ESOPs: A Powerful Incentive for Employee Retention and Business Growth

As companies strive to attract and retain top talent, they are constantly seeking new ways to incentivize and reward employees. One approach that has gained popularity in recent years is the use of Employee Stock Ownership Plans (ESOPs). ESOPs are a type of employee benefit plan that allows employees to own a portion of the company's stock. This not only provides employees with a stake in the company's success but also aligns their interests with those of the company's shareholders. In this article, Compliance Calendar will delve deeper into ESOPs, how they work, and their benefits for both employers and employees. 

What is ESOP Scheme? Name some companies issuing ESOPs.

 ESOP is a scheme that allows eligible employees of a company to purchase shares of the company at a pre-determined price, usually at a discount to the market price. The purpose of an ESOP is to provide employees with an ownership stake in the company and to incentivize them to work towards the company's growth and success.

There are many companies in India and globally that have issued ESOPs as a means to attract and retain talented employees such as- Infosys, TCS (Tata Consultancy Services), Wipro, Amazon, Google, Facebook, Microsoft, Zomato, Flipkart, Ola, Uber, Netflix etc are the few examples of companies that have implemented ESOP schemes to incentivize their employees and align their interests with the company's growth. This list is not exhaustive and there are many other companies, especially startups in India, that have also implemented ESOP schemes to attract and retain talent. Read more here.

How ESOPs have been more popular in recent times?

By offering equity-based compensation, ESOPs  can be a valuable tool for  startups looking to grow quickly and retain employees can attract and retain employees who are invested in the success of the company and are motivated to work hard to achieve a common goal. ESOPs can also be used to incentivize key employees to take on additional responsibilities or to meet specific performance targets. For example, a startup may grant options to an employee who successfully leads a new product launch or helps to close a major new customer.

In addition, ESOPs can help startups to conserve cash by offering equity-based compensation instead of cash-based compensation. This can be especially important for startups that are in the early stages of development and have limited financial resources. Overall, ESOPs can be a powerful tool for startups looking to grow quickly and retain talented employees. However, it is important to ensure that the ESOP scheme is structured and implemented in compliance with all applicable laws and regulations, and that the company has the appropriate resources and expertise to manage the scheme effectively.

The government of India recently introduced various measures to support startups for implementation of ESOPs-

• Tax exemption: Under Section 56(2)(vii b) of the Income Tax Act, 1961, startups are exempted from paying tax on the issuance of shares to their employees under ESOPs, subject to certain conditions.

• Relaxation in regulations or Compliances : The Securities and Exchange Board of India (SEBI) has relaxed regulations related to ESOPs for startups, such as increasing the limit on the number of options that can be granted to employees and reducing the vesting period.

• Funding support: The government has launched various funding schemes and initiatives, such as the Startup India Seed Fund Scheme and the Fund of Funds for Startups, which provide financial assistance to startups to support their growth and expansion.

• Incubation support: The government has set up incubation centers across the country to provide startups with access to infrastructure, mentorship, and other resources to help them develop their business and succeed.

Well; the government is taking steps to support startups and make it easier for them to implement ESOPs and other employee benefit schemes, with the aim of encouraging entrepreneurship and driving economic growth.

ESOPs in India are primarily governed by the Companies Act, 2013-

• Section 62(1)(b) of the Companies Act, 2013: This section allows companies to issue shares through ESOPs to their employees, subject to certain conditions.

• Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014: This rule sets out the detailed requirements for ESOPs, including the maximum amount of equity that can be issued through ESOPs, the eligibility criteria for employees, the minimum vesting period, the exercise price, and the period within which the options must be exercised.

• Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014: These regulations provide additional guidelines for ESOPs, including requirements related to the disclosure of information, the calculation of fair value of options, and the accounting treatment for ESOPs.

• Companies (Prospectus and Allotment of Securities) Rules, 2014: These rules set out the requirements for filing the return of allotment with the Registrar of Companies, including the details of the ESOPs issued by the company.

• Income Tax Act, 1961: This act provides tax implications for ESOPs, including the tax treatment of stock options at the time of grant, vesting, and exercise.

It is important for companies to comply with all applicable provisions and regulations related to ESOPs to ensure that the scheme is structured and implemented in a legally compliant manner. This will help to avoid any penalties or legal issues in the future.

Here are the key steps involved in drafting an ESOP agreement under the Companies Act, 2013:

» Determine or check Eligibility: The first step is to determine which employees are eligible for the ESOP. This may include criteria such as job position, length of service, and performance.

» Determine the Number of Shares: The next step is to determine the number of shares that will be available for purchase under the ESOP, and the price at which they will be offered.

» Draft the ESOP Agreement: Once the eligibility criteria and share allocation have been determined, the ESOP agreement can be drafted. The agreement should include details such as the vesting period, exercise price, exercise period, and any restrictions on the transfer of shares.

» Obtain Board Approval: The ESOP agreement must be approved by the company's board of directors before it can be implemented.

» Disclose the ESOP to Shareholders: Companies must disclose the ESOP to their shareholders and obtain their approval through a special resolution, which must be passed by at least 75% of the shareholders.

» File the Necessary Forms: Companies must file the necessary forms with the Registrar of Companies, including Form MGT-14 for the special resolution and Form PAS-3 for the allotment of shares.

It is important to note that drafting an ESOP agreement can be complex and time-consuming, and it is advisable to seek the guidance of legal experts to ensure compliance with all applicable laws and regulations.

The key features of an ESOP under the Companies Act, 2013 are:

» Eligibility: ESOPs can only be offered to employees of the company or its subsidiaries, as defined under Section 2(87) of the Companies Act, 2013.

» Approval: The ESOP scheme must be approved by the board of directors and shareholders of the company, through a special resolution passed by at least 75% of the shareholders.

» Pricing: The price at which the shares are offered to employees must be determined by an independent valuer, as per Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

» Vesting Period: The ESOP scheme must specify a vesting period, which is the period during which the employee has to wait before being able to exercise the option to purchase the shares. The vesting period cannot be less than one year.

» Exercise Period: The ESOP scheme must also specify an exercise period, which is the period during which the employee can exercise the option to purchase the shares. The exercise period cannot exceed ten years from the date of grant.

» Limits on Grant of ESOPs: The total value of the ESOPs granted in any financial year cannot exceed 10% of the paid-up share capital of the company, as per Section 62(1)(b) of the Companies Act, 2013.

» Lock-in Period: The shares acquired by employees through the ESOP scheme must be subject to a lock-in period of at least one year from the date of allotment.

» Disclosure Requirements: Companies must disclose the details of the ESOP scheme in their annual report, including the number of options granted, the exercise price, and the vesting and exercise periods.

These are some of the key features of an ESOP scheme under the Companies Act, 2013. It is important to note that the rules and regulations governing ESOPs may vary depending on the specific circumstances of the company, and legal advice should be sought to ensure compliance with all applicable laws and regulations.

Compliance with ESOP regulations essential for companies to avoid any legal or financial consequences. Here are some ways that can help ensure ESOP compliance:

» Engage Legal Experts: Start-ups should engage experienced legal experts to ensure that their ESOP is compliant with all applicable laws and regulations. Legal experts can review the ESOP documents, advise on compliance requirements, and provide guidance on regulatory filings and disclosures.

» Review ESOP Plan Document: Companies should ensure that the ESOP plan document clearly outlines the terms and conditions of the plan, including the number of shares being offered, the eligibility criteria for employees, vesting period, exercise price, and other key terms.

» Follow Regulatory Filings: Companies should ensure that they comply with all regulatory filings and disclosures required by the Companies Act, 2013 and the Rules made thereunder. These filings may include a return of allotment of shares in Form PAS-3 and a copy of the special resolution authorizing the ESOP.

» Ensure Proper Administration: It is important for companies to ensure that the ESOP is properly administered, including the management of the shares, the exercise of the options, and the distribution of the shares. This can include maintaining proper records, implementing proper internal controls, and ensuring that all transactions related to the ESOP are properly documented.

» Communication: Companies should ensure that the ESOP is properly communicated to the employees, and that they understand the terms and conditions of the plan. This can include providing information about the plan in a clear and understandable manner, and providing employees with regular updates on the status of their shares.

If we look closely the big startups, most of them have the ESOP pool in place. However, what is more important here to note is that compliance with ESOP regulations requires a detailed understanding of the legal and regulatory requirements, as well as a commitment to ethical business practices. Compliance Calendar can help you and ensure that your ESOP is compliant and effective in attracting and retaining talented employees.

Offering ESOPs can be a good way for start-ups to maintain cash flow?

The answer is yes. ESOPs allow start-ups to compensate their employees with equity instead of cash. By offering equity-based compensation, startups can attract and retain talented employees, while conserving their cash resources for other critical areas of the business. ESOPs also provide employees with a sense of ownership and alignment with the company's success, which can be a powerful motivator. This can help to create a strong company culture and a team that is invested in the success of the business.

Additionally, ESOPs can be structured to include vesting periods and other conditions that encourage employees to stay with the company for the long term. This can help to reduce turnover and maintain stability within the organization.

Overall, ESOPs can be a valuable tool for startups looking to attract and retain talented employees while maintaining cash flow. However, it is important to ensure that the ESOP scheme is structured and implemented in compliance with all applicable laws and regulations, and that the company has the appropriate resources and expertise to manage the scheme effectively.

ESOP Compliances -Mandatory under the Companies Act, 2013

According to Section 62 of the Act, any issue of shares, including those issued through ESOPs, must be filed with the ROC within 30 days of their issuance. Specifically, the following documents related to ESOPs must be filed with the ROC:

» Board Resolution: The board resolution approving the ESOP scheme must be filed with the ROC.

» Shareholders' Approval: The shareholders' resolution approving the ESOP scheme must also be filed with the ROC.

» ESOP Agreement: A copy of the ESOP agreement must be filed with the ROC.

» Return of Allotment: The return of allotment must be filed with the ROC, which includes details of the shares issued through the ESOP scheme.

Failure to comply with the ESOP filing requirements can result in penalties under the Companies Act, 2013. Therefore, it is important for startups to ensure that they comply with all ESOP filing requirements and maintain accurate and up-to-date records related to their ESOP schemes.

ESOP agreement can vary depending on the specific terms and conditions of the scheme. However, a general ESOP agreement may include the following key points-

• Introduction: This section provides an overview of the ESOP scheme and sets out the purpose of the agreement.

• Definitions: This section defines key terms used in the agreement, such as "Option", "Exercise Price", "Vesting Period", and "Employee".

• Grant of Options: This section specifies the number of options to be granted to each eligible employee, the vesting schedule, the exercise price, and any other terms and conditions of the options.

• Exercise of Options: This section sets out the procedure for exercising the options, including the time period during which the options can be exercised and the methods for exercise (such as cash or stock).

• Restrictions on Transfer: This section specifies any restrictions on the transfer of the options or the underlying shares, such as lock-in periods or limitations on the transfer of shares.

• Termination of Employment: This section sets out the consequences of termination of employment, including the impact on the options and the right of the company to buy back any vested shares.

• Miscellaneous Provisions: This section includes any other provisions that are relevant to the ESOP scheme, such as tax implications, confidentiality obligations, and dispute resolution mechanisms.

It is important to consult with legal and financial experts to draft an ESOP agreement that is tailored to the specific needs of the company and complies with all applicable laws and regulations.

What are the penalties can be imposed for non-compliance under ESOP:

Non-compliance with the ESOP regulations can result in penalties for start-ups, such as-

» Penalty under the Companies Act, 2013: Non-compliance with the ESOP regulations can result in penalties under the Companies Act, 2013. The penalties can range from fines to imprisonment, depending on the nature of the violation.

» Tax implications: If the ESOP scheme is not structured properly, there may be tax implications for both the company and the employees. For example, if the shares are allotted at a price below the fair market value, the difference between the exercise price and the fair market value may be treated as income and taxed accordingly.

» Non-Enforceability: If the ESOP scheme is not compliant with the regulations, the employees may challenge the scheme and the options granted under it. This can result in the options being declared null and void, and the employees being entitled to compensation for any loss suffered as a result of the non-compliance.

» Investor Concerns: Non-compliance with the ESOP regulations can also raise concerns among investors and may impact the company's ability to raise funds.

¶Bonus Points: Non-compliance with the ESOP regulations can have serious consequences for startups, including penalties, tax implications, non-enforceability, and investor concerns. It is therefore important to ensure that the ESOP scheme is structured and implemented in compliance with all applicable laws and regulations. Compliance Calendar have dedicated ESOP Professionals who can help you right from drafting the ESOP Scheme to its applicable compliance.