Employee Stock Option Plan (ESOP) Under the Companies Act 2013: A Complete Guide

Introduction to Employee Stock Option Plan (ESOP)

The Employee Stock Option Plan (ESOP) is an employee benefit scheme that allows employees to acquire ownership in their company by purchasing shares at a discounted price. This scheme is designed to encourage employee participation in the company’s growth and align their interests with the organization’s long-term objectives.

In India, ESOPs are governed by the Companies Act, 2013, and Companies (Share Capital and Debenture) Rules, 2014 for unlisted companies, whereas listed companies must comply with SEBI (Share-Based Employee Benefits) Regulations, 2014.

Section 2(37) of the Companies Act, 2013 defines ESOPs as the option given to employees, officers, or directors of a company or its subsidiaries to purchase or subscribe to shares at a future date at a predetermined price.

This article provides a comprehensive guide on ESOPs, including eligibility criteria, issuance procedures, statutory requirements, taxation, and compliance under the Companies Act, 2013.

Key Terminologies in ESOPs

1. Grant

The grant refers to the formal issuance of ESOPs to eligible employees. It indicates that employees are eligible to receive ESOPs at a pre-determined exercise price.

2. Vesting

Vesting is the process by which employees gain the right to exercise their stock options. The minimum vesting period is one year between the grant date and the vesting date.

3. Exercising

Once the vesting period is complete, employees can choose to exercise their ESOPs and purchase shares. Until exercised, employees do not have shareholder rights such as voting or dividends.

4. Option Pool

Startups create an option pool, a reserved percentage of shares, to attract and retain employees with stock-based compensation.

5. Strike Price

This is the price at which employees can purchase company shares under the ESOP scheme.

6. Expiration Date

ESOPs have an expiration date, by which employees must exercise their options; otherwise, they will lapse.

Eligibility Criteria for ESOP Issuance

According to Rule 12(1) of the Companies (Share Capital and Debenture Rules), 2014, ESOPs can be issued to:

1. A permanent employee of the company (working in India or abroad).

2. A director (excluding independent directors).

3. A permanent employee or director of a subsidiary, associate, or holding company working in India or abroad.

Who Cannot Receive ESOPs?

1. Employees belonging to the promoter group or promoters of the company.

2. Directors holding more than 10% equity in the company, directly or indirectly.

Exceptions: Startups are exempted from these restrictions for 10 years from their incorporation date.

Process of Issuing ESOPs

The issuance of ESOPs is governed by Section 62(1)(b) of the Companies Act, 2013 and follows these steps:

1. Drafting of ESOP Scheme

A detailed ESOP scheme must be prepared in compliance with the Companies Act, 2013, and Companies (Share Capital and Debenture) Rules, 2014.

2. Board Meeting

1. A board meeting must be conducted with at least seven days' notice to all directors.

2. The board resolution approving the ESOP scheme must be passed.

3. A general meeting must be scheduled for shareholder approval.

3. Shareholder Approval

1. A special resolution must be passed in a general meeting.

2. The company must file MGT-14 with the Registrar of Companies (ROC) within 30 days.

4. Granting ESOPs to Employees

• Employees are notified about their ESOP grants, including vesting schedule, exercise price, and expiration date.

5. Vesting Period

1. The minimum vesting period is one year.

2. Employees must complete the vesting period before exercising their options.

6. Exercise of ESOPs

1. Employees pay the exercise price to purchase shares.

2. Shares are transferred, and employees become shareholders.

7. Maintaining ESOP Register

The company must maintain a Register of ESOPs (Form SH-6) containing details of issued ESOPs.

Statutory Requirements Under Companies Act, 2013

1. Section 2(37)

Defines ESOPs but does not cover Phantom Stock or Stock Appreciation Rights (SARs).

2. Section 62(1)(b)

Requires companies to pass a special resolution before issuing ESOPs.

3. Rule 12 of Companies (Share Capital and Debenture) Rules, 2014

Requires the special resolution to include:

• Number of ESOPs issued

• Eligibility criteria for employees

• Vesting schedule

• Lock-in period

• Methodology for valuation

• Conditions for lapse of ESOPs

SEBI Regulations for Listed Companies

Listed companies must comply with SEBI (Share-Based Employee Benefits) Regulations, 2014, which include:

• ESOP Trust Mechanism: Companies can transfer shares to a trust that manages ESOPs.

• Compensation Committee: A compensation committee must oversee ESOP implementation.

Disclosures in Board Report

The board report must disclose:

• Total number of ESOPs granted

• Eligible employee categories

• Vesting schedule and lock-in period

• Valuation methodology

• Lapse conditions

• Compliance with applicable accounting standards

Taxation of ESOPs in India

ESOP taxation occurs at two stages:

1. At the Time of Exercise

Employees are taxed on the difference between the fair market value (FMV) and exercise price as perquisite income under Section 17(2) of the Income Tax Act, 1961.

2. At the Time of Sale

When employees sell their ESOPs, capital gains tax applies:

• Short-term Capital Gains (STCG): If sold within 12 months, taxed at 15%.

• Long-term Capital Gains (LTCG): If sold after 12 months, taxed at 10% if gains exceed ₹1 lakh.

Administration & Governance of ESOPs

A trustee or ESOP committee ensures smooth administration, compliance, and record-keeping.

Conclusion

ESOPs are an excellent tool for companies to attract, retain, and incentivize employees. However, strict compliance with the Companies Act, 2013, and SEBI regulations is crucial. Understanding the eligibility, process, taxation, and statutory requirements can help employees and employers maximize benefits.