Employment LawFrom Founders to Team: ESOPs as a Catalyst for Start-Up Growth in India

INTRODUCTION

Employee Stock Ownership Plan (hereinafter referred to as “ESOP”) is a plan to benefit the employees and incentivize them to buy the ownership or stocks of the company. Under this plan, the employer offers qualifying workers the opportunity to purchase company stock at a significantly discounted price. These stocks are kept in the ESOP trust fund until the employee exercises their option to buy them.

ESOPs are primarily governed by the Companies Act, 2013 (hereinafter referred to as “Companies Act”) and the Companies (Share Capital and Debenture) Rules, 2014 (hereinafter referred to as “Companies Rules”). For listed companies, the ESOP guidelines must adhere to the Securities and Exchange Board of India Regulations (hereinafter referred  to as “SEBI Regulations”).

The objective is to increase the share value and performance of the company and give financial rewards to the workers. Through the alignment of employee interests with those of the company, ESOPs seek to increase shareholder value, foster creativity, and foster a sense of dedication and loyalty among team members.

Thus, ESOPs in start-ups can be extremely helpful in creating a collaborative, performance-driven work culture where each team member has a personal stake in the company’s objectives. This sense of ownership has the potential to greatly improve productivity, employee engagement, and organisational resilience in general.

ELIGIBILITY CRITERIA AND ISSUE OF ESOPs

Section 2 (37) of the Companies Act defines ESOP as the option given to the officers, directors, or employees of a company or the holding or subsidiaries of the company, which grants them the right to buy or subscribe to the company’s shares at a pre-decided price on a future date.

The Employees who are eligible for ESOP include:

1. An employee is working exclusively in India or outside India as designated by the company. However, as specified in notification number GSR 180(E) dated February 17, 2016, issued by the Government of India Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, in the case of start-ups, this condition shall not apply up to five years from the date of its incorporation or registration.
2. An employee as defined by sub-clauses above of a group company, including a subsidiary or its associate company, in India or abroad, or of a holding company of the company; however, an employee who is a promoter or a member of the promoter group is not included.

Participation in ESOPs is prohibited for any employee or director who is a member of the promoter or promoter group. According to Rule 12(1) of the Companies Rules, the following employees are eligible to receive an ESOP:

1. A long-term worker for the company who is based in India or elsewhere.
2. A director of the corporation, not an independent director, but one who serves full- or part-time.
3. A director or permanent employee of a holding company, associate company, or subsidiary business located in or outside of India.

Additionally, ESOPs cannot be granted by a firm to the following workers:

1. An employee who either represents the firm or is a member of the promoter group.
2. A director who, directly or indirectly, owns more than 10 per cent of the outstanding equity shares of the company through himself, any body-corporate, or a relative.

Nevertheless, Start-up Companies are exempt from the aforementioned two requirements for ten years following the date of incorporation.

The issue of ESOP is governed by Rule 12 of the Companies Rules and Section 62(1) (b) of the Companies Act. The process under the Securities and Exchange Board of India’s Employee Stock Option Scheme Guidelines for listed businesses is comparable to the process for issuing ESOPs under the Rules.

The steps involved in the  issuance  of ESOP include assembling the ESOP draft in compliance with the Companies Act . Then the draft resolution is prepared which is to be passed at the board meeting as well as the notice for the meeting is made.

Within fifteen days following the board meeting’s conclusion, the draft minutes are given to each director and MGT-14 FORM is filed with the Registrar of Companies. Thereafter, a minimum of twenty-one days prior to the meeting date, all the company’s directors, auditors, shareholders, and secretarial auditors of the general meeting are notified. At the general meeting, the special resolution authorising the company’s officers, directors, and employees to receive shares under the ESOP has to be approved and only then within a period of thirty days the accompanying documents are filed with the Registrar of Companies.

THRESHOLD REQUIREMENTS FOR ESOPs

There are no set minimum or maximum limits on the number of ESOPs or employees who can participate in ESOPs under the Companies Act of India. Because of this flexibility, businesses, including start-ups, can create ESOP plans that are unique to their requirements.

If a director owns more than 10% of the outstanding equity shares of the company, either directly or indirectly through himself, his relative, or any other corporate entity, they will not be eligible for ESOPs. Therefore, if a director’s holding does not go above this limit, they may be awarded ESOPs. It must however be ensured, that his holding on shares allotted under ESOPs does not go beyond 10% of the company’s paid-up capital.

Currently, there is a relaxation for certain qualified start-ups concerning the issuance of ESOPs to their promoters and directors. This allows the start-up company to award grants to directors who own more than 10% of the company’s capital.

Moreover, usually, no employee may get options worth more than 1% of the company’s issued capital. A company needs the special resolution of the shareholders at a general meeting in order to surpass these specified limits.

It must be noted that the exercise of an option by a qualified employee won’t be regarded as trading. The sale of shares obtained as a result of exercising ESOP shall be regarded as a trade in the open market. Only shares acquired through the ESOP exercise may be sold by designated persons, provided that they haven’t purchased any Company shares before the six-month period after the date of the sale. Shares held by designated individuals are not transferable after the trading window closes.

In the event that a listed issuer uses an ESOP to issue and distribute shares to qualified employees, and the ESOP plan is carried out through a trust and involves the purchase of shares from the secondary market, the company may only purchase shares up to 2% of its paid-up capital during a given financial year.

EMPLOYEE PERSPECTIVE ON ESOPs

ESOPs are fruitful for attracting fresh talent and enhancing productivity. They foster a sense of ownership among employees, which not only improves their loyalty but also boosts motivation and performance in their respective roles. Thus, ESOPs result in employee retention, and establishing a long-lasting relationship between the company and its workforce.

Employees gain job security, satisfaction, and opportunities for wealth creation, through means of ESOPs in start-ups. Start-ups can attract and retain bright workers, increase productivity, and draw in new hires by providing ESOPs, particularly in the early stages when paying high salaries might not be possible. The vesting period also encourages employees to stay with the start-up which facilitates long-term commitment of the employees. ESOP also aligns the employee’s interest with that of the employer thus, fostering the growth and success of the start-up.

A low exercise price is advantageous because of the ESOP’s tax structure. Certain companies choose to use the vesting price as the base price. Every ESOP is subject to different forms of taxation: capital gains tax on the sale of the shares when the shares are exercised. The difference between the exercise price and fair market value is considered taxable at the time of exercise. Taxes are levied on the difference between the sale proceeds and the item’s fair market value at the time of sale.

Some businesses may provide limited stocks, equity, and direct purchase programmes in addition to ESOPs. The employees evaluate these factors to determine what is beneficial and which alternative is best suited for them.

PRACTICAL IMPLICATIONS FOR START-UPs AVAILING ESOPs

Any start-up should take into account a number of crucial factors when dealing with ESOPs. First and foremost, it’s necessary to design a workable and manageable stock option structure. This could mean creating a start-up funded Employee Stock Option Trust to assist in managing and distributing the stock options. Second, complying with the foreign exchange management laws is necessary, particularly in cases when Indian employees can access an ESOP that was created by a foreign parent business.

Thirdly, in compliance with Indian Generally Accepted Accounting Principles (hereinafter referred to as “GAAP”), including the Guidance Note on Employee Share-Based Payments, all expenses associated with the ESOP should be appropriately recorded on the earnings statement each year. By doing so, openness and compliance with the financial reporting guidelines are guaranteed. Finally, it’s critical to inform the employees about the stock option plan and help them navigate it. Because their interests are paramount, employees need to be aware of the terms, circumstances, and implications of the ESOP. Several giants of the market have achieved success by ensuring compliance with such requirements in the real world when they were in their start-up phase.

One of the top e-commerce companies in India, Flipkart, has made ESOPs a crucial part of its strategy for employee retention and remuneration. Through the ESOP programme, employees have been able to participate in the growth and success of Flipkart, thereby aligning their interests with the company’s long-term goals.

Likewise, Zomato’s workforce now actively participates in advancing the firm’s goal and vision subsequent to ESOPs, which have allowed the company to cultivate a culture of ownership and dedication among its workers. The top digital payments and financial services platform in India, Paytm, has also made ESOPs a crucial part of its strategy for employee retention and remuneration. Through the company’s ESOP programme, staff members may now take part in and contribute to Paytm’s success.

AMLEGALS REMARKS

ESOPs have thus proven to be  a powerful instrument for Indian businesses. Positively, in a competitive market environment, ESOPs are effective tools for drawing in and keeping top people. ESOPs help firms save money by providing staff with incentives based on possible future profits, which encourages more effective use of resources.

However, ESOPs can diminish the holdings of current shareholders and complicate capital structure management, especially for startups with limited funding, their implementation demands careful planning. Thus, distribution plans are essential to optimize ESOP benefits. Startups need to create fair and open plans that meet employee expectations as well as organizational objectives. This could entail creating equitable price structures, defining precise eligibility requirements, and putting in place vesting and exercise schedules that strike a balance between employee incentives and business goals.

– Team AMLEGALS assisted by Ms. Akanksha Yadav (Intern)