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Terms and conditions for ESOPs

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Terms and conditions for ESOPs

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The first time I heard of the term ESOPs was when Infosys got listed on the U.S. stock exchange. Office assistants and secretaries became millionaires overnight. It was as fascinating a piece of news as any, and even before understanding what it was, I was clear - I wanted ESOPs! Now, almost 2 decades later, I have become older (and hopefully a bit wiser). Having gained a good understanding of the overall concept and ESOP terms and conditions, let me share with you my two cents on the topic.

What is an ESOP?

The Employee Stock Option Plan (also referred to as the Employee Stock Ownership Plan) is an employee benefit program that allows you to buy your company's shares at a highly discounted rate. In other cases, the employee might give away the shares for free in lieu of cash rewards or as a performance-based or retention incentive.

The occurrence of this is far more likely to happen in a startup environment or in a fledgling small and medium business. This is because these enterprises are at the stage of their lifecycle when they do not have a lot of cash to spare. Hence, ESOPs become a big part of the compensation package to attract the right talent. The ESOP terms and conditions are thus devised to encourage employee loyalty, commitment, and productivity. 

Important ESOP terms and conditions

There is no fixed set of rules when it comes to the ESOP. In other words, it is not mandatory for each organisation to follow the same ESOP terms and conditions, and there is a certain leeway in implementing and executing the policy. Yes, of course, they have an umbrella of regulations to ensure fair trade practices are followed and no misuse is done. These have been formulated by the watchdog agency, the Securities and Exchange Board of India (SEBI). 

When it comes to the actual administration and policy governance, SEBI is only responsible for companies that have been listed on the Indian stock exchanges. For unlisted startups and other SMBs, the Companies (Share Capital and Debenture) Rules, 2014 sets and monitors the guidelines. Let us take a look at some of the key terms and conditions for ESOP.

Key terms to know

Before we commence, there are a few key terms that are repeatedly used in connection to an ESOP. Let us know them first for the ease of understanding other concepts.

  • Granting: The issuance of the stocks by the employer is referred to as granting. 
  • Vesting: When the employee applies for the shares granted by the employer, it is known as vesting.
  • Exercising: This refers to the actual conversion of the vesting right and taking ownership of the stock, whether to hold or to sell. The exercise period starts post vesting, and upon the completion of the lock-in, the employee is free to do what he likes with the shares. The exercise price is fixed early on and refers to the price at which the employee will buy the share from the company or the trust.

Eligibility 

ESOPs, as the name suggests, are meant for employees only. These include permanent employees on the payroll, directors of the company (but not more than 10% shareholding), and even employees of a subsidiary. Promoters, freelance and contractual employees do not qualify for ESOP.

Issuance

As per the guidelines, ESOPs can be issued in 2 ways. One, via issuance of equity shares when the employee wishes to exercise the option. Two, through a trust created by the employer. This trust acts as the holding party and intermediary between the employer and the employee. 

Lock-in period

As per the rules, there is a minimum one-year lock-in period that needs to be in place between the grant of the ESOP and the vesting of its option. Different companies can choose to set a duration of their choice, as long as it is above one year. Meanwhile, employees are not eligible to earn dividends (if declared) or vote in company proceedings until they have exercised the option. Failure to exercise on time can lead to a default forfeit of the option.

Transferability

The ESOP shares are non-transferable. If an employee resigns, then the vesting rights remain with the employee, and the exercise options are valid until the prescribed time period. If the employee is fired for misconduct, the ESOP can become null and void. In the unfortunate event of the employee's death, the ESOP can be transferred to the nominee.

Taxation

The terms and conditions of ESOP stipulate two types of tax implications. 

One is when the option to buy the shares from the employer is exercised. This is because, in this stage, the ESOP is treated as a perquisite ( a perk that is part of the salary). Hence, it becomes mandatory for the employer to deduct tax at source (TDS) and furnish the details under Form 16. 

The second is when the shares are sold on the stock market. This attracts capital gains tax on the profits made in the sale. If you have held the shares for over one year, then long-term capital gains tax (LTCG) is levied. If the shares were sold off before 12 months from the date of purchase, you would incur short-term capital gains tax (STCG). 

Disclosure

A very important document is the ESOP Scheme Disclosure. While it may be referred to in many ways, it is essentially the ESOP terms and conditions governing your employer's process. This is a must-read document before you decide to accept ESOP in any form. Ideally, the employer needs to categorically disclose all the pertinent information, including (but not limited to):

  • Establishing eligibility criteria and identification of eligible employees.
  • A clear and concise description of terms including vesting period, exercising period, exercise price, etc. 
  • Valuation mechanism.
  • Conditions when the benefit can lapse, such as misconduct-related termination.
  • Any limitation on the maximum number of stock that can be owned.
  • Taxation and other accounting policies.
  • Procedure for application.

Conclusion 

ESOP can be a lucrative and rewarding tool. However, it does come with risks. This is especially true for unlisted startups and smaller enterprises as it may be a little difficult to visualise how the performance will be in, say, three years from now when the company will get listed and what gains you can expect to receive. This is reasonably easier in already listed firms as you can easily check the current share price to gauge the possible gains upon exercising the option. Moreover, there is the liability of dual taxation as well.

Hence, experts think that ESOPs are great as a rewarding mechanism for performance or incentivising employee retention. But, before you decide to accept ESOP in lieu of cash salary, carefully read the disclosure document to understand all the ESOP terms and conditions and thoroughly research the company’s current performance versus the projected future scope of growth. 

FAQs

What is the locking period in ESOP?

As per the guidelines laid down by SEBI, there needs to be a minimum of one-year lock-in between the grant of options (which we now know means the issuance of the ESOP) and the vesting application of the option. The employer has the freedom to make this higher and also stipulate its own lockin for exercising the option.

What rights do ESOP employees have?

There are several rights awarded to employees under the ESOP terms and conditions to safeguard their interests. Some of the prominent ones include full disclosure by the employer regarding the ESOP plan, calculation formulae, and accounting policies. Issuance of individual benefit statements for each employee. Clarity on voting and other rights. Transparency of company’s performance and financials. And so on.

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