Employee stock option plans ("ESOP(s)") provide an opportunity to reward employees who are recognized performers for the growth of an enterprise, by incentivizing them with an equity stake or a cash payout based on an equity stake. Employee stock options, often being a part of the overall remuneration package, also work as an efficient tool to provide motivation for long-term commitments from employees to whom they are awarded, thereby making them an integral part of the growth narrative of a successful enterprise.
In this article, we give an overview of the regulatory landscape and the types of ESOPs which may be considered. However, by way of a caveat, this article does not address the accounting or taxation aspects concerning ESOPs.
2. DEFINITIONS OF "EMPLOYEE STOCK OPTION" AND "SWEAT EQUITY SHARES"
The definition of "employees stock option" was originally introduced in the Companies Act, 1956, which defined the term as "the option given to the whole-time directors, officers or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price". This definition underwent a change in the Companies Act, 2013 (the "2013 Act"), to include within its ambit, securities offered by the holding company or subsidiary companies of the company issuing such employee stock options.
The definition of "sweat equity shares" was originally introduced in the Companies Act, 1956, which defined the term as "equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called". This definition was retained in the 2013 Act.
3. REGULATORY LANDSCAPE
ESOPs can be by way of the issuance and allotment of shares (a) for cash, based on the fair market value of the shares, (b) for cash on a concessional basis, or (c) on a cashless basis. We have briefly addressed below the relevant provisions under the 2013 Act and the Companies (Share Capital and Debentures) Rules, 2014 (the "Share Capital and Debenture Rules"), as applicable to ESOPs on a for-cash basis, and on a cashless basis in the form of sweat equity.
3.1. Employee stock options
The 2013 Act incorporated an enabling provision for the issuance of employee stock options, subject to certain prerequisites, such as the passing of a special resolution by the shareholders of the company and compliance with the relevant rules under the Share Capital and Debenture Rules (in case of unlisted companies), and SEBI (Share Based Employee Benefits) Regulations, 2014 (the "SEBI (SBEB) Regulations") (in case of listed companies). Hence, any issuance of employee stock options by an unlisted company would have to be in accordance with the 2013 Act read with Rule 12 of the Share Capital and Debenture Rules.
The 2013 Act requires an employees' stock option scheme (the "ESOP Scheme") to be adopted only pursuant to a special resolution passed by the shareholders of the company. However, in 2015, the said requirement was relaxed for private companies by allowing them to pass only an ordinary resolution for adopting an ESOP Scheme.1 Since Rule 12 of the Share Capital and Debenture Rules has not yet been modified to reflect the relaxation provided to private companies, and continues to mandate a special resolution to be passed by the shareholders for the adoption of an ESOP Scheme, it would be prudent for the shareholders of a private company to pass a special resolution for the said purpose.
Rule 12 of Share Capital and Debenture Rules ("Rule 12"):
Rule 12 lays down the specific requirements for the issuance of employee stock options by an unlisted company. The rule defines an "employee" as (a) a permanent employee of the company who has been working in India or outside India; or (b) a director of the company, whether a whole time director or not; or (c) an employee or a director as defined in sub-clauses (a) or (b) above of a subsidiary, in India or outside India, or of a holding company of the company. The abovementioned definition of "employee", specifically excludes (i) an independent director, (ii) a promoter or a person belonging to the promoter group; and (iii) a director, who either himself or through his relative or through a body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.
In a move to provide much-required impetus to start-ups to incentivize their employees, recent amendments to Rule 12 have permitted a start-up company2 to issue employee stock options to the persons mentioned in (ii) and (iii) above, for a period of up to 10 years from the date of its incorporation or registration.
Rule 12 provides for various administrative compliances such as the maintenance of registers, and disclosures required in (i) the explanatory statement annexed to the notice for passing of the resolution by shareholders for adoption of the ESOP Scheme, and (ii) the directors' reports. It also gives unlisted companies granting employee stock options pursuant to an ESOP Scheme, the freedom to determine the exercise price of these options in conformity with applicable accounting policies. Further, Rule 12 also requires approval of the shareholders by way of a separate resolution, in case of (a) the grant of options to employees of a subsidiary or holding company, or (b) the grant of options equal to or in excess of 1% of the issued capital (excluding outstanding warrants and conversions) to any employee, in a given year. While flexibility has been built into the said rule for varying the terms of the ESOP Scheme, through a special resolution, for options not yet exercised by employees, such variation should not be prejudicial to the interest of the existing option holders. The rule also mandates a minimum period of 1 year for the vesting of any employee stock option which has been granted to an employee.
Rule 12 also places fetters on employees holding options by not allowing an employee to transfer, pledge, hypothecate, mortgage or otherwise encumber any employee stock options granted to them, thereby treating options as a right exercisable only by the concerned employee. Having said that, Rule 12 also clarifies how the vesting and exercise of options would work in case of death or permanent incapacity of an employee while in employment, or in case of resignation by or termination of the employment of such employee. It is pertinent to note here that the only scenario where the rule permits exercise of options by a person other than the employee, is in case of the death of such employee, wherein his/her legal heirs or nominees are permitted to exercise the options. While there appears to have been a very noticeable application of the legislative mind to address ESOP Schemes, we wonder whether employees may have been better served by allowing a transfer post exercise, subject to any restrictions the granting company may see fit to impose.
3.2. Sweat equity
The issuance of sweat equity is governed by the 2013 Act read with (i) the provisions of the SEBI (SBEB) Regulations for listed public companies, and (ii) Rule 8 of the Share Capital and Debenture Rules for unlisted companies. Hence, any issuance of sweat equity by an unlisted company would have to be in accordance with the 2013 Act read with Rule 8 of the Share Capital and Debenture Rules.
The 2013 Act:
The Act provides that a company may issue sweat equity shares of a class of shares already issued if the following conditions are fulfilled:
- the issue of sweat equity shares is authorised by a special resolution passed by the shareholders of the company in a general meeting;
- the resolution specifies the number of shares, current market price, consideration, if any, and the class or classes of directors or employees to whom such equity shares are to be issued;
- the sweat equity shares of a company, whose equity shares are listed on a recognised stock exchange, should be issued in accordance with the regulations made by the Securities and Exchange Board of India in this respect, i.e., the SEBI (SBEB) Regulations. In the case of a company whose equity shares are not listed on any recognised stock exchange, the sweat equity shares are to be issued in accordance with Rule 8 of the Share Capital and Debenture Rules; and
- the rights, limitations, restrictions and provisions which are applicable to equity shares shall be applicable to sweat equity shares as well, and holders of such shares shall rank pari passu, i.e., on equal footing, with the other equity shareholders of the company.
Rule 8 of the Share Capital and Debenture Rules ("Rule 8"):
Rule 8 defines an "employee" as (a) a permanent employee of the company working in India or out of India; or (b) a director of the company, whether a whole time director or not; or (c) an employee or a director as defined in sub-clauses (a) and (b) above of a subsidiary, in India or outside India, or of a holding company of the company. Further, pursuant to recent amendments made to the Share Capital and Debenture Rules, Rule 8 also permits a start-up company3 to issue sweat equity shares not exceeding 50% of its paid-up capital, up to 10 years from the date of its incorporation or registration.
Rule 8 mandates that the approval of shareholders, by way of a special resolution, is required for the issuance of sweat equity shares at a discount or for consideration other than cash, to its directors or employees for providing know-how or making available rights in the nature of intellectual property or value additions, by whatever name called. The rule also prescribes that a company shall not, in a year, issue sweat equity shares for more than 15% of its total paid-up equity share capital or shares of the issue value of INR 5 crores (approximately USD 668,000) or more, whichever is higher, provided that the issuance of sweat equity shares in the company should not exceed 25% of its total paid-up equity share capital at any time.
Rule 8 also provides for various administrative compliances such as the maintenance of registers, disclosures required in directors' reports and the accounting treatment of sweat equity plans. In addition, Rule 8 mandates that the price of sweat equity shares to be issued to employees and directors shall be at a fair price determined by a registered valuer giving justification for such valuation. This rule contains elaborate provisions with respect to valuation, and requires sweat equity shares issued to employees or directors to be locked in for a period of 3 years from the date of allotment.
3.3. Analogy between Rule 8 (sweat equity) and Rule 12 (employee stock options) of the Share Capital and Debenture Rules
(i) Definition of "employee"
Drawing an analogy between the definitions of "employee" prevalent under Rule 8 (with respect to sweat equity) and Rule 12 (with respect to employee stock options), it is clear that employee stock options are not allowed to be issued to (i) independent directors, and (ii) promoters and persons being part of the promoter group. Sweat equity, on the other hand, does not exclude such class of persons, and hence, may be issued to independent directors and promoters. Further, employee stock options also provide for a threshold-based exclusion, i.e., if a director holds 10% or more shares prior to the issuance of employee stock options, he would be precluded from being issued additional employee stock options as he would not be considered an employee to whom the issuance is possible.
(ii) Lock-in requirement
Rule 8 specifically mandates that sweat equity shares issued to directors or employees shall be locked in and non-transferable for period of 3 years from the date of allotment of such shares. Further, the said rule also requires, in a prominent manner on the share certificate, the mention of the fact that the share certificates are under lock-in and of the period of expiry of the lock-in. However, such a lock-in requirement is not prevalent under Rule 12 concerning employee stock options, and the company is permitted to specify a lock-in period for the shares issued pursuant to the exercise of an option by the employee, as commercially decided by the company issuing the employee stock options.
(iii) Cap on issuances
Rule 8 permits the issuance of sweat equity shares only up to a maximum of (a) 15% of the total paid-up equity capital of the company in a year, or the issue value of INR 5 crores (i.e., approximately USD 668,000 at the prevailing exchange rate), whichever is higher; and (b) 25% of the total paid-up equity capital of the company, at any time. There are no such caps which are prevalent under Rule 12 with respect to the issuance of employee stock options. However, Rule 12 mandates a separate resolution from the shareholders of the company if, during any given year, options equal to or more than 1% of the issued capital (excluding outstanding warrants and conversions) are proposed to be granted by the company to any employee.
3.4. Provision of money by company for purchase of its own shares by employees or by trustees
The 2013 Act states that no public company4 shall provide, whether directly or indirectly, any financial assistance for the purchase of shares in itself or in its holding company. However, the 2013 Act does permit, as an exception to the previously stated rule, a company to provide financial assistance, pursuant to an ESOP Scheme (approved through a special resolution), to the following:
- trustees of an ESOP trust, for purchase or subscription of shares held by the trustees (for the benefit of the employees), or such shares held by the employees of the company; and
- employees of the company, other than its directors or key managerial personnel5, up to an amount not exceeding their salary or wages for a period of 6 months, to enable them to purchase or subscribe to fully paid-up shares in the company or its holding company, to be held by them by way of beneficial ownership.
These are important exceptions utilized by many companies in the implementation of their ESOPs. Since these exceptions (enshrined in sub-sections (2) and (3) of Section 67 of the 2013 Act) are applicable only to public companies (and a private company which is a subsidiary of a public company), all private companies are allowed as well, to provide financial assistance to trustees of an ESOP trust or its employees, as set out hereinabove. Further, an amendment by way of a notification was also introduced to clarify that sub-sections (1), (4) and (5) of Section 67 of the 2013 Act were not applicable to private companies which met certain conditions.6
It is also pertinent to note that the abovementioned exceptions are subject to certain other conditions prescribed under Rule 16 of the Share Capital and Debenture Rules.7
3.5. Other legislations
The Indian Contract Act, 1872 and trust-related legislations (including the Indian Trusts Act, 1882) are other important legislations that have an impact on ESOPs, particularly in the context of plans which are not on a sweat equity basis.
Income tax and foreign exchange laws, rules and regulations are also important to assess the formulation, structuring, and implementation of ESOPs. Stamp duty implications, which arise upon every share transfer, should also be considered at the time of formulating and structuring an ESOP.
4. TYPES OF ESOP
In our experience, there is no uniformity with respect to an ESOP structure, or whether they will be on a for-cash or sweat equity basis. However, we have noticed that Indian companies normally choose to either go down the route of directly implementing stock option plans, or through the route of ESOP trusts. We have also noticed that stock option plans usually have a vesting period of between 4 and 6 years, and the grants are yearly in most cases. We summarise below the various types of ESOPs that we have come across in India.
(i) Employee Stock Option Scheme:
An ESOP Scheme is a plan under which a right is given to employees covered by the plan to buy shares at a pre-determined price. The options granted under such a plan confer a right, but not an obligation, on the employee to exercise the options. Stock options are subject to vesting conditions that normally require continuous employment over a specified period. Upon vesting of options, employees can exercise the options to get shares in the company, by paying the pre-determined exercise price. Companies often provide loans to employees for this purpose. In this kind of ESOP, the employee, upon exercise, becomes a shareholder of the company.
(ii) Employee Stock Purchase Plan:
An employee stock purchase plan allows employees to purchase shares directly from the company. The purchase is normally at a price which is at a discount to the fair market value at the time of the grant or exercise. Such plans set out the conditions, date and price at which the employee is entitled to purchase the shares. In this kind of ESOP, the employee, upon purchase of the shares, becomes a shareholder of the company. We have observed that, at times, companies also give loans to employees to purchase shares pursuant to employee stock purchase plans.
(iii) Restricted Stock Award:
In a restricted stock award plan, an employee receives an award of a certain number of shares, subject to certain conditions with respect to the award. Normally, in such plans, the employee is considered the owner of the shares from the date of the award, with an entitlement to receive dividends and voting rights. If the conditions underlying the award are not met, the shares are forfeited. The shares may not actually be transferred to the employee until the conditions are met. Such awards are normally administered through a trust structure. The conditions for such awards normally include continued employment over a period of time, and may also be subject to performance parameters (depending upon the level of the employee covered by the ESOP). Such plans are formulated both on a sweat issue basis, as well as a cash exercise basis. Payment, in plans that require them, may be at a discount, or at the fair market value (for which the awarding company may either directly, or through a trust established for the ESOP, advance loans). In this kind of ESOP, the employee is treated as a shareholder of the company from the time of the award.
(iv) Restricted Stock Unit:
In a restricted stock unit kind of ESOP, the plan normally provides that an employee is awarded an entitlement to receive shares at some specified date in the future, subject to certain conditions being met. Like the other kinds of ESOP, the conditions under such a plan include continued employment over a period of time, and may also be subject to performance parameters. Unlike a restricted stock award plan, the employee is not considered to be a shareholder until the shares are actually issued to the employee, and the employee normally does not have voting rights or rights to receive dividends. It is not uncommon for a restricted stock unit plan to provide for the payment of some form of dividends to employees, to foster a sense of ownership. Such plans are also implemented both on a sweat issue basis, as well as a cash exercise basis. In this kind of ESOP, the employee becomes a shareholder of the company, but only upon meeting the set conditions and the arrival of a previously specified date.
(v) Phantom Equity Plan / Stock Appreciation Rights:
In a plan that is modelled as a phantom equity plan or a stock appreciation rights plan, employees are allotted notional units or shares at a pre-determined price. The strike price is not actually paid but is recorded as the strike price on the date of the grant. Upon the completion of vesting conditions (which, just like the other plans, could involve both time and performance parameters), the employee is paid the cash equivalent of the net gain, if any, i.e., appreciation in the price of the underlying shares without any cash investment. Some plans also include the payment of a "quasi-dividend" during the period of the plan. These plans have the significant advantage of fostering a shared sense of purpose in employees, without changing the cap table of the company, or resulting in employees becoming shareholders of the company at any point in time. However, these plans do require the outflow of cash from the company consequent to the terms of the ESOP.
5. POINTS TO PONDER
We have noticed that the primary drivers for choosing the structure of ESOPs are tax and accounting aspects, with structure and administration being the next important consideration. Another important aspect to consider is whether the implementation of the ESOP would change the capital structure of the company. In this regard, we have noticed a significant preference for ESOPs which are structured as phantom equity plans or stock appreciation rights.
If the choice of a plan results in the employees becoming shareholders of the company, promoters may consider the implementation of such plans through trusts. The implementation of such plans through trusts enables the control of voting rights on such shares (through trustees of such trusts), at least until the final point at which employees become shareholders in the records of the company. ESOP trusts work in conjunction with the compensation committee of the company to administer the plan. The terms of the grant, vesting period, and decisions with respect to the plan are taken by the compensation committee and administered by the ESOP trust.
At the formulation stage, we have noticed that plans tend to neglect or fail to consider fully the consequences of capital restructurings (including rights and bonus issues, splits, and consolidations), as well as merger events. Administration of ESOPs through trust structures, where the ESOP trust actually holds the shares of the company, prompts the consideration and resolution of such issues, in case they have not been previously addressed.
While ESOPs, and their various types, as set forth above, are an attractive means to motivate, incentivize and retain employees, one must weigh the types of plans and their pros and cons before deciding on an ESOP ideal for the company. Some plans require liquidity in the form of direct cash outflow from the company with no participation in equity to the employees, while others offer direct participation in equity for the employees without requiring an outlay of cash. Hence, the interests of all stakeholders concerned must be weighed against each type of ESOP, before finalizing the one which is best suited for the specific needs and commercial objectives of the company.
1. In accordance with notification number G.S.R. 464(E), dated June 5, 2015 issued by the Ministry of Corporate Affairs, a private company was permitted to adopt an employee stock option scheme pursuant to passing of an ordinary resolution by its shareholders in a general meeting.
2. In accordance with notification number G.S.R. 127(E), dated February 19, 2019 issued by the Department for Promotion of Industry and Internal Trade, an entity shall be considered as a "startup" upon fulfilment of the following conditions:
- Up to a period of ten years from the date of incorporation/ registration, if it is incorporated as a private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) in India.
- Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
- Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a "startup".
3. See footnote 3 above for the definition of startup company.
4. A "public company" is defined under Section 2(71) of the Companies Act, 2013 to mean a company which (a) is not a private company; and (b) has a minimum paid-up share capital, as may be prescribed, provided that a company which is a subsidiary of a company, not being a private company, shall be deemed to be a public company for the purposes of the Act even where such subsidiary company continues to be a private company in its articles.
5. A "key managerial personnel" is defined under Section 2(51) of the Companies Act, 2013 to mean (i) CEO or managing director or manager; (ii) company secretary; (iii) whole-time director; (iv) CFO; (v) such other officer, not more than one level below directors who are in whole-time employment, designated as key managerial personnel by the Board; and (vi) such other officer as may be prescribed.
6. The conditions for exemption of Section 67 of the 2013 Act to private companies were laid out under the amendments introduced pursuant to notification number G.S.R. 464(E), dated June 5, 2015 issued by the Ministry of Corporate Affairs. Accordingly, Section 67 is exempt only for such private companies (a) in whose share capital no other body corporate had invested any money, (b) if the borrowings of such a company from banks or financial institutions or any body corporate, is less than twice its paid-up share capital or INR 50 crores, whichever is lower, and (c) which are not in default in repayment of such borrowings subsisting at the time of making transactions under the abovementioned provisions.
7. Rule 16 of the Share Capital and Debenture Rules states that (i) such financial assistance being approved by shareholders of the company by passing a special resolution; (ii) in case of listed companies, purchase of shares being made only through recognized stock exchange, and in case of unlisted companies, valuation of the shares to be purchased to be made by a registered valuer; and (iii) value of shares to be purchased/subscribed in aggregate together with money provided by the company, not to exceed 5% of the aggregate paid-up capital and free reserves of the company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.