How to issue ESOPs in Indian Company

Employee Stock Option Plans (ESOPs) have become a pivotal tool for businesses in India to attract, retain, and reward their employees. By offering a stake in the company’s future success, ESOPs align the interests of the employees with those of the shareholders. This guide delves into the process of issuing ESOPs, the taxation implications for employees, key considerations, FAQs, and the potential benefits under the Startup India scheme.

What are the steps / process to issue ESOP in India?

Issuing ESOPs in India involves a structured approach:

  • Board Approval: The process begins with the company’s board of directors approving the ESOP scheme, including the total number of shares to be granted, eligibility criteria, vesting period, and exercise price.
  • Shareholder Approval: Following board approval, the scheme must be ratified by the shareholders through a special resolution.
  • ESOP Scheme Drafting: The company drafts the ESOP scheme document detailing the plan’s governance, administration, and operational guidelines.
  • Grant of Options: Eligible employees are then granted options, which are documented through a grant letter specifying the terms of the grant.
  • Vesting and Exercise: Over time, as the options vest according to the predetermined schedule, employees can exercise them to acquire shares at the exercise price.

Taxation to Employees:

Taxation of ESOPs in India occurs at two stages:

  • At Exercise: When employees exercise their options, the difference between the exercise price and the Fair Market Value (FMV) of the shares is taxed as a perquisite under the head “Salaries.”
  • At Sale: Upon selling the shares, any gain from the sale price over the FMV at exercise is taxed as capital gains, with the rate depending on the holding period.

The tax benefits provided to startups registered under the Startup India scheme, particularly in relation to ESOPs (Employee Stock Option Plans), are outlined under Section 80-IAC of the Income Tax Act, 1961. This section specifically offers tax incentives to eligible startups to encourage their growth and development within India.

Additionally, for the taxation of ESOPs, an important amendment was made in the Finance Act, 2020, which introduced Section 80-IAC, providing a tax deferral benefit for ESOPs issued by startups. According to this amendment, employees of eligible startups can defer the tax payment on ESOPs to within 14 days after the following events:

  • 5 years from the end of the financial year in which shares are allotted upon exercise of the option.
  • The date of sale of such ESOP shares by the employee.
  • The date when the employee ceases to be the company’s employee.

This deferral is significant because, traditionally, the tax on ESOPs was due at the time of exercise, which could lead to a cash flow issue for employees since they would owe tax before realizing any actual gain from selling the shares. The introduction of this deferral mechanism under the Startup India scheme helps alleviate this burden, making ESOPs a more attractive and viable option for startups to attract and retain talent.

What are the major points to be covered in ESOP policy

An ESOP policy should comprehensively address:

  • Eligibility Criteria: Clearly define who qualifies for the ESOP scheme.
  • Vesting Period: Outline the timeframe over which the options will vest and any conditions attached to vesting.
  • Exercise Price: Specify the price at which employees can purchase shares.
  • Exercise Period: State the window during which employees can exercise vested options.
  • Clawback Provisions: Include any conditions under which the company can retract the ESOPs.
  • Treatment of ESOPS if the employee leaves the company: The treatment of unvested and vested options varies and should be detailed in the ESOP policy.

The important terms in an ESOP agreement are:

Options

  • This is the option to purchase stock. You don’t actually own shares until the options convert (exercise) into shares
  • Options are the right but not the obligation, meaning a requirement to purchase stock, at a specified price (exercise price), for a specified period of time, or when the options expire, which is typically 10 years
  • You exercise your options if the value of the shares is higher than the option price (i.e. the spread is greater than 0)

Exercise / strike price

  • Exercise price I the price at which the company offers the shares to its employees. Generally a discount of 15-20% is given on the fair market price.

Exercise

  • Exercise means the employees actually opt to buy the shares at the exercise price agreed before

Exercise date

  •  This is the date at which shares get vested and the employees can actually convert their options in to the shares.

Vesting schedule

  • This means the total period over which the stocks is vested. For example, the if the company offers 100 shares to a employee and the vesting period is 4 years. In this case every year the employee gets 25 shares for 4 years. Once the vesting is complete the employee can then convert the options into shares.
  • Most companies vest their shares over a period of 4 years. There can be some variances, and it is up to you to decide on the schedule.

Cliff

  • A vesting “cliff” means that there is a period of time of no vesting, but when the specified time (the “cliff”) is hit, the benefit becomes fully vested
  • For example, in a 48-month vesting schedule with a 12 month “cliff”, no vesting occurs for the first 12 months, but at the 12-month point, the stockholder receives full credit for 12 months of vesting. In effect, the staff has now vested 25% of the shares they were issued
  • After the “cliff” is met, vesting would continue thereafter on a ‘monthly’ basis
  • A “cliff” is often used with new employees. It acts as a probationary period during which the new employee has to prove himself or herself

Maturity

  • This means how long the exercise period will be. Employee need to exercise within a defined period which is typically 7-10 years. If the options are not exercised during this time the options will disappear.

Accelerated vesting

  • Some founders and key executives negotiate into their equity arrangements (stock based, not options) that they will be entitled to some form of acceleration of the vesting on their equity upon the occurrence of a triggering event, which is typically acquisition
  • Simply put, you might get to vest fully before the vesting schedule says so.
Clawback Provisions

Clawback provisions in the context of Employee Stock Option Plans (ESOPs) are contractual clauses that allow a company to reclaim, or “claw back,” previously granted stock options or shares from employees under certain circumstances. These provisions are designed to protect the company’s interests and ensure that the incentives provided through ESOPs align with the company’s long-term goals and performance.

Clawback provisions can be triggered by various events, including:

  1. Misconduct: If an employee engages in fraudulent behavior, breaches company policies, or is involved in activities detrimental to the company’s interests, clawback provisions can be invoked to retract the stock options or shares.

  2. Termination for Cause: Companies might include provisions that allow them to claw back options or shares if an employee is terminated for cause, such as violation of company policies or failure to meet performance standards.

  3. Financial Restatements: In cases where a company needs to restate its financials due to errors or misconduct, clawback provisions might be used to reclaim options or shares that were granted based on the initially reported, incorrect financial performance.

  4. Competition: Some ESOP agreements include clawback clauses that activate if an employee leaves the company and joins a competitor or starts a competing business within a specified period.

  5. Early Departure: Clawback provisions may also apply if an employee leaves the company before a certain period, ensuring that ESOPs reward long-term commitment.

Clawback provisions are a means for companies to ensure that the ESOPs serve their intended purpose of incentivizing employees to contribute to the company’s success and remain aligned with its objectives over the long term.

 

Frequntly asked questions

Generally, all employees are eligible for an ESOP except for directors and promoters holding more than 10% of the company. Eligible participants may include full-time or part-time company directors, current employees of subsidiaries, associates, or holdings in India or overseas, and full-time employees working at the company’s offices either in India or abroad

The treatment of unvested and vested options varies and should be detailed in the ESOP policy.