Employee Stock Option Plans (ESOPs) are perhaps the most important form of remuneration for employees. From a start-up’s perspective, it helps to maintain liquidity and from an employee’s perspective, it is a reward for loyalty. However, like pretty much a lot in life, ESOPs are not simple. Sometimes, employees do not bother to understand how their ‘options’ will work and often employers do not explain the intricacies and legal framework associated with these stock options. The result is that most employees who have been granted ESOPs suddenly believe that they will walk out with millions!In this article I have discussed the law behind granting ESOPs as well as some key areas of interest from the employees’ point of view.
What are ESOPs?
Simply put, an ESOP scheme gives employees the option to purchase a certain number of shares in a company at a predetermined price at a future date that is determined at the time of granting the option.It, typically, forms part of the compensation package for employees. The advantage to the employee lies in the lower price at which they may be able to acquire the shares.
Who are eligible for ESOPs?
Before diving any further, let us understand what kind of employees are entitled to ESOPs. As per Company Rules, only (i) a permanent employee working in or outside India; (ii) a whole-time or part-time director of company; and (iii) an employee of a subsidiary (whether in India or abroad), holding company or an associate company, can claim benefits under an ESOP scheme. It is important to note that neither a ‘promoter’, nor a director holding more than 10 per cent of the equity shares of the company is entitled to take part in this scheme.
How do ESOPs work?
A company grants to an employee the option to buy a certain number of shares in the company at a fixed price after a certain number of years (option period). Before the employee can exercise the option, he/she is usually required to complete the vesting period which typically means that he/she has to continue to work for the company for a minimum number of years before part or all of the options can be exercised.
Can ESOPs be transferred or pledged by an employee to third parties?
ESOPs are not shares per se. These are options which may or may not be converted into shares, subject to underlying conditions. Till the time these options are converted, these are not shares and hence there is no property in existence. Thus, ESOPs cannot be transferred or pledged. However, when these ESOPs are converted into shares of the company, those are freely transferrable, subject to terms and conditions of ESOP scheme.
What is the difference between ESOP and Sweat Equity?
People usually tend to mix the concepts of Sweat Equity Shares and Employees Stock Options, but it should be well kept in mind that both the concepts differ a lot from various aspects. Sweat Equity shares are those shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing know-how, or IPR, or value additions, by whatever name called.
An ESOP (Employees Stock Option Plan) on the other hand is an option given to the employees to buy certain number of shares of the Company at a pre-determined price.One of the basic differences between Sweat Equity and ESOP is Sweat Equity can be issued for consideration other than cash while ESOP must be issued only in lieu of cash.
How are ESOPs taxed in the hands of the employee?
There are two stages of taxability in the hands of the employee which is as below:
1. The first stage is when the options are exercised by the employee. The benefit, which is the difference between the fair market value (“FMV”) of the shares on the date of which the option is exercised and the amount at which the options were granted to the employee, is treated as a perquisite as per Income Tax Act, 1961 (the “Act’).
2. The second stage is when the shares are sold or transferred by the employee in which case the difference between the sale consideration and the FMV of the shares would be treated as capital gains and will be subject to capital gains tax.
In the end, I would like to state that ESOPs are a great incentive for employees to put their heart and soul into an organisation. However, grant of options does not mean that the employee will walk out of that organisation with millions in their bank account and employees should be conscious of this fact. Most young employees have only heard positive stories about ESOPs and often do not do their own diligence to understand the key terms governing their options.So, the next time you are offered ESOPs by your employer I hope this article will help in guiding you through its intricacies and make an informed decision.
