Doling out ESOPs? Here’s everything about Employee Stock Option Plan for SMEs
ESOPs allow grantees to have a stake in the company which directly results in greater loyalty.
India is the third largest startup ecosystem in the world and has attracted global investor attention as is evident from the expanding list of Indian unicorns. Small businesses with strong founding teams are able to raise funds at a very early stage, despite having no revenue. The hope to transform from a small business to a unicorn drives these entrepreneurs and schemes such as Employee Stock Option Scheme (ESOS) ensure that everyone in the company is striving for the same goal, that is, stock value appreciation.
All SMEs/startups, that is, unlisted companies must follow the rules laid out in the Companies Act 2013 for issuances of employee stock options. In this article we have listed key features of ESOS for unlisted companies.
An Employee Stock Option Plan (ESOP) is essentially an incentive, granted to an employee, director or officer to buy or subscribe to the shares of the company at a pre-determined price in the future. In this way, grantees are offered equity compensation instead of/in addition to the remuneration. The benefit of ESOPs is that it allows grantees to have a stake in the company which directly results in greater loyalty and motivation while aligning the incentives of various stakeholders.
Permanent employees, directors and officers are eligible to receive an option under an ESOP scheme. However, the following individuals are not eligible to participate in the scheme:
- an Independent Director,
- an employee who is a promoter or belongs to the promoter group,
- a Director who directly or indirectly holds more than 10% of outstanding equity shares
The company granting an option under ESOS has the freedom to determine the exercise price subject to accounting policies and regulations. The pre-determined price at which an employee can exercise the option is called strike price or exercise price.
If the price of the stock increases, the employee gains by exercising the option at the strike price, which is below the current stock price. However, If the stock goes down, the option will be worthless, and the employee will not incur a notional loss which is the case with normal stock ownership. Simply put, the employee benefits from the gains when the stock price rises but loses nothing in case the company is unsuccessful.
The term of the ESOS is called the vesting period. It is the time period that a grantee must wait in order to exercise the option to buy the shares. ESOPs may vest in a phased manner, that is, 5% in the second year, 5% in the third year and so on.
Taxation of ESOP
The value of the employee stock option is taxable as a perquisite in the hands of the employee. The value of the ESOPs is calculated as follows:
Fair market value (FMV) of shares on the date of exercise
Less : Exercise price actually paid by the employee
Let’s say, Raj was granted ESOPs at an exercise price of Rs 1,000 per option. The FMV on the date of vesting is Rs 4,500 while the FMV on the date of exercise is Rs 5,000, the taxable value in Raj’s hands will be Rs 5,000- Rs 1,000 = Rs 4,000.
Capital gains tax on ESOP
In case the employee makes a subsequent sale of such shares, the gain on such sale will be taxed as capital gains. The cost of purchase for computing capital gains would be the FMV on the date of exercise of the option.
Compliance requirements for issuance of ESOP
1. Approval of shareholders of the company shall be obtained by passing a special resolution
2. The company shall make the following disclosures in the annexure to the notice for passing a special resolution
- Total number of stock options to be granted
- Identification of classes of employees entitled to participate in the ESOS
- Appraisal process for determining the eligibility of employees to the ESOS
- Requirements of vesting period and period of vesting
- Maximum period within which the options shall be vested
- Exercise price and the formula for arriving at the same
- Exercise period and process of exercise
- Lock-in period, if any
- Maximum number of options to be granted per employee and in aggregate
- The method which the company shall use to value its options
- The conditions under which option vested in employees may last, for example, in case of termination of employment for misconduct
- Specified period within which the employee shall exercise the vested options in the event of a proposed termination of employment
- A statement to the effect that the company shall comply with the applicable accounting standards
- Grant of option to employees of subsidiary or holding company
- Grant of option to identified employees, during any one year, equal to or exceeding 1% of the issued capital of the company at the time of grant of option
5. The company shall maintain a Register of Employee Stock Options in Form SH-6.
( The writer is the Founder and CEO, Insta C.A (www.InstaCA.in) . Insta C.A. is an online tax and accounting services for SMEs and startups. For more information contact firstname.lastname@example.org and their twitter handle is @InstaCA1.)