Employee Stock option plan

Employee Stock Option Plans or ESOPs are the employee-benefit plans under which the employees get the right to purchase shares instead of salary in the company at a discounted price. The option provided under this scheme grants a right and is not an obligation on the employee. Employees need to wait for a specific time known as the vesting period before they can exercise the right to purchase those specified number of shares at a pre-determined price.

Who is entitled to ESOPs?

The employees of the company can opt for the Employee Stock Option Plan (ESOP), but the company sets certain criteria for the same. The benefits under the ESOP scheme can be claimed by-

  • The employee of the company who is working in or outside India
  • A part-time/whole-time director of the company
  • An employee of holding, subsidiary, or associate company, whether he/she is residing in or outside India

Note: It is important to note here is that the promoters or directors of the company who are holding more than 10 percent of its equity cannot take part in an ESOP.

How does an ESOP work?

In India, ESOPs are governed by the Companies (Share Capital and Debenture) Rules, 2014. ESOPs are very popular among the early-stage start-ups. 

From a start-up’s perspective, these are the steps to offering an ESOP.

  • Firstly, the company drafts an ESOP scheme and get it approved in a shareholder’s meeting. Previously, this scheme gets the approval by a ‘special resolution’ and filed with the Registrar of Companies. With effect from 5th June 2015, the private limited companies do not have to comply with this rule.
  • After the approval, a ‘Letter of Grant’ is issued to the concerned employees. This letter contains information about the number of options granted, vesting period, calculation of the exercise price, etc. 
  • If an employee wishes to exercise this option granted to him by the sponsoring company, he/she needs to make an ‘Exercise Application’. After this, their options are converted into equity.

The benefit of ESOP-

For Company

The Employee Stock Option Plans helps the employer to retain the best talent and assure a good level of performance in the work. 

For Employees

  • ESOPs offer financial benefits to the employees in the form of higher pay, benefits, and overall wealth generation. It also allows a comfortable retirement for them.
  • Employees feel more responsible for their organization because they hold the shares in the company. This results in active participation in the company’s decision making.
  • ESOPs provide a better job security and job satisfaction to the employees.

Understanding Important Terms related to ESOP

Grant- It means the commitment made by the employer to employees by issuing them a ‘Letter of Grant’. In this letter, all the benefits which the employees can avail of are mentioned.

Vesting- It is the process that gives an employee the right to own shares in the company.

Exercise- When an employee decides to convert options into shares, it is known as ‘exercising’ the option.

Exercise Price- Also known as the strike price. It is the price at which the shares are offered to the employees. Generally, it is below the market value and is pre-determined.

Exercise Period- It is the time for which the employee is eligible to exercise the options granted to them.

Tax implications of ESOPs

ESOPs are taxed at 2 instances –

At the time of exercise – as a perquisite. When the employee has exercised the option, i.e. when they decide to buy the share; the difference between the fair market value as on exercise date and exercise price is taxed as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of total income from salary in the tax return.

At the time of sale by the employee – as a capital gain. When an employee chooses to sell the shares, another tax event happens. The difference between the sale price and fair market value on the exercise date is taxed as capital gains.

Budget 2020 amendment: From the FY 2020-21, an employee receiving ESOPs from an eligible start-up need not pay tax in the year of exercising the option. 

The TDS on the ‘perquisite’ stands deferred to earlier of the following events:

  • Expiry of five years from the year of allotment of ESOPs
  • Date of sale of the ESOPs by the employee
  • Date of termination of employment