ESOP Under Companies Act 2013: What Founders Need to Know
What is ESOP?
Before we look at ESOPs under Companies Act, 2013 let’s first understand the meaning of ESOPs. Employee Stock Option Plans, or ESOPs, incentivize employees for performance. Many firms use ESOPs as a retention strategy to retain employees in the long term. When a company awards an ESOP to an employee, they get a ‘right to purchase’ shares in the company at a predetermined price. This right is usually subject to certain conditions.
A critical difference between issuing stocks and issuing ESOPs is that the stockholder becomes a startup owner when startups issue stocks to investors. However, in the case of ESOPs, employees get a “right” to become an owner in the future, subject to certain conditions. ESOPs are also called Employee Stock Ownership Plans.
Since stocks or shares can be issued only by companies, only companies can issue ESOPs. This article will examine ESOPs under Companies Act 2013, specifically focusing on ESOP for private limited companies.
The ESOP Scene in India
ESOPs have acquired prominence because of the boom in several private companies debuting with IPOs and employee benefit programs. Statistics show that in 2021 alone, investors invested $36 billion in new startups in India, with 35 non-founder senior management entering the Rs 100-crore stock options club.
eCom company Flipkart has acquired the top position, generating India’s largest ESOP pool worth a mindboggling Rs 17,000 crore. And that’s not all: the company also made waves with its Rs 600-crore buyback. Close behind is ShareChat, which announced an ESOP pool of Rs 462 crore.
ESOP Issue Under Companies Act – To Whom?
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
In most companies, the issue of such ESOPs is governed by the Employee Stock Option Scheme (ESOS).
Key Terms in ESOPs
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.
As the name suggests, ESOPs are available only for employees. Promoters, consultants, advisors, freelancers, and contractual employees do not qualify for ESOPs.
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 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.
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.
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.
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.
The strike price (also called the exercise price) is the rate employees can purchase the stock options granted to them.
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.
How Do ESOPs under Companies Act Work?
The procedure for issue of ESOPs under Companies Act broadly covers the following steps:
Step 1 – 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.
Step 2 – 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.
Step 3 – 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.
Step 4 – 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.
Ram is an employee of ABC Limited. Ram gets promoted to General Manager on 1st January 2020 and becomes eligible for 500 options on the date of promotion. These shares vest equally over five years. Ram can exercise his options any time after three years of promotion. The exercise price is Rs.100 per share. According to the employee stock option scheme, Ram can sell his shares to other existing shareholders upon exercise.
In this illustration, the grant date is the date of promotion – i.e., 1st January 2020
The vesting of his shares is equal over five years. Therefore, his total vested shares will be:
- 1st January 2021: 100 shares
- 1st January 2022: 200 shares
- 1st January 2023: 300 shares
- 1st January 2024: 400 shares
- 1st January 2025: 500 shares
Let’s assume Ram exercises 300 shares on 1st January 2023.
Ram is not a shareholder to this date, and he only has the right to become a shareholder (subject to the vesting schedule). On 1st January 2023, Ram will pay the company Rs.30,000 (i.e. 300 vested shares at Rs.100 per share). The company will allot 300 shares to Ram.
Let’s assume that the company’s current valuation is Rs.750 per share. Ram decides to exit partially and sell 150 shares to another shareholder at Rs.600 per share.
This proposition attracts Ram because he can cash in on his options. The other shareholder is also interested in this deal because he is getting shares at a price lower than the market value.
On this day, Ram sells 150 shares for Rs. 90,000. He makes a profit of Rs.60,000 (i.e., the excess of the sale price over the cost of acquiring the shares).
Statutory Requirements For ESOPs under Companies Act, 2013
Section 62(1)(b) of the Act governs the issue of ESOPs to employees. ESOPs can be issued when the company passes a special resolution, and the employee fulfils the terms and conditions associated with the ESOP.
Section 2(37) defines employee stock options as options given to a company’s directors, officers, or employees. The law is vague on how to treat employee benefit schemes such as Stock Appreciation Rights (SAR) or Phantom Stock. In the case of SARs and Phantom Stock, real shares or stocks are not issued, and the employees only benefit from the increase in the value of the underlying shares. So, these benefits are akin to a stock-linked bonus settled in cash.
Rule 12 of the Companies (Share Capital and Debenture) Rules, 2014 lays out the following requirements:
The shareholders shall approve the ESOP scheme by passing a separate resolution. This resolution should be accompanied by an explanatory statement, which should contain the following:
- Number of stock options to be granted
- Manner of identification of the employee
- Vesting requirements
- Lock-in period, if any
- Valuation methodology
- Conditions for lapse of the options (i.e. reverse vesting)
A statement that the company will comply with the relevant accounting standards.
- Options granted cannot be transferred, pledged, hypothecated or mortgaged.
- Modification of the scheme is valid only by passing a special resolution, and such modification should not be detrimental to the existing option holders.
- A minimum lock in one year is required between grand and vesting.
- Employees will not be eligible for dividends or voting rights until they exercise their options.
- The options shall be transferred to their legal heir in case of the employee’s death.
- In case of permanent incapacitation during employment, all the options shall immediately vest on the date of such incapacitation.
- All companies issuing options shall maintain a register of employee stock options at the company’s registered office.
- The board’s report under Section 134 of the Act mandates certain disclosures in the Board report (discussed later in this article)
Specific Requirements for a Listed Company
In addition to requirements for ESOP under Companies Act, 2013, listed companies are required to follow the SEBI (Share Based Employees Benefits) Regulations, 2014. The summary of these requirements is as follows:
- The ESOP scheme can be implemented directly by the company or a trust (known as the ESOP trust).
- The company shall transfer the option pool to the trust and provide financial assistance to the trust.
- All listed companies are required to have a compensation committee. This committee would determine the eligibility of the employees and the terms and conditions associated with the options.
Guidelines for ESOP under Companies Act 2013 requires the Board of Directors to disclose the following in the company’s directors report:
- Number of options granted, vested, exercised and lapsed,
- The total number of shares arising as a result of the exercise of options
- the exercise price of the option
- variation of terms of options, if any
- money realized by exercise of options
- total number of options in force, and
- employee-wise details of options granted to the key managerial personnel, any other employees and identified employees.
In conclusion, employee stock options can be a valuable benefit for both employers and employees. They can incentivize employees to work harder and contribute more to the company’s success while offering employees the opportunity to share. However, it is essential for both parties to fully understand the potential risks and rewards involved with stock options. Employers should consider the impact on their financials and have a solid plan for communicating and administering the options.