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”.

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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.

Alternatives to ESOPs

Companies that are not intent on adopting full-fledged ESOP schemes may prefer to choose a “phantom stock option scheme” where, instead of stock options and shares, employees are given the benefit of notional shares and appreciation in the value thereof. Some companies may also allot shares to an employee welfare trust upfront, which can then be transferred by the trust to employees. or as may be permitted by the trust and scheme documents.

Importance of the fine print in ESOPs

Both employees and employers must pay close attention to the manner in which ESOPs will be dealt with, in the event that the employer company undergoes an acquisition or merger. Employees must also clearly understand the terms of vesting of the company’s ESOP, and its granting and vesting schedule, all of which affect their actual benefit from the scheme. Further, the employee must be clear on the rules governing her ESOP in the event that she resigns/retires, or her services are terminated by the employer. It is likely that the employee will still be able to exercise the stock options for a certain period after the employment has ended, depending on the terms of the scheme.

Re-evaluating ESOPs in the COVID-19 crisis

As with all things equity, the impact of the current pandemic and resultant restrictions on ESOPs remains to be seen. However, employees must carefully consider the value of their stock options, and the terms of the ESOP of their employer company, in the event that they consider resigning from their job or the employer company is likely to downsize and offer a severance package. Uncertain times need certain cautions.

-Archana Tewary is Partner and Pooranimaa Hariharan is Principal Associate at J. Sagar Associates. The views expressed are personal.

First Published:May 6, 2020 6:37 PM IST