India: Role Of ESOP In Start-Ups

Last Updated: 16 October 2017
Article by Kumardeep

Introduction : The Employee Stock Option Plan (ESOP) & Start -ups

ESOPs

The Employee Stock Option Plan (ESOP) or Employee Stock Option Scheme (ESOS) is the option or a right which is being offered by a company to its employees to purchase its shares at a pre-determined price in the future. ESOP is not an obligation rather it is a right of the employee to purchase certain amount of share of the company as pre decided price.

ESOP is basically a tool used by a company to retain its employees and get them awarded for being associated with the company. As a part of an employee's compensation ESOP creates a sense of ownership in the mind of employees and their interest in the organization remains intact. ESOP plays vital role to attract employees at the growing stage of the company.

As defined under the provisions of section 2(37) of the Companies Act, 2013, "employees' stock option" means 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 predetermined price.

The Companies Act, 2013 under Section 62(1)(b) provides that a company may, subject to compliance with conditions as prescribed under the Rules (in case of unlisted company) and SEBI Regulations (in case of listed companies), offer shares to the employees under a scheme of employees' stock option.

Start -ups

Start-up, literally means a newly established business. However, as defined by the Department of Industrial Policy and Promotion ("DIPP"), vide Notification1 number G.S.R. 180(E), dated 17th February, 2016 and amended vide Press Release2 dated 25.05.2017, 'Startup' means an entity, incorporated or registered in India :

  1. Not prior to seven years, however for Biotechnology Startups not prior to ten years,
  2. With annual turnover not exceeding INR 25 crore in any preceding financial year, and
  3. Working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Provided that such entity is not formed by splitting up, or reconstruction, of a business already in existence. Provided also that an entity shall cease to be a Startup if its turnover for the previous financial years has exceeded INR 25 crore or it has completed 7 years and for biotechnology startups 10 years from the date of incorporation/ registration. Provided further that a Startup shall be eligible for tax benefits only after it has obtained certification from the Inter-Ministerial Board, setup for such purpose.

It may be noted that under the provisions of the Companies Act, 2013 read with the Companies (Share Capital and Debentures) Rules, 2014, following class of persons are not considered as employee to be eligible for ESOP:

  1. An employee who is a promoter or a person belonging to the promoter group; or
  2. A director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.

    However, in order to promote startups, the Ministry of Corporate Affairs vide Notification3 dated 19.07.2016 issued the Companies (Share Capital and Debentures) Third Amendment Rules, 2016 wherein it was provided that Startups may issue the shares under ESOP to their promoters and directors who hold more than 10% for the first 5 years from the date of their incorporation. The restriction on issuing shares under ESOP to promoters and such directors continues for companies which does not fall under the category of startups.

Advantages of ESOPs in Startups

Startups being newly formed entities may get benefits of ESOPs in one or more of the following ways:

  1. To attract and retain talented employees:

    As discussed above, ESOPs are structured in such a way that it gives a sense of ownership of the employees in the organization if they stay over a period of time to gather the benefits. Accordingly, Startups can use this tool to retain its talented resources. In the initial phase, it is important for a startup entity to retain the talented manpower resources, the manpower resources can be a promoter/director/ employees. To retain them the best way is to make them feel that they are also a part of the kitty which is being created. No better tool than ESOPs can bring this feeling among them.
  2. To motivate employees to work better and participate actively in the success of the company:

    ESOPs play vital role in motivating employees of a startup as the employees understand that better the company performs, the greater will be the value of their shares. Therefore, they work hard for the growth of the company. The employees are well aware that if the company does not perform well then the market value of the shares would be less than the price paid by them to acquire shares under the ESOP and thus they take active parts for the success of the company.
  3. To control costs and minimize the risk:

    Under the ESOPs shares are issued as part of compensation in substitution of cash variables and bonus. The startups, in the early stages of their businesses are unable to pay competitive and high salaries to their employees as compare to well established businesses or large companies, however, at the same time startups also in need of talented and motivated human resources who can perform well for the growth of the company in future. Therefore, by offering under ESOPs, such deserving employees may be retained by startups without spending much cash variables.

Challenges for the success of ESOPs in Startups

Undoubtedly, ESOPs benefit both the company and its employees mutually, however, there are certain challenges for the successful implementation of ESOPs in startups. Though ESOPs are considered an excellent tool for startups to magnetize and retain talented employees although it's a challenge to convince the employees about the growth of the company in future. This is the foremost hurdle in the successful implementation of ESOPs in startups as in the initial phase of operation the success of startups is only anticipated and thus it become a game of chance for the employees. The startups are basically unlisted companies and their shares are not readily marketable which create a doubt in the minds of employees to realize profit from such shares acquired by them under ESOPs in consideration of their compensation which were sacrificed as an employee. In case the startups remain unlisted company even after the vesting period, the shares cannot be sold in open market and employees will find no way to exit from the scheme.

Another aspect of challenge in the startups is the taxability issues in the hands of employees. Under the ESOP, the taxability arises at two stages i.e. at the time when the employee exercises their option and at the time when they sell such shares. At the time of exercising the option, the tax is to be paid on the amount of difference between the fair market value and the exercise price (i.e. the price at which the shares were bought). Later on at the time of selling such shares acquired under the ESOP, the employee has to pay capital gain tax on the differential amount of selling price and the fair market value.

In light of above, ESOPs cannot be implemented successfully in Startups unless and until the ESOPs plan is drafted in such a way that ensures the attainment of desired objectives of both the company and employees and also provide mutual benefit to them.

Conclusion

Undoubtedly, the ESOPs are very trendy method used by companies to attract, motivate and retain employees. This tool of ESOPs have two fold benefit i.e. reducing cash outflow and retaining deserving employees for their growth. Employees also see this scheme as a long term investment for which they have to compensate with their cash perquisites and bonuses. ESOPs are beneficial to both employees as well as Startups if implemented effectively.

Footnotes

1. http://dipp.nic.in/English/Investor/startupindia/Definition_Startup_GazetteNotification.pdf

2. http://pib.nic.in/newsite/PrintRelease.aspx?relid=162140

3. http://mca.gov.in/Ministry/pdf/Rules_19072016.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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