Key Takeaways

• Indian EdTech startups reported approximately 20% of their employees have ESOPs, of which, those in leadership positions receive ESOPs ranging between 0.2% and 1.5% of the company’s valuation¹.
• Employee do not have shareholder rights until shares are issued on exercise of options.
• No promoter or any person belonging to a promoter group shall be issued ESOPs.
• A company can avail tax deductions on the discounted amount allowed while issuing ESOPs.

Introduction

In the recent times businesses have reportedly granted their employees a stake of the company via ESOPs, in fact, the year 2021 was considered as the golden year for Start-ups as more companies integrated ESOPs for their strategic advancements, since it preserved the capital for other business operations rather than utilizing it for employee compensation. Employee Stock Option Plan (“ESOP”) is essentially a scheme that grants an employee with an option or opportunity to own shares of the company at a predetermined price and date. There is an innate correlation between the performance of employees and the company’s growth, influenced by this, employee perform much more efficiently towards maximizing their returns from ESOPs. Although, ESOPs appear to be a simple solution to issue equity-linked compensation, there are multiple factors a business need to consider before implementing an ESOP scheme. However, before moving on to some of these key considerations, it is pertinent to know how an ESOP works.

Operation of an ESOP scheme

Once a company decides to establish an ESOP scheme, it can initiate the scheme with a grant of option to the employees, giving them the right to purchase the company’s shares at a fixed price. Before exercising the option, the employees are subjected to a minimum vesting period of one year², after which the company, at its discretion, can decide the exercise period based on their requirements³. Only after the option is vested shall the employee hold the right to exercise the option and be allotted shares of the company. This approach not only provides a structured timeline but also allows the company flexibility in aligning employee incentives with organizational objectives. Only after the options vest does the employee gain the right to exercise them and be allocated shares in the company, fostering a sense of commitment and ownership among the workforce.

Key Considerations before setting up an ESOP scheme.

Eligibility

An ESOP is issued to permanent employees, directors, and officers of the company, as well as employees of subsidiary, holding, or associate companies, both in India and abroad⁴. However, a private unlisted company in India cannot grant ESOPs to a promoter or a director who, directly or indirectly, has more than 10% of the outstanding equity shares of the company⁵.

Shareholder Approval

A shareholder’s approval by special resolution in a general meeting is required⁶, with a separate shareholder approval for the issue of ESOPs to employees belonging to a subsidiary or a holding company and identified employees during any 1 (one) year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and conversions) of the company⁷.

Valuation of shares

A registered valuer must value shares issued under ESOPs in accordance with the provisions of the Companies Act, 2013, and the Rules made thereunder⁸. A category 1 Merchant Banker registered with SEBI as of a date no earlier than 180 days prior to the date of exercise is required to provide a valuation certificate to an unlisted company⁹.

Taxation on ESOPs

ESOPs under the Indian tax regime are subject to taxation in a few key aspects. For an employee, the tax is levied when the option is exercised after the vesting period as “Perquisites”¹⁰ under the head “Salaries”, and such is deducted by the employer as TDS¹¹. After which, capital gains tax is levied on income or loss from sale of allotted shares¹². In addition to this, while filing corporate tax, companies issuing ESOPs at a discounted rate can avail of tax deductions on the discounted amount allowed for during the issue¹³. This interplay of tax implications underscores the intricate financial landscape surrounding ESOPs in India.

Conclusion

Employee Stock Option Plans are a valuable tool for incentivizing and retaining employees, but they come with considerations and complexities that must be carefully managed. ESOPs showcase a two-fold benefit, i.e., reducing cash outflow from the company, ensuring that such can be used for other business operations and retaining talented employees for business growth. Employees view this scheme as a long-term investment, offsetting it against their cash perks and bonuses. Employees view this scheme as a long-term investment, offsetting it against their cash perquisites and bonuses. In addition, ESOPs lead to higher productivity and more profit. ESOPs are the most beneficial tool for employees and Startups if implemented effectively.

¹ Business Standard, 10 August 2023 – https://shorturl.at/owzF6

² Rule 12(6)(a) of the Companies (Share Capital and Debentures) Rules, 2014.

³ Rule 12(3) of the Companies (Share Capital and Debentures) Rules, 2014.

⁴ S.2(37) of the Companies Act, 2013.

⁵ Rule 12(1)(c) of the Companies (Share Capital and Debentures) Rules, 2014.

⁶ Rule 12(1) of the Companies (Share Capital and Debentures) Rules, 2014.

⁷ Rule 12(4) of the Companies (Share Capital and Debentures) Rules, 2014.

⁸ S.54 of Companies Act, 2013 and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

⁹ Valuation Issue – ESOPs – CAClubIndia

¹⁰ S.17(2)(vi) of the Income Tax Act, 1961

¹¹ S.192 of the Income Tax Act, 1961

¹² S. 45 of the Income Tax Act, 1961

¹³ ESOP expenditure and their in Income Tax – Tax Management India.