ESOP (Employee Stock Ownership Plan) in India

The idea of an Employee Stock Ownership Plan, also known as ESOP, is to give employees an ownership stake in the company they work for. In India, ESOPs are primarily offered as part of stock-based compensation in private companies. With the purpose of retaining, motivating, and rewarding employees, ESOPs have grown in popularity over the last decade. The year 2021 has proven to be a fantastic year, with more than 35 Indian startups participating in a 100 billion rupee of Employee Stock Option Plan. In order to implement ESOP, it is essential to have a thorough understanding of ESOP in terms of setting up, managing, taxation, and even reporting. In this article, we will be covering all the aspects of ESOPs in India that are important for you to know.

ESOP in India

In India, with increasing interest in startups, the use of equity compensation has increased by a significant margin. It has been noticed that ESOPs are generally used as part of stock-based compensation by early-stage startups or small businesses. Since ESOPs can be used as a mechanism to attract and retain employees, it is considered a powerful tool to enhance productivity and create a high-performing workplace.

While in practical terms, ESOPs are similar to the stock options of private companies. Basically. ESOPs are granted to select employees wherein an employee is allotted a particular number of shares in the company at a certain price that can be purchased after a predefined period of time. In this regard, the adoption of ESOP in India is driven by the need for better management and alignment of interests that can be achieved by empowering employees with an ownership stake.

Understanding ESOP in India

An employee stock option plan (ESOP) is an arrangement that gives employees an ownership stake in the company. Under ESOP in India, employees are granted a number of shares and an option to purchase them at a particular price over a certain period of time. In this context, companies can use ESOP as a way to reward employees, align interests, and attract talent.

While ESOPs are a viable alternative for startups to offer stock-based compensation, it does not come without their share of challenges. From equity dilution to legal and reporting obligations, there are a number of issues startups will have to consider before implementing ESOP in India. As a result, in order to ensure a smooth path to ESOP implementation, it is essential for startups to create a robust plan in order to manage and optimize properly.

How does ESOP work in India?

If you are a startup or a small business owner, you may want to consider implementing ESOP. The most important aspect of ESOP is to understand how it will work in your particular business. To begin with, the first step is to identify and select the employee for the ESOP program, determine the number of shares to be granted, and frame an ESOP agreement that contains all the terms and conditions. As a result, when ESOPs are granted, the shares are held by the company under the option pool, which is also known as the vesting period.

To benefit from equity ownership under the ESOP, employees must remain with the company for the vesting period. Employees get the right to execute their ESOPs after the vesting period has ended. Employee stock ownership plans (ESOPs) can be used to purchase company shares at fixed prices that can be less than the fair market value. Further, employees can potentially profit from their ownership by selling the shares they acquired through ESOPs. Overall, with ESOP in India, startups can implement stock-based compensation and offer an effective retention strategy.

Benefits of having an ESOP in India

Implementing an ESOP in India is one of the most effective ways to retain and motivate employees. As a result, it can also help create a healthy work environment, which in turn can positively impact the productivity and profitability of a company. Some of the key benefits of ESOP in India are as follows:

• Dividend income – In general, the profit that a company generates is distributed to shareholders as dividends. So, when employees participate in the ESOP plan and become the shareholders of a company, they will be entitled to receive dividends on the shares that are held.
• Higher productivity – ESOPs have been observed to increase employee morale and improve workplace productivity. As a matter of fact, in India, several companies that have implemented ESOPs report a significant improvement in the productivity of their employees and enhanced levels of retention.
• Long-term investment – When it comes to stock-based compensation, ESOPs can be a sustainable and long-term investment. As a result, employees are motivated to stay with the company for a longer period and help achieve long-term goals that would allow them to benefit from their long-term investment.

How to set up an ESOP in India

In order to implement an ESOP in India, there are a number of things that you will have to consider. From choosing the right strategy and framing employee stock ownership plan agreement to employee selection and compensation arrangements, everything about ESOP comes with its own set of considerations. Below mentioned are the steps that you need to follow in order to set up an ESOP in India.

• ESOP agreement – The first thing that you need to consider is the agreement that will be incorporated into your company’s bylaws. It is an essential part of the ESOP, and it will define various terms such as eligibility criteria, vesting period, number of shares granted, strike price, etc.
• Grant shares under ESOP – After you have drafted the ESOP agreement, it is time to allocate and start granting shares under ESOP to the employees. It is important to note that grants to employees must be made after the ESOP agreement is signed between both parties.
• Managing the ESOP program – Once you have granted the ESOP shares to the employees, the management team of the company must look at and review that the ESOPs are exercised in a timely manner. Thus, it is essential to keep track of the ESOPs and ensure that employees can execute them before the expiry date.

SEBI regulation for share-based compensation/ESOP in India

The Securities and Exchange Board of India (SEBI) is the authority that oversees and regulates stock markets in India. In regard to share-based compensation or ESOP, SEBI has set up a set of rules and regulations. In this context, startups that implement ESOP in India need to take the necessary steps to ensure compliance with the SEBI regulation. The following are some of the key points that should be taken into consideration:

• Scope of eligible employees broadened – The previous regulations permitted the eligible employees of the company to receive stock-based advantages in the form of ESOPs, Stock Appreciation Rights (SARs), and equity shares. However, the new SEBI ESOP regulations give listed companies more flexibility and allow them to incentivize non-permanent employees as well.
• Flexibility in the implementation of the scheme – The share-based compensation system might be implemented directly or via an irrevocable trust, according to the previous legislation. The latest SEBI ESOP laws have taken things a step further by enabling listed companies to alter how the programme is implemented.
• Limit set on the issue of sweat equity shares – Listed companies have been allowed to issue no more than 15% of their existing paid-up equity capital in a year. The total number of sweat shares issued by a listed company that is not registered on the Innovators Growth Platform (IGP) must not exceed 25% of paid-up equity share capital, and if the company is registered, issuance of more than 50% is not allowed.
• No vesting period in case of death or permanent incapacity – In the event of an employee’s death or permanent incapacity, the benefits accruing to that employee are transferred to the employee’s legal heirs or nominees on the date when the employee expired, or on the day when they become permanently incapacitated, as the case may be.
• Vesting benefits transferred because of merger – According to the new SEBI ESOP requirements, the amalgamation plan must outline how unvested and unexercised ESOPs will be handled so that the interests of the employees are not adversely affected. In the previous regulations, employees did not dad access to this form of protection.
• Secondary sale allowed to make payment of exercise price of ESOPs – When a trust is in charge of a share benefit transfer plan, the trust is allowed to engage in secondary market sales to enable employees to pay for the exercise price of ESOPs and associated taxes and fees. Thus, the employee’s interests are protected, even in the absence of any other support.
• Use of excess money and shares after winding up of schemes – As per the new regulations, the excess funds or shares with the trust are transferred to that of other schemes as suggested by the compensation committee when a scheme is actually ended up, however, it is subject to the permission of shareholders.

Challenges of setting up and managing an ESOP in India

ESOP is one of the most widely used stock-based compensation plans in India, especially by startups and small-sized companies. It is extremely beneficial for these companies as it helps them to promote employee ownership and build a positive work culture. Here are a few things that you need to keep in mind while implementing and managing an ESOP

• The employer would have to monitor the taxable event as well as events that cause the employee to owe taxes. It is important for startups to know about ESOP taxation in India in order to avoid penalties.
• If an employee leaves the company, they might be required to sell the ESOP shares that were granted in order to pay the taxes. Employees will be significantly impacted if their employment is terminated due to a disability or death.
• In the event that the share price is greater at the time of allocation but falls at the time of tax withholding, the employee may be taxed on a higher value on exercise. In this scenario, although receiving a notional gain rather than an actual benefit, the employee is still required to pay perquisite tax.

How does ESOPs tax work in India?

In the case of India, ESOPs are taxable at the time of exercise. Basically, the difference between the fair market value (FMV) of the share and the strike or exercise price. Due to the non-marketability of private company shares, the tax provisions need a merchant banker valuation. Employees might need to take out loans to cover this obligation if there is no ready market for selling shares.

As a result, in 2020, a provision was introduced that deferred the tax on ESOPs of eligible startups. In accordance with the law, an employer of a qualified start-up may postpone the employee’s tax deduction for ESOPs for five years, until the employee leaves the business or until the employee wants to sell the shares, whichever occurs first. Thus, employee stock ownership plans of startups are at the time of exercise.

Tax implication

As a matter of fact, ESOPs are taxed at the time of exercising and when the shares acquired under the ESOP program are sold at a profit. However, selling shares in private companies is restricted. In this way, when an employee exercises ESOPs and purchases shares, the difference between the fair market value of the shares and the amount which is paid (strike price) is taxed. In addition to this, in the case of shares sold at a profit, depending on the selling price, purchase price, and time period, a capital gains tax rate is applicable. Overall, the tax implications of ESOP in India can be quite challenging.

Tax calculation example

To better understand how the tax on ESOPs is calculated, let us look at an example of an employee exercising ESOPs. Assuming that the ESOP is exercised at a strike price of $10, while the fair market value of the share is $15, the number of shares granted was 1,000 and the tax rate is 30%. In this case, the tax is $1,500 as per the formula, [(FMV – Strike price)*Number of shares]*tax rate. Therefore, in this example, the tax will be [(15- 10)*1,000]* 30% = $1,500.

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ESOPs are beneficial for startups and small-sized companies in India. However, the tax implications, the process of implementing and managing ESOPs can be daunting tasks. Are you looking for a solution to manage your ESOPs? Look no further. Eqvista has a solution that is tailor-made for you. We provide a comprehensive set of tools to create, manage and track your ESOPs. Eqvista’s software is packed with features that will help you to manage the entire contractual process of your ESOPs. It helps you with everything from the preparation of agreements to keeping track of individual employee data. If you would like to know what Eqvista can do for your company, contact us today!