. 

• Rule 12 of the Companies (Share Capital and Debenture Rules), 2014: This Rule provides the requirements for the passing of the special resolution. The contents of the Special Resolution must include:

• The Manner of the Identification of the Employees
• The Number of Stocks to be granted to such an employee
• The Vesting Requirements
• Lock-In Period (if any)
• Methods of Valuation 
• The Conditions for the Buy-Back

Requirements of the Listed Companies for the Issuance of the Employee Stock Option Plan 

Apart from the requirements specified in the last section of this Article, the Listed Companies are also required to fulfill the requirements set out in the SEBI (Share Based Employee Benefits) Regulations, 2014:

• The Listed Companies are required to transfer their option pools to the trust and lastly provide financial assistance to the trust

• ESOPs can be implemented by the company or under a trust which is also known as the ESOP Trust

• All the Listed Companies are required to form a Compensation Committee. This Committee is responsible for determining the eligibility criteria of the terms and conditions associated with these options. 

Disclosures made in the Board Report at the time of the issue of the Employee Stock Option Plan 

• Number of the Stocks to be issued in the Board Report

• The identified Class of the Directors, Employees, and Officers who are eligible for the ESOPs.

• Vesting Period Requirements

• Maximum Period within which the Options are required to be vested

• Period and the Price of the Exercise of the Stocks

• Lock-In Period (if any)

• Granting the maximum number of options

• The various methods for the valuation of the Company Stocks

• Conditions for the lapse of these options

• Statement that the company is required to comply with the applicable accounting standards. 

Procedure for Issuing the Employee Stock Option Plan

Section 62(1)(b) of the Companies Act, 2013 along with Rule 12 of the Companies (Share Capital and Debenture Rules), 2014 prescribes the procedure for the issuance of the ESOPs, this procedure is similar to the grant of the shares as specified under the Securities and Exchange Board of India Employee Stock Option Scheme:

• Preparation of the Draft: The draft of the ESOPs is required to be drafted in accordance with the Companies Act and the Companies (Share Capital and Debenture Rules), 2014

• Notice Preparation: A Notice of the board meeting is required to be served upon the directors of the company by giving them at least seven days notice before the meeting

• Passing of the Resolution: A resolution for the issuance of the ESOPs is required to be passed in the Board Meeting. It is essential that the resolution must determine the price of the shares, time, and date of the issue of the shares. Approving the calling of the general meeting is also covered in the resolution. 

• Notice of the General Meeting: A Notice of the General Meeting is required to be served upon the shareholders, auditors, directors, and secretarial auditors of the company at least 21 days before the date of the general meeting. 

• The Passing of the Special Resolution: A Special Resolution is required to be passed in the general meeting regarding the issuance of the shares under the ESOPs. 

• MGT-14 Filing: MGT-14 Form is required to be submitted within 30 days with the registrar of the companies for the passing of the special resolution regarding the issuance of the ESOPs.

• Share Purchase: The options are required to be served upon the directors, employees, and officers of the company for purchasing the shares under the ESOPs. 

• Maintaining the Register of the ESOPs: The company issuing the ESOP is required to maintain a register of the ESOP in FORM SH.6. 

What are the Types of Employee Stock Option Plans? 

• Employee Stock Purchase Plans: These Plans are distinct from the ordinary stock options in which companies allow employees to buy the shares of the company at a discounted price usually through the convertible payroll deductions. This allows the employees an opportunity to become the shareholders of the company at a more accessible cost. These ESPPs have specific enrollment periods during which an employee may choose to participate. 

• Incentive Stock Options: These types of stock options are also known as ISOs as these are the specialised form of stock options that are primarily designated for the key executives and the employees of the company. At the time when the employees exercise their ISOs, the employees are not required to pay regular income tax at the time of the exercise. The employees can defer their tax liabilities until and unless they decide to sell the acquired shares. 

• Restricted Stock Units: These types of ESOPs offer a different approach to equity compensation. With these types of shares, the employees are granted the right to receive the shares of the company upon the specific vesting conditions. As the stock options, the employees are not required to purchase the shares. In these types of stocks, the employees are awarded with outright ownership once the vesting criteria are met.

• Non-Qualified Stock Options: These types of stock options offer a more flexible approach to employees as compared to the ISOs. These options are exercised for a broader category of individuals including the directors, employees, contractors, and consultants. Unlike the ISOs, these options do not enjoy the same tax leverage as when an employee exercises the NSOs they are required to report the difference between the period of the exercise and the fair market value of the shares as ordinary income in the year of the exercise. 

What are the Tax Implications of the Employee Stock Option Plan?

Tax Treatment at the time of the Buying of the Shares 

Employees are allowed to buy the shares after the passing of the vetting date at a rate that is lower than the Fair Market Value (FMV) of the shares, this means that the difference between the Fair Market Value of the Shares and the exercise price of the shares are treated as a prerequisite in the hands of the employee which are taxed at the applicable income tax slab rate. 

Example of the ESOP 

Exercise Date	January 1, 2022
FMV	Rs. 150/share
Exercise Price	Rs. 85/share
Taxable Value of the Perquisite	150-85 = Rs. 65/share
Number of Shares exercised	1,000
Total Taxable perquisite	1,000 * 65 = Rs. 65,000
Tax Payable (assuming a tax slab of 30%)	30% of 65,000 = Rs. 19,500

The Government has relaxed the implications of the taxes on start-ups. Start-ups are not required to pay taxes on the perquisite in the year they exercise the ESOP. For start-ups the ESOPs. For start-ups the TDS on ESOPs are deferred as the following dates, whichever is earlier:

• Completion of the five years from the date of the grant of the ESOP
• The Date when the employees sell their ESOPs.
• The date of the leaving of the company

The Treatment of Tax at the Time of the Selling of the Shares 

If the employee sells the shares, then the difference between the fair market value of the shares and the selling price of the shares when the share was exercised would be subject to the capital gains tax. 

If the gains are earned after selling the shares after the passage of the 12 months of buying, a 10% tax will be applicable on the gains exceeding Rs. 1 Lakh. But if the shares are sold before the completion of 12 months the gains will be taxed at 15%

ESOP Example 

Exercise Date	January 1, 2022
FMV	Rs. 150/share
Case 1: Shares sold on October 1, 2022
FMV on October 1, 2022	Rs. 165/share
Difference between the FMVs	165 – 150 = Rs 10/share
Number of shares	1,000
The total amount of short-term capital gain	1000 * 10 = Rs. 10,000
Short-term capital gains tax payable	15% of 10,000 = Rs. 1500
Case 2: Shares sold on February 2023
FMV on February 2023	Rs. 180/share
Difference between the exercise FMV and sale FMV	180 –  150 = Rs. 30/share
Number of shares	1,000
The total amount of the long-term capital gains	1000 * 30 = Rs. 30,000
Long Term Capital Gains Tax Payable	NIL as the gain is below Rs. 1 Lakhs

Conclusion 

Employee Stock Option Plan is a scheme that is also known as the Employee Benefits program because the shares of the company are issued to them at a discount rate as compared to the market rate. These schemes allow the companies to retain superior talent and at the same time allow monetary benefits to the employee. 

Frequently Asked Questions 

Q1. What is ESOP and how does it work?

Ans1. ESOP stands for the Employee Stock Option Plan which is an employee benefit plan which enables the employees of the organisation to own a share in the company. 

Q2. What is ESOP’s salary?

Ans2. An ESOP salary aligns with the interests of the employee to the interests of the shareholders which acts as a potential motivational instrument for the employees.

Q3. Is ESOPs good or bad?

Ans3. Yes, opting for the ESOPs is a good decision but depending upon the individual circumstances and the prospects of the company. 

Q4. How is ESOP paid out?

Ans4. ESOP is paid out in various ways such as Lump Sum, Periodic Installments, and Rollover. 

Q5. Is ESOP better than salary?

Ans5. No, because ESOP includes a vesting period for which the ESOPs cannot be exercised while salaries are immediately available to the employee. 

Q6. Is ESOP included in CTC?

Ans6. Yes, ESOPs are part of the CTC and included in the same 

Q7. Who is eligible for ESOP?

Ans7. All the employees of the organisation except the directors and promoters holding more than 10% equity are eligible for the ESOPs. 

Q8. Can I sell my ESOP shares?

Ans8. Yes, as an employee of the ESOP, you can sell your ESOP after the completion of the vesting period. 

Q9. Can an ESOP lose money?

Ans9. Yes, in the event that an employee is solely invested in the stock of the company and the company fails in the hard times. 

Q10. Do I get my ESOP money if I quit?

Ans10. Yes, if an employee quits the company, the company makes the payment of their ESOP either by the distribution of shares, in cash or in both cases.