ESOPs - Employees Know you Kitty

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Employee Stock Option Plan (ESOP), is a plan through which a company awards Stock Options to the employees based on their performance. Under an ESOP, the employees have right to buy the shares of the company on a predetermined date at a predetermined price. The objective of ESOP is to motivate the employees to perform better and improve shareholders' value. Apart from giving financial gains to the employees, ESOP also creates a  sense of belonging and ownership amongst the employees. 

Different terms used in an ESOP

Grant date - The date on which the company grants an option to its employee.
Option price - The price at which such shares in a scheme are offered. It is also known as the ‘strike price’ or ‘grant price’. Normally such option price would be below the market value/ fair value of the shares on the date of grant.
Vesting date - An ESOP would provide for a date on which an option is vested with employees and time frame over which the stock option would vest with employees (‘Vesting period’).
Exercise period - The employees would be given a time period, called exercise period, within which they are required to exercise the option. The date on which employees exercise this option is known as ‘exercise date’.

There are two ways in which a company can set up an ESOP.

(a) Create a Trust (Special Purpose Vehicle) - Depending on the number of options to be given to the employees, the company will issue shares or options to the trust. The trust would need funds to buy these shares. For this, the company can either give soft loans from its own funds or the trust can raise loans through other sources to meet its financial requirement. The company can act as a guarantee to the lender to the trust. With the funds so raised, the trust then acquires shares/options required. The trust repays its loans as and when the employees purchase the options offered and when they exercise their options by paying the exercise price.

(b) Give options directly to employees - The selection of the employees can be based on performance of the employee, indicated by the annual performance appraisal, minimum period of service, present and potential contribution of the employees, and such other factors deemed to be relevant for the success of the company. Number of options per employee can be determined taking into consideration, the grade, level, years of service, salary, etc. These selections would entirely depend upon the objective of the company for setting up the ESOP.

The real advantage of ESOPs is that, the exercise price remains fixed over the term of the option. So, the employee would exercise his option when the market price of the shares goes substantially high and he would gain on the difference between the market price and exercise price.

Different types of ESOPs

ESOP can be a one-time plan or an ongoing scheme depending upon the objectives that the company wants to achieve. ESOPs can be in the form of ESOS (Employee Stock Option Schemes), ESPP (Employee Stock Purchase Plans), Compensation Plans, Incentive Plans, SAR/Phantom ESOPs etc.

Employee Stock Option Scheme (ESOS) - Under this scheme, the company grants an option to its employees to acquire shares at a future date at a pre-determined price. Eligible employees are free to acquire shares on vesting within the exercise period. Employees are free to dispose of the shares subject to lock-in-period if any. Generally exercise price is lower than the prevalent market price.

Employee Stock Purchase Plan (ESPP) - This is generally used in listed companies, wherein the employees are given the right to acquire shares of the company immediately, not at a future date as in ESOS, at a price lower than the prevailing market price. Shares issued by listed companies under ESPP will be subject to lock-in-period, as a result, the employee cannot sell the shares and/or the employee has to continue with the employer for a certain number of years.

Share Appreciation Rights (SAR)/ Phantom Shares - Under this scheme, no shares are offered or allotted to the employee. The employee is given the appreciation in the value of shares between two specified dates as an incentive or performance bonus, that is linked to the performance of the company as a whole, as reflected in its share value.

Rules and Regulations

Companies Act
Issue of stock options requires approval of shareholders by way of a special resolution as per section 81(1 a). This is not applicable for private companies who can issue stock options without shareholder approval but approval by the board of directors.

Income Tax Issues

For employees:
Till recently, the difference between the cost of the share to the employees and market value on the date on which an employee got the share would be taxed as perquisite in addition to capital gains tax payable by the employee on sale of those shares. However with the recent announcement by the Finance Minister the perquisite tax has been removed. Tax is now payable only at time of sale of shares as capital gains.Since perquisite tax has been removed employers are not liable for tax deduction at source, thus removing administrative inconvenience.

For the company:
As per SEBI guidelines listed companies have to account for ESOP by treating the same as an expense. As yet there is no clarity whether this expense will be allowed as deductible expense by the Income Tax authorities.



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