Employee stock options: What startups should know

By Rajesh Begur, ARA LAW
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Employee stock option plans (ESOPs) are being widely used by both public companies and startups as a means of monetary compensation and to provide incentives for employees. While startups use employee stock options in order to attract talent on account of not being able to afford high salaries and to manage direct cost, publicly traded companies use such plans as a retention tool. The wealth creating potential of ESOPs has been highlighted by reports about how they have created millionaires of employees at Infosys and the likes of Flipkart.

Rajesh Begur is the managing partner of ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.
Rajesh Begur is the managing partner of ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.

Globally, companies adopt one or more of the following types of plans, depending on their business requirements and objectives: (a) employee stock option scheme (ESOS); (b) employee stock purchase plan; (c) restricted stock units; (d) stock appreciation rights; and (e) phantom stocks. In India, the most commonly used ESOP vehicle by private companies is the ESOS. Also, ESOP structuring can be done by setting up a trust based on commercial and tax considerations.

Statutory compliance: It is mandatory for every private company and public unlisted company that proposes to issue employee stock options to employees to have in place an ESOP scheme that is in consonance with section 62(b) of the Companies Act, 2013, read with rule 12 of the Companies (Share Capital and Debentures) Regulations, 2014 (ESOP Regulations). Prior to the ESOP Regulations, there was no legislation regulating issuance of ESOPs by private companies. Public listed companies, however, have been governed by the Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014.

Who is an eligible employee: The ESOP Regulations permit issuance of ESOPs to: (i) permanent employees who have been working in India or outside India; (ii) directors; and (iii) employees of subsidiaries, associate companies and holding companies. However, a director (directly or indirectly holding more than 10% of equity shares), an employee who is a “promoter” and consultants are excluded from definition of an employee to whom employee stock options can issued.

There has been a major concern around exclusion of promoters from the definition of employees under the ESOP Regulations, which has led to structuring promoter compensation by way of issuance of sweat equity, convertible preference shares, equity shares with lock-in provisions, etc. The startup community and the report of Companies Law Committee led by Tapan Ray have raised this issue, which is expected to be addressed in this budget session.

The Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, permit resident employees of foreign subsidiaries in India or Indian companies (in which a foreign corporation directly or indirectly holds equity) to acquire options from its foreign holding company, provided the options are issued under a cashless ESOS (without any remittance from India) and that the shares under the scheme are offered globally on a uniform basis.

Vesting schedule: The ESOP Regulations stipulate a minimum lock-in period of one year between grant of options and vesting. However, as a general practice most companies adopt a vesting period over four years, where options vest proportionately or otherwise over each year. Typically, vested options become exercisable on the occurrence of a liquidity event.

Exercise price: Vested options can be exercised at an exercise price which is usually at par for startup companies and at a discount to fair market value for slightly more mature companies. ESOP vehicles usually also stipulate the exercise period, i.e. the period during which the vested options can be exercised.

Transfer restriction: ESOPs usually impose transfer restrictions in line with the charter documents of companies on the shares that are issued upon the exercise of options. In certain cases, companies prefer to keep control over the vested shares. In such situations various mechanisms or structures can be devised to address this concern.

Conclusion

Startups and public listed companies consider ESOPs as a major incentive to motivate key employees, retain intellectual capital, attract new talent and create wealth for employees. Accordingly, it is important to structure an ESOP vehicle taking into account the commercial and tax implications on the company.

The startup community as well as the Companies Law Committee led by Tapan Ray in its report pressed for relaxations of the ESOP Regulations and ESOP taxation so as to allow flexibility in structuring of ESOPs and simplify the ESOP issuance process. It is hoped that the budget session will be productive in addressing these concerns.

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