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Demystifying ESOP vis a vis Indian Private Limited Companies – Part I

What is an Employee Stock Option Plan (ESOP)?

An Employee Stock Option Plan (hereinafter referred to as ESOP) is a scheme that involves the allocation of shares by a company to its employees with the objective of creating a sense of ownership. Under a typical ESOP, employees who are in continued employment of the company are given the right (not an obligation) to purchase at a future date the shares of the company at a pre-determined discounted price. Section 2(37) of the Companies Act 2013 defines ESOP as ‘The option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.’

Which provisions of the Companies Act and related Rules govern the implementation of ESOP by a Private Limited Company?

The implementation of an ESOP by a Private Limited Company in India is governed by the Companies Act 2013 and the Companies (Share Capital and Debentures) Rules 2014 (hereinafter referred to as Rules).The key provisions governing the implementation of an ESOP by a Private Limited Company are:·

Section 2(37) of the Companies Act 2013 (hereinafter referred to as Act)- This section defines ESOP (see definition above).·

Section 62 (1)(b) of the Act states that ‘Where at any time a company having a share capital proposes to increase its subscribed capital by the issue of further shares, such shares can be offered to employees under a scheme of employees stock option, subject to special resolution passed by company and subject to such conditions as may be prescribed.’ Thus section 62(1)(b) expressly states that shares under an ESOP can be granted to employees only. It further expressly provides the eligibility criteria of employees by explaining the ambit of the term ‘Employee’.For the purposes of clause (b) of sub-section (1) of section 62 of the Act and Rule 12 of the Rules, ‘Employee’ means:(i) A permanent employee of the company who has been working in India or outside India;(ii) A director of the Company, whether a whole time director or not but excluding an independent director;(iii) An employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company or of an associate company but does not include:an employee who is a promoter or belongs to the promoter group;a director who either himself or through his relative or through any body corporate, whether directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.·

Rule 12 read with section 62(1)(b) of the Act governs the implementation of ESOP through the direct issue of employee stock options.·

Rule 16 read with section 67 of the Act governs the implementation of ESOP through the creation of a trust.

Why do companies implement an ESOP?

There are several reasons that encourage companies to issue stock options to their employees, some of them being:· It is a great tool for instilling loyalty within and long term commitment from employees, thereby helping in the retention of talented employees;· It helps motivate employees to perform better and to improve the overall corporate performance;· It serves as an efficient compensation tool offering a win-win combination for both the employer as well as the employee. While stock options offer employees a stake in the organisation’s ownership, as an employee compensation component they remain affordable for the employing organization as it relieves them from the pressure of giving cash benefits;· ESOPs help smaller companies to compete with larger companies in attracting greater talent.

What are the benefits of an ESOP?·

The issue of stock options gives the employees a sense of ownership thereby helping in (a) The retention of key talent;(b) Increasing company loyalty;(c) Increasing innovation;(d) Increasing employee efficiency;(e) Improved association of the employees with the organization;(f) Greater awareness and participation of employees in the achievement of corporate goals;(g) Better communication between the management and the employees· It helps align the interests of the employees with those of shareholders;· It is an affordable compensation tool that may result in rewards beyond employee expectations while relieving the recruiting organisation from the pressure of paying cash benefits.

What are the disadvantages of an ESOP?

Employees may feel that they do not have any control over the value of shares- If the value of shares decreases it may impact the value of the employee’s holding in the company thereby adversely affecting their morale;· Setting up and administering an ESOP requires the organization to incur expenses;· The issue of stock options can result in share dilution, i.e. the more the number of stock options are issued the smaller each share’s percentage value in the company becomes. The above information represents basic information about an ESOP in respect of a Private Limited Company in India and in no way represents any professional legal advice regarding the same. For an in-depth understanding of the concept of ESOPs professional advise is recommended.

By Geeta Daswani

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