In India, the legal framework and working of employee stock options (ESOPs) is extremely crucial for the overall development of the companies. Companies must appreciate and adhere to the complex rules and regulations pertaining to the issuance of ESOPs. Compliance with these multidimensional rules is of utmost importance considering the fact that all these legislations, in one way or another, safeguard both the corporation and the employees in respect to the Companies Act, 2013.
Understanding ESOPs
First introduced in 1950s, ESOP was conceptualized by a lawyer and investment banker named Louis Kelso. Kelso contended that for enhanced capitalism and better corporate governance, employees must also be a part of the stakeholders' group of a company apart from the other shareholders. Subsequently, Kelso worked with another philosopher Mortimer Adler in the promotion of the benefits derived from ESOPs that turned into the essential places where modern ESOPs originated1.
Primarily, ESOPs are employee benefit plans that enable employees of a company to purchase company options (shares) at a predetermined price. The other major use of ESOPs, apart from recognizing the value of marshaling human resources to meet business objectives, is to create and enhance the sense of belongingness towards the organization among its employees. In addition, this strategy allows the companies to lower turnover rates and thus retain key people, valuable for business development. This is especially the case for the employees oriented company towards the perpetuation and enhancement of its market position.
In India's vibrant startup and tech strata, ESOPs have become a key strategy for rewarding staff, ensuring talent retention and boosting employee involvement. ESOPs often include a waiting period before employees can buy shares, known as vesting. This period motivates employees to stay with the company longer, helping them to sync their personal goals with the firm's future business goals.
The Legal Realm of ESOPs
The Companies Act, 2013 serves as the primary legislation governing corporate entities in India. Section 62(1)(b) of the Act is particularly relevant to ESOPs, as it empowers companies to offer shares to employees under stock option schemes. The provision forms the bedrock upon which more specific regulations are built. Under the 2013 Act, companies were initially required to pass a special resolution through shareholder vote to implement an employee stock option scheme. However, this requirement was eased for private companies in 2015. The amendment allowed private firms to adopt ESOP schemes through a simpler ordinary resolution, streamlining the process for these businesses2.
Rule 12 of the Companies (Share Capital and Debentures) Rules 2014 sets forth specific guidelines for startup companies in issuing ESOPs. This rule provides a comprehensive definition of 'employee' for ESOP purposes. It encompasses permanent staff members working domestically or internationally, all types of company directors including non-executive ones, and extends to employees and directors of the company's subsidiaries and holding companies, both within India and abroad.
More specifically, the rule also delineates the person(s) who are excluded from the definition of an 'employee'. In the rule, independent directors are not eligible for ESOPs. Furthermore, promoters and individuals belonging to the promoter group are excluded as well. The rule also bars directors who, either personally or through their relatives or corporate entities, hold more than 10% of the company's outstanding equity shares, whether directly or indirectly. These exclusions aim to maintain the integrity of the ESOP system and prevent potential conflicts of interest.
This rule clarifies that employees cannot access shareholder benefits until they exercise their options and receive actual shares. Specifically, before exercising options and obtaining shares, employees lack shareholder rights such as dividend payments, voting rights, or other ownership-related benefits. These regulations aim to ensure fair and transparent ESOP administration, protecting both corporate and employee interests. Moreover, Rule 16 addresses the requirements for providing funds for share purchases, emphasizing the need for transparency and shareholder approval in this process.
Process of Issuance of ESOPs
The process for issuance of ESOP initiates with the grant phase, where the company identifies employees for stock option eligibility, which often hinges on factors such as tenure or significant contributions to the organization's success and employee efforts.
This is followed by the vesting stage, and it forms a crucial period during which employees become qualified to exercise their offered ESOP options. Companies typically structure this phase using either time-based criteria or performance milestones, spread over a predetermined timeframe.
The vesting of options is a gradual process through which employees earn the right to exercise their stock options. This mechanism is designed to foster long-term commitment and drive performance. The vesting period represents the time an employee must wait before becoming eligible to exercise a specific portion of their granted options.
Once options are fully vested, employees enter the exercise phase. Here, they can act on their right to purchase company shares at the previously established strike price, transforming them from option holders into actual shareholders. Following this, employees may opt for an exit strategy, which could involve selling shares on the open market, during an initial public offering (IPO), or to fellow shareholders in subsequent funding rounds.
Conclusion:
In conclusion, ESOPs in India serve as a powerful tool for businesses to retain talent, align employee goals with company objectives, and foster long-term growth. By adhering to the regulatory framework under the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014, companies can ensure fair and transparent implementation of ESOPs. Proper compliance not only safeguards corporate and employee interests but also strengthens the integrity of the ESOP system, enabling businesses to incentivize key contributors while maintaining legal accountability.
Footnotes
1 Evaluating the Effect of Employee Stock Option Plans on the Financial Performance of Indian Construction & Infrastructure Companies, ISSN: 2250-0758 |p-ISSN: 2394-6962 Volume- 9, Issue- 4 (August 2019)
2 In accordance with notification numberG.S.R. 464(E), dated June 5, 2015 issued by the Ministry of Corporate Affairs, a private company was permitted to adopt an employee stock option scheme pursuant to passing of an ordinary resolution by its shareholders in a general meeting.
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