Overview of ESOP Policy

One might have doubts about the pros and cons of an employee stock option plan. Let's discuss some:

Advantages for Employee

• ESOP policy gives employees a direct ownership which can create a sense of pride, commitment, and loyalty among employees, as they have a vested interest in the company's success.
• As the company's stock value increases, employees under ESOP policy can potentially benefit financially. The value of the allocated shares can grow over time, providing capital appreciation.
• Employees may have the opportunity to defer taxes on the shares allocated to them until they sell those shares.
• As employees accumulate shares through the ESOP policy, the value of those shares can grow, potentially providing a significant source of retirement savings.

Advantages for Employer

• ESOP policy can facilitate smooth ownership transitions and succession planning. They provide a mechanism for owners to gradually sell their shares to the employees, ensuring the continuity and longevity of the business.
• Employers can also benefit from tax advantages by establishing an ESOP. Contributions made to the ESOP can be tax-deductible, reducing the company's taxable income.

Disadvantages for Employee

• ESOP policy ties employee's wealth to the performance of the company's stock. This lack of diversification can expose employees to higher risk in case the company experiences financial difficulties.
• Understanding the value of ESOP shares can be challenging for employees. The valuation of the stock may be subjective or based on infrequent assessments, making it difficult for employees to accurately gauge the worth of their shares.
• ESOP policy has restrictions on when and how employees can sell their vested shares. Employees have limited options for selling their shares. This lack of liquidity can restrict employee ability to access the value of their ESOP holdings when they need it.
• Employees have limited influence on the decision-making process. Major company decisions are usually made by the board of directors or majority shareholders, which may not align with employees' preferences or interests.

Disadvantages for Employer

• Establishing and maintaining an ESOP policy can involve significant costs and administrative complexities. Companies need to comply with legal and regulatory requirements which can strain resources and increase administrative burdens.
• While ESOPs policy can enhance employee engagement, there is no guarantee that all employees will actively participate or value the ESOP benefits.
• Implementing an ESOP policy means issuing additional shares of company stock to employees, which dilutes the ownership stake of existing shareholders.

The following documents are essentially required:

• ESOP policy documents or plan agreement which includes details such as eligibility criteria, grant guidelines, exercise price, vesting schedule, and expiration date. This document also define the rights and obligation of the employees towards the company
• Board Resolutions passed by the board of directors of the company approving for ESOP policy. It authorizes the issuance of stock options and provides the necessary authority to administer the plan.
• Shareholder Approval documentation is required for approval of establishing ESOP policy.
• Stock Option Grant Agreements to specify the number of options granted, exercise price, vesting schedule, and other relevant terms.
• Valuation report is important to determine the fair market value of the company's shares and helps in establishing stock options to further ensure compliance with relevant regulations.
• Tax Documents are required by local tax authorities, such as filings or notifications. Legal Compliance Documents required filings or registrations with regulatory bodies or authorities.

How is ESOP allotted?

Allotment of ESOP policy in India involves the following steps:

Grant of ESOP

The ESOP will specify the number of shares that can be purchased, the exercise price, and the vesting period to the eligible employees as per the terms of the scheme

Exercise of ESOP

 The employees can exercise their ESOPs after the vesting period is over and the options become exercisable. The exercise price will be the price specified in the ESOP agreement. It is mandatory for the company to ensure that it has a liquid shares available for ESOP scheme

Allotment of Shares

Once the ESOPs are exercised, the company will allot shares to the employees who have exercised their options. The share allotment must be paid within 15 days from the date of exercise of ESOP

Transfer of Shares

The company must transfer the shares to the employees' Demat accounts within two days of the allotment of shares. The company must also inform the stock exchange where its shares are listed about the allotment of shares to employees

Payment for Shares

The employees must pay the exercise price for the shares allotted to them. The payment must be made within six months from the date of allotment of shares

Compliance with Regulations

The company must comply with all applicable regulations while issuing and allotting ESOPs to its employees

Reporting Requirements

The company must also comply with the reporting requirements of the SEBI regulations. This includes making periodic disclosures to the stock exchange and filing the necessary reports with SEBI.

Draft ESOP policy rules set out the terms that apply to all options granted under the plan which includes the process for granting options, how and when employees can exercise their options, and what happens if an employee leaves.

Grant a letter

• A grant letter setting out the terms of the options one wants to grant.
• The form of the exercise notice is to be delivered to the company when an option holder wants to exercise their vested options.
• An option certificate is required which records the number of options, exercise price and vesting provisions.

Approval of Rules

• The directors and shareholders will need to sign some corporate approval documents to adopt the ESOP rules and set up the option pool.

Board and Shareholder Approval

• The approval of the Employee Stock Option Plan rules and the total number of options in the ESOP pool.

Authorisation from the board  

• Authorisation to issue shares on any exercise to grant options.

Shareholder Waivers and Consents

• The shareholder’s agreement may include pre-emptive rights on the issue of new shares. If this is the case, these shareholders with preemptive rights will need to sign a waiver in respect of any options granted the ESOP.

Prepare the Directors’ Resolutions

• Each time the corporate secretary needs to prepare a new set of directors’ resolutions in writing, approving the grant of options to a specific recipient.

Send Each Recipient Their Grant Letter

• Once the grant letter is received then the issuance of option certificate to recipients is done.

Update Your Register Option

• Internally, it is important to keep an option register, which is a record of all the options the company has granted, the vesting schedules, expiry dates, and exercise dates.

Tax Implication on ESOP Policy

ESOP policy is a popular form of employee compensation that offers employees the opportunity to purchase company stock at a discounted price. Here are the tax implications of ESOPs:

Tax-Deferred Contributions

When an employee contributes to ESOP policy, the contribution is typically made on a pre-tax basis. It means that the amount contributed is deducted from the employee's taxable income, reducing their current income tax liability. These contributions and earnings within the ESOP account grow as tax-deferred until distribution.

Tax-Free Rollovers

In some cases, employees may have the option to roll over funds from certain qualified retirement plans, without incurring immediate tax liabilities. This can provide flexibility in managing retirement funds while maintaining tax advantages.

Tax Deductibility for Employer Contributions

Employers funding an ESOP can often deduct the contributions made to the plan as a business expense. Contributions made to an ESOP are generally tax-deductible within certain limits and subject to compliance with relevant tax laws.

Capital Gains Tax Deferral

In certain situations, shareholders who sell their company stock to an ESOP can defer the recognition of capital gains taxes. This tax deferral can be especially advantageous for business owners looking to transition out of their company.

ESOPs have proved to be very effective tools for both big companies and start-ups. Startupfino helps companies use ESOP policy to retain their workforce and the talent whereas start-ups use these tools to hire fresh talent and to attract more workforces. Our talented professionals will help companies which cannot afford to pay high salaries to employees at work.