This blog post is written by Shvena Neendoor and Edited by LAWYASA.
Start-up founders frequently ask questions, “Now must my Company adopt Employee Stock Option Plan (“ESOP”) or not?
We unequivocally say yes.
A properly implemented ESOP can be a potent instrument for boosting development, enhancing organizational performance, and generating wealth for both founders and employees.
The ESOP is a useful instrument for remuneration. A carefully crafted ESOP plan will assist an Employer in cash management while also allowing Employees to participate in the success and expansion of the Company.
So how do the ESOPs work, and what advantages and disadvantages do they present to employees? Let’s read ahead.
The word “ESOP” refers to a broad range of techniques and incentive programmes that are popular with the newly socially mobile salaried class and are intended to encourage, recognize, compensate, and retain high achievers.
Louis Kelso, a lawyer, and investment banker pioneered the concept in the 1950s. He suggested that if all workers could own assets that generate wealth, the capitalist system would be stronger. An ESOP scheme encourages employees to take part in corporate stock ownership. India has embraced ESOP in a way that was unthinkable a few years ago. Now, Income Tax, Company Law, and other corporate laws also include ESOP-related laws. After considering ongoing development in India and overseas, SEBI regulates the ESOP scheme vide SEBI (ESOS & ESPS) Guidelines which are updated from time to time.
ESOPs – What are they?
An ESOP is a right given to an employee to purchase Company stock at a predetermined price and future date, subject to the satisfaction of specific vesting requirements. These requirements could be time- or performance-based (on the part of the Employer or Employee). The ESOPs become the Employees upon satisfaction of the vesting requirement. Thus giving the Employee an unrestricted right to purchase stock in the Company at the predetermined price.
Section 2(37) of the companies Act, 2013 defines ‘Employee Stock Option’ (ESOP) as the “option given to the directors, officers or employees of a company or its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.”
An option given by a company to its employees to buy company shares at a set price is known as an Employee Stock Option Plan (ESOP). In general, employers award ESOPs to top performers as a means of rewarding them and cultivating a sense of loyalty to the company. ESOPs are currently prevalent among start-ups as well as large corporations. The key focus is that companies want to keep their employee around for a while yet cannot afford to pay them well in order to retain them.
While ESOPs were traditionally used to incentivize long-tenured senior executives, recent developments show that ESOPs are being actively employed as a recruiting tactic to attract talent. Employee remuneration has evolved with the times in the start-up ecosystem, moving beyond basic wage packages of monthly pay-outs. Companies have developed strategies like ESOPs for tying an employee’s additional incentive to the real business success of the company, thereby retaining the talent in the business.
ESOPs have many benefits, but what are they?
Depending on whether you are an employer, an existing shareholder, or an employee/ participant, the benefits and attractions of an ESOP are significant and diverse.
Benefits for Employees
- Wealth Creation: If an employee has been with the company for a long time and the company’s stock has appreciated during that time, an ESOP can provide significant investments and savings.
- Tax Benefit: Employees are not taxed on ESOP contributions or earnings until they receive income. Even so, “rollovers” into an IRA or other techniques of calculating income might actually reduce or postpone the tax effects of distribution.
- Sense of Ownership: Employees that become shareholders possess voting rights in the management of the company. They generally receive dividends on their shareholdings, which serves as an additional source of income while also providing them with a sense of ownership.
Benefits for Company
- Retain Talent: ESOPs are often used by companies to attract and retain quality talent. Making them stockholders is a useful technique to instil ownership and consequently improve performance in employees.
- Borrow Funds: The ESOP is the only qualifying employee benefit plan that can borrow funds under employer credit to acquire company stock. This feature allows companies flexibility that uses an ESOP as a tool of corporate finance.
- Raise new Capital/ Refinance a debt: Through leveraging with third-party lenders, an ESOP can be utilised to garner new equity, refinance outstanding debt, and so on. The contributions to an ESOP are entirely tax-deductible. Thus, an employer can use pre-tax resources to make both the principal and interest payments on such an ESOP’s debt service commitments. Dividends used to repay a loan may also be eligible for deduction.
Benefit for Shareholders
- Ready Market: When a majority or controlling shareholder is ready to retire, an ESOP provides an exit route. For a minority shareholder in a closely held company, an ESOP is frequently the sole market. It can also offer shareholders a ready market for some or all of their shares.
- Liquidity: ESOP allows a selling shareholder to obtain cash instead of incurring the possibility of a delayed payment agreement.
- Tax Benefits: A shareholder can sell stock to an ESOP and delay capital gains taxes by using the ESOP benefit rollover. Shareholders are also eligible for certain tax benefits which allow them to reinvest the revenues in other qualifying securities.
What is the Indian Sentiment on ESOPs?
Many Indian firms turned to creative strategies in 2021, such as offering freebies as well as other employee reward programmes, to retain talented employees. Also making a comeback was the conventional employee stock option plan (ESOP), which guarantees that workers have a stake in the outcome. Last year in 2021, Indian startup employees earned more than $335 million through ESOPs.
Flipkart announced the largest ESOP repurchase in 2021, at $125 million. Udaan, ShareChat, and PhonePe, accordingly, offered ESOP buybacks for $23 million, $19.1 million, and $17.7 million. Razorpay, Chalo, Khatabook, and Unacademy all announced $10 million ESOP repurchase schemes.
According to a Siason Capital report titled ‘The State of ESOPs In India – 2021,’ two out of every five firms still do not employ ESOPs. While ESOPs are more prevalent in the Indian startup environment than in the Southeast Asian area, the survey found that underfunded startups lack the clarity of ESOPs.
The year 2022 won’t be any different. Employee stock option buybacks from Indian startups have already totalled $159 million this year. PhonePe, ShareChat, Wakefit and Licious, have lately granted ESOPs to all of their staff members. The ESOPs have been given to the back office, production, on-the-ground sales workers, and administrative staff, as a way to share the success of the company with them and keep employees motivated.
Here is a list of top 10 companies which have accounted for largest ESOP Buyback in 2022:
Given the fierce talent wars and the fact that companies now recognise the value and necessity of a good employee. India continues to experience a frenzy over startups offering ESOPs and the subsequent buyback.
What are the steps for creating an ESOP?
If your start-up is incorporated in India, the following steps must be taken:
First step: To have an ESOP scheme designed by a specialist. This document contains legal clauses that govern ESOP administration, vesting, grants, pool size employee termination, exercise period, and so on.
Second Step: Board approval for the adoption of the ESOP scheme. The shareholder’s approval must also be obtained through a special resolution at the EGM. (favourable votes must be three times the non-favourable ones)
Third Step: EGM resolution and Board resolution are to be filed with the ROC online under the MGT14 form.
Fourth Step: Grant letters to employees issuing ESOPs.
Including ESOPs in the recruiting and retention strategy gives a company a competitive advantage. It also helps them generate an inspired and motivated team. In India, ESOPs are primarily utilized to inspire employees to give their best. This in turn allows the firm to experience lower employee turnover and maintain its talent pool. These two purposes likely account for more than two-thirds of all ESOPs in existence, and their numbers are predicted to grow over time.
An Analytical Study of Employee Stock Option Scheme of Leading Indian Companies. International Journal of Commerce and Management Studies, [online] 4(1). <https://www.ijcams.com/wp-content/uploads/2019/03/An-Analytical-Study-of-Employee-Stock-Option-Scheme-.pdf> [Accessed 13th July 2022]. ↑
New Regulations for ESOPs will aid in Good Governance < https://www.livemint.com/money/personal-finance/new-regulations-for-esops-will-aid-good-governance-11632855544122.html> [Accessed 3 July 2022]. ↑
The Companies Act, 2013 <https://www.mca.gov.in/Ministry/pdf/CompaniesAct2013.pdf> [Accessed on 15th July 2022] ↑
Stock Option!: How Indian startups are using ESOPs in talent war < https://www.peoplematters.in/article/benefits-and-rewards/stock-option-how-indian-startups-are-using-esops-in-talent-war-33447> [Accessed on 10th July 2022] ↑
What are Esops and what do they mean for employees and employers? https://economictimes.indiatimes.com/tech/tech-bytes/ettech-explainer-what-are-esops-and-what-do-they-mean-for-employees-and-employers/articleshow/91915258.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst [Accessed on 5th July 2022] ↑
ESOPs: The Basics and the Benefits < https://mercercapital.com/article/esops-the-basics-and-the-benefits/> [Accessed on 5th July 2022] ↑
What Is an ESOP? (With Advantages, Disadvantages, and Types) < https://ca.indeed.com/career-advice/career-development/what-is-esop> [Accessed on 8th July 2022] ↑
ESOP Benefits < https://sesesop.com/esop-knowledge-center/esop-benefits/> [Accessed on 5th July 2022] ↑
ESOPs Gaining Traction Among Indian Startups, But Lack Of Awareness A Hurdle In Widespread Adoption < https://inc42.com/buzz/esops-gaining-traction-among-indian-startups-but-lack-of-awareness-a-hurdle-in-widespread-adoption/> [Accessed on 4th July 2022] ↑
THE STATE OF ESOPS – Saison Capital < https://www.saisoncapital.com/state-of-esops-india> [Accessed on 11th July 2022] ↑
Indian Startup Employees Have Made Over $159 Mn Through ESOP Buybacks In 2022 < https://inc42.com/buzz/esops-galore-indian-startup-employees-have-made-over-159-mn-through-buybacks-in-2022/> [Accessed on 3rd July, 2022] ↑
ESOP Guide For Start-Ups < https://taxguru.in/income-tax/esop-guide-start-ups.html> [Accessed on 11th July 2022] ↑