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Things companies need to know before implementing ESOPs

As the startup ecosystem matures, companies are struggling with acquiring and retaining talent as employees are on the constant lookout for better opportunities. Considering that the number of new-age companies is growing in India, the employee attrition rate is quite high. This is especially true for the IT sector which is witnessing 26%  attrition – the highest among all sectors in India. In this highly competitive and attrition-prone environment, companies are striving to drive organizational performance and sustained growth.

For this, companies today are looking for unique ways to boost retention and encourage employees to commit to an organization. One of the best approaches to do so is by ensuring that the company’s gains are aligned with those of the employees. In other words, companies are turning valued employees into shareholders to reward them for their past association and performance as well as to motivate them to contribute to the growth and profitability of the company in future. In India, not many knew this was possible until a few leading organizations started issuing ESOPs (Employee Stock Operation Plans) to incentivize their employees to perform better.

ESOPs: When employees become shareholders

ESOP is a type of employee benefit plan which gives the employee the right to purchase a certain number of shares in the company at a predetermined price after the expiration of a predetermined period.

The practice of issuing ESOPs first started among large companies with the intention of rewarding well-performing employees. Today startups are using it to hire talent, as they cannot always afford to pay salaries as high as their more established counterparts can. Most importantly, companies can leverage ESOPs to give employees a sense of ownership. This can boost their loyalty to the company and drive its long-term growth.

However, if employees invest in ESOPs, what are the chances there will be no conflict at the time of exercise? A company can ensure a smooth transfer of benefits to the employees by aiming for transparency while issuing ESOPs. For that, it needs to properly understand how ESOPs work before implementing it.

Who is eligible to get ESOPs?

ESOPS can be granted to:

(a) a permanent employee of the company who has been working in India or outside India; or

(b) a director of the company, whether a whole time director or not but excluding an independent director; or

(c) an employee as defined in point (a) or (b) above, of a subsidiary, in India or outside India, or of a holding company of the Company or of an associate company of the company but does not include (I) an employee who is a promoter or a person belonging to the promoter group; or (ii) a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten percent of the outstanding equity shares of the company.

The restriction mentioned above for the promoters and directors are not applicable if the company is recognized as a startup by the Department of Industrial Policy and Promotion.

What is the procedure to issue ESOPs?

Once an ESOP scheme is approved and adopted by the Board and shareholders of the Company, the company shall issue a letter of grant to the employee. The company should also communicate all the details about the vesting period, mechanism and period for exercise and the exercise price of these options to the employees in the letter of grant. The employee then has to deliver an exercise application to the employer when the employee wishes to exercise his vested options pursuant to which the employee shall be issued equity shares in lieu of the options held by him.

Different routes of granting ESOPs

Trust Route: In this, the company forms an employee welfare trust for the administration of ESOPs in the company. The company issues shares to the trust, which are then transferred to the employees when they exercise their respective options. This route involves significant cost and compliance and is recommended for established startups.

Virtual Pool– The company carves out a virtual pool on its share capital and adopts an ESOP Policy which is administered through the board of the company or the compensation committee, if appointed. The Company makes fresh allotments of the equity shares to employees, as and when they exercise their respective options. This is a more practical and cost-effective way for structuring ESOPS in early and growth stage startups.

ESOPs bring a lot of scope for the company’s growth, yet there are some costs attached to them. They result in dilution of the shares of the founders/shareholders. ESOPs are taxed in two instances – at the time of exercise as a prerequisite and at the time of sale by the employee as a capital gain. To maintain transparency and to ensure the benefit of ESOPs flow to the employees, it is strongly suggested that the company should educate their employees about the taxation regime associated with exercise of ESOPs while granting ESOPs.

It is thus imperative for the company to understand the intricacies of ESOP and ensure that its implementation is as per the organization’s requirements. With the right structure and implementation, ESOPs can enable a truly symbiotic relationship between employees and employers, providing a significant fillip to India’s unicorn dream!

By Ms. Roma Priya, Founder of BurgeonLaw

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