This article is written by Srishti Kaushal, a first-year student of Rajiv Gandhi National University of Law, Patiala, Punjab, pursuing B.A.LL.B. (Hons.). In this article, she discusses why a company should have an Employee Stock Option Plan and what are the essential clauses an ESOP must have.
Many times employees in a company can get lethargic and feel that their efforts and creativity is not being rewarded. To motivate them and encourage them to continue with their good work, a company should formulate an Employee Stock Option Plan (ESOP). ESOP is basically an option given as a right (not an obligation) to the employees of a Company. This right enables them to purchase the Company’s shares at a fixed price during a specified period of time.
Thus, it is an employment scheme under which the employees are encouraged to acquire ownership of a company in the form of its shares. These shares are given to the employees at a price less than the market price. It is done so that the employees can feel as a part of the company, be motivated and their productivity can be enhanced. A business that wants to implement ESOP needs to have an ESOP policy or scheme for its employees.
In this article, we will discuss who can it be granted to? Which type of corporation can issue ESOP? Why should a company have an ESOP? What are the clauses that an ESOP must have?
Laws regulating ESOP
ESOP is an employee benefit plan which enables some tax-favoured advantages under the Internal Revenue Code. To take advantage of these tax benefits, the ESOP must comply with various requirements.
ESOP is subject to regulations set forth in the Securities and Exchange Board of India Act (for listed companies), the Companies Act 2013 (Section 62), Companies (share capital and debentures) Rules, 2014, and the Income Tax Act, 1961.
It is the Companies Act 2013, which lays down enabling provisions for issuing the ESOP.
Who can issue ESOP and to whom can it be issued?
Any unlisted company by way of an ordinary resolution, an unlisted company by way of a special resolution or an unlisted company (following SEBI ESOP guidelines) can issue ESOP.
The ESOP can be issued to the following people:
- A permanent employee of the company,
- A director of the company.
However, it can not be issued to:
- An independent director.
- An employee who is a promoter.
- A director who through himself or through any of his/her relative or a body corporate, holds more than 10% of the company’s shares.
- A consultant or an advisor.
The ESOP agreement is signed between the authorized representative of the corporation and the eligible employees and directors (called participants).
Why should you have an ESOP scheme?
Now that we understand what an employee stock option plan (ESOP) means, let’s understand the advantages issuing ESOP can have:
- A ready market for the owner’s stock: The owners of a privately held company can use an ESOP to create a ready market, consisting of employees and directors, for their shares.
- ESOPs enables the owners to borrow money at a lower after-tax cost.
- It provides various tax benefits as well. Some of these benefits are:
- Contributions of stock are tax-deductible, which means that the companies can have a current cash flow advantage by issuing new shares through ESOP.
- Contributions of cash are tax-deductible: This means that to build up a cash reserve in the ESOP for future use, a company is permitted to contribute cash on a year-on-year basis and get a tax deduction.
- The ESOP Scheme acts as a retainership instrument, which is very important for small businesses. This is because this scheme provides a lock-in period for employees to exercise their right to purchase the shares. Thus, If an employee opts for this, he/she has to serve the company within the lock-in period and cannot quit it. This allows the business to retain its employees.
- ESOP gives employees a feeling of ownership. They feel that they are not mere employees of the business, but also the owners. They are more motivated and encouraged to fulfill organisations objectives as they get a share in the profits of the company (in the form of dividends).
- It acts as a non-cash compensation tool which enables the company to compete for the best human resources.
- It also acts as a vehicle for the owners to receive the liquidity without selling the business to a competitor or other third parties.
Essentials of Employee Stock Option Plan Scheme
Now that you know why it is so essential to have an Employee Stock Option Plan, let’s see what are the essential clauses that an ESOP scheme must have.
Objectives of the ESOP scheme
The first clause that is essential in an ESOP is the clause explaining the objectives of the plan. The objectives can include: to provide an incentive to attract, recruit and retain the employees; to motivate the employees of the company with reward opportunities; to create a sense of ownership and provide the employees, with wealth creation opportunities, to achieve sustained growth of the company and align the interest of the employees and the company, etc.
Term of the scheme
This clause would provide from when and till when the ESOP plan would be effective. It may also be provided if and how this ESOP scheme can be extended.
This clause provides all the important definitions and interpretations, in relation to the ESOP. This can include ‘n’ number of definitions and interpretations. Some words and phrases which can be defined and explained are, the applicable laws; board of directors; employees; employee stock option; exercise; exercise period; grant; option; promoter; relative; vesting; vesting period; market price, etc
Equity shares subject to the ESOP scheme
This clause will specify in detail the quantum as well as the price of the equity share.
It must provide the maximum percentage of total shares which can be issued under the ESOP scheme. It may also provide that this maximum amount can be changed by the board of directors through the appropriate procedure (like a resolution).
Besides this, the clause must provide the face value of each equity shares issued under the scheme. It may also lay down that other terms and conditions in relation to these equity shares can be determined by the board of directors.
This clause will explain in detail, how an employee can be eligible to receive a grant or vested option. The criteria may be based on the number of years of continued service or fulfillment of certain performance goals etc. It can include seniority, length of service, merit and performance record of the employee, the future potential performance of the employee etc.
Grant of options
Grant refers to the process through which the company issues shares, options or other benefits under the employee stock option plan. The grant date is the date on which the compensation committee or any similar authority approves the grant.
This clause will specify how the employees fulfilling the criteria would be recognised and enlisted. It would also define the price at which the grant would be made and provide the method through which the price of the grant would be decided. For instance, it may provide, that in the ESOP, the price for the grant would be decided by the board of directors.
This clause should also specify the maximum amount of time, an employee gets to accept the grant. It may also specify that till the employee does not convert his/her option into a share, he/ she would have no rights in regards to it, including the right to get a dividend and/or vote in this respect etc.
Vesting of options
Vesting is the process by which an employee can apply for the shares of the company against the rights granted to him/her. Vesting period is the time period in which the employee can apply for the company’s shares against the option granted to him/her.
This clause must provide the maximum vesting period. It may also enable the directors or the compensation committee, or any other authority recognised for this purpose, to specify the lock-in period.
To understand this clause better, let’s look at an Illustration: The maximum vesting period would not be more than 1 year from the date of grant of option. Subject to this maximum period, the board of directors will have the freedom to decide the maximum vesting period for the equity shares issued in regards to this ESOP.
Option exercising plan and consideration
This clause would specify the exercise price and period. Exercise price refers to the commission paid by an employee who wishes to exercise his right to hold the shares of the company. The exercise period refers to the time period after vesting within which the employee must exercise his right to apply for the shares of the company and make all the required payments in this regard.
Illustration: This clause can specify that the exercise period would be two years from the date of vesting, and the exercise price and the method of payment would be determined by the board of directors/compensation committee etc.
If the company chooses to provide some sort of bridge financing to the employees for this purpose, it should also be mentioned in this clause.
The methodology of exercise of option
This clause would provide for the procedure for exercise of option. It would explain how the option can be exercised (whole or in part). It would also explain how the option would be exercised in case there is a separation between the employee and the company, like when the employment is terminated, or when the employee suffers disability or death etc.
Rights of an employee who owns the shares of the company under ESOP scheme
This clause would explain all the rights that an employee would have once he converts his option into the shares of the company. For instance, it may be stated that all equity shares allotted under this ESOP will be equal to all the other equity shares of the company which have been issued at that time, except with regards to transferability in certain cases. This clause would also explain in whose name the share will be issued.
Amendment and Termination of the ESOP scheme
This clause would specify who has the right to amend the ESOP and in what circumstances. For instance, it may be provided that the Board of Directors can amend, modify and alter the ESOP, as and when required after an ordinary resolution is passed.
This clause would also provide answers to questions like can the ESOP be terminated before its lapse date? how can it be terminated? who has the authority to terminate it? etc.
Dispute resolution and jurisdiction
This clause provides that the ESOP would allow issuance of shares only in accordance with the applicable laws, as well as the Memorandum of Association and Articles of Association of the company.
It would also provide how a dispute arising out of this ESOP would be resolved. It can be through a mediation/ arbitration/ litigation. This clause would also provide how the arbitrator/ mediator can be appointed.
The ESOP scheme is an essential legal documentary proof that rewards the employees for their creativity, efforts and performance while creating a feeling of trust, faithfulness and dedication in them. It motivates them to focus their efforts towards the betterment of the company, instead of focusing on their individual goals.
Thus, ESOPs are a really good tool which companies, especially startups can use to attract and retain talent. However, at the same time, it must be understood that investing in the company is a bet for the employees. For the ESOP to be successful, it is important that the employees are convinced about the growth of the company.
An ESOP must be detailed and informative. It should provide the terms and conditions, eligibility criteria, the price of shares, the rights of the employees, dispute resolution process etc. This is to ensure that the employees are able to make a wise decision and a knowledgeable bet while investing in the company.
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