Employee stock option plans (ESOPs) are a key part of the employee benefits offered by companies today. Start-ups, in particular, use ESOPs as an effective recruitment tool to attract and retain talent. However, employers and employees often do not fully understand the terms and implications of such stock option schemes. From an employer’s perspective, such a scheme enables them to offer an attractive compensation package while keeping the cash component of the employment offer low. It also serves as a motivational tool by ensuring that employees have “skin in the game”.

From the employee’s perspective, such schemes help build a sense of belonging and ownership in the employer company and investment in its growth and thereby fosters long-term commitment. An introduction to employee stock option schemes and similar benefits, which are offered by private limited companies in India to their employees, may provide helpful insights into current corporate employment offers. It is worth noting that limited liability partnerships cannot, generally speaking, offer similar employee schemes.

Essence of ESOPs

ESOPs allow employees to subscribe to the equity capital of the employer company at a reduced price from the fair value. Initially, the options are allotted or granted to employees, but cannot be exercised until certain conditions are met, after which time the options are said to be vested. Once the options are vested, the employee has the right to exercise the options, by paying either no consideration or a nominal amount, to the employer company in consideration of the allotted shares.

How companies adopt an ESOP

The company will need to prepare an ESOP scheme, pass necessary resolutions and frame a separate stock option grant letter for each employee who can participate in the scheme. Such essential groundwork is often neglected by employers while offering employees their ESOP entitlements in the appointment letters. It is incumbent on companies, particularly those companies engaged in raising funds, to take the utmost care in ensuring the ESOP scheme is correctly put in place before the ESOPs are taken into account to calculate fully diluted capitalization tables.

The details of granting, vesting, and exercise of the stock options being offered, including the timelines, trigger events, lock-in period restrictions, and other conditions should be clearly spelt out in the ESOP scheme and/or the grant letters. Any variation in the terms of the originally approved ESOP would need shareholders’ approval and comply with such other conditions as prescribed under the Companies Act, 2013 (and the rules formulated thereunder).

Who can participate in an ESOP?

By definition, an ESOP is for the benefit of a company’s employees, directors, and the employees of its holding company(ies) and/or subsidiaries. Typically, neither consultants nor independent directors are allowed to participate in ESOPs. Even more importantly, founders or promoters of a company cannot participate in an ESOP unless the company is a registered start-up under Indian law. If the intent is to allow founders or promoters of a company to participate in such stock benefit schemes, companies will need to adopt alternate structures (which are discussed briefly here).

Employees and directors of companies in India are also allowed to participate in ESOPs of their holding companies outside India, either under a cashless scheme or where a price component is involved. However, if an employee or a director in India were to exercise such an option, several tax-related compliances are applicable, and these should be considered carefully before opting for participation.

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