ESOPS are basically rights given to employees of a company. These rights pertain to buying shares of the company at a fixed price on the date of the grant. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans and Stock Purchase Plans.
ESOPs are the best and most frequently used tools to retain top notch employees in a company. Apart from this, ESOP has various other advantages like:
- It instills a sense of Ownership and belonging among the employees.It can get employees highly inspired and focused for their jobs.
- It helps aligning the interest of the managers with those of the owners.
- It is a non-cash compensation tool to compete for the best human resources at affordable consideration.
- It gives an opportunity to corporate to pay without a reduction in book profits.
- ESOP is the most regular international tool that is used for granting retirement benefits to employees and as succession plan for owners.
Usually, companies adopt one or more of the following types of plans. There can be variations in the specific terms to make it relevant to its business needs and objectives:
- Employee Stock Option Scheme (ESOS)
- Incentive Stock Option (ISO)
- Employee Stock Purchase (ESP)
- Stock Appreciation Rights (SARs)
- Restricted Stock Award (RSA)
- Restricted Stock Unit (RSU)
The selection criteria would completely depend upon the objective of the implementation of the ESOP Plan. Say, if the objective is to use ESOP as a talent retention tool, then you can plan the vesting period to be longer than usual. If your objective is to use it as an incentive tool, you may keep the exercise price low. This would enable the employee to enjoy an upside when he sells off his holding. Again, if your objective is to use it as a part of remuneration mechanism, the eligibility criteria could be accordingly widened.
Mere grant of an option does not make an employee shareholder of the company. Options are not shares; they are rights to own shares. These become shares only when employee exercises that right.
Private limited companies and closely held companies are eligible to issue ESOP to its employees but, as per Industry practice, since the shares are not publicly traded, employees need to be provided with an exit option.
Taxability of ESOPs
There are two stages of taxability in the hands of the employee which is as below:
- 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’).
- 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.
Compliances for ESOPs
Yes, there are quite a few corporate and legal compliances associated with ESOPs. The laws that dictate implementation of Equity Compensation plans are:
- SEBI (ESOP guidelines)
- Companies Act
- Income Tax Act
- Accounting guidelines (ICAI, IFRS, US GAAP)