Startup’s Guide to Employee Stock Ownership Plans

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Employee Stock Ownership Plans

In the era of startup business, having committed and motivated employees is significant for development and success. There is one effective mechanism that develops the employee’s interest in the company’s vision is the Employee Stock Ownership Plans (ESOP). It not only offers employees a sense of ownership but also provides a great incentive for driving business operations. Here we are to make you understand ESOP from a startup perspective, which puts the employees and employers on the same path. 

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What do you mean by Employee stock ownership Plans (ESOP)?

Employee Stock Ownership Plan also known as ESOP, is an employee benefit plan and helps employees to have ownership interest in the company they work for. In the scheme, a company establishes a trust fund and collects new shares of their stock or cash to purchase existing shares. These shares are given to the employee’s account separately within the ESOP. It generally depends on eligibility like service length or salary. 

After a period, when employees have sufficient shares in their ESOP, they become the beneficial owners of the company’s portion. ESOPs are mainly used as a mechanism for incentivizing employees, giving them a sense of ownership along with alignment with the company’s objectives and giving retirement benefits. 

Execution of Startup Employee stock ownership plans (ESOP) Scheme

The execution of the ESOP startup scheme in two ways:

  • Direct Route: In this route, the company directly issues shares to the eligible employee, during the time the employee selects his exercise rights. Whenever the employee exercises his right, the company will issue as well as allot full paid-up shares to the employees and also file a form PAS-3 for return of allotment with the Registrar. This route is used by the unlisted and private companies.
  • Trust Route: There is an ESOP trust, which is incorporated under the Indian Trust Act. Initially, the company grants a loan to the trust for the acquisition of their shares, then the trust will have shares of the company by private placement or secondary transfer from the promoter. At the time, the employee is eligible to exercise his options, one can apply to the trust to get paid up shares through paying exercise fees to the trust. Then the trust will return the loan to the company. There is no initial issuance of shares every time, in case employees exercise their right, however, there is no need to file a return of allotment, which is form PAS-3 with the Registrar every time. The trust route is generally utilized by the big unlisted companies and listed companies. 

Step-by-step process for Issue of Stock Options

Here is a general procedure for issue of stock options:

  • Made a list of employees, who are eligible to whom stock options will be provided. 
  • Need to draft the ESOP Scheme.
  • Schedule a board meeting to permit the ESOP Scheme.
  • Schedule the general meeting to permit the scheme by the special resolution in terms of a public company and ordinary resolution in the case of a private company.
  • Submit e-form MGT-14 to the Registrar to file the appropriate shareholder resolution within 30 days of passing.
  • After confirming the ESOP Scheme by the shareholders and board, the Company shall offer options to the eligible employees by grant letter. 
  • After permission, there are options like vesting. There must be a minimum time of a year between the option grant and the vesting of the option as per the provision of the Companies Act, 2013.
  • Once, the options are vested, the employee is eligible to exercise it.
  • When the employee can exercise their right, the Company will create a share allotment to the Company and employees shall submit an e-form PAS-3, which is an allotment return to the Registrar.
  • In the SH-6 form, the company has to maintain a Registrar of Employee Stock Options and must enter therein the elements of the option provided.

ESOP Taxation for Startups

There is taxation impact of Employee stock ownership plans (ESOP) in Indian Startups can be high in case of two conditions:

  • Share on sale: Shares sale, the difference between the prevailing market price and selling price. In terms of FMV, unlisted shares as of the exercise date will be taxable as Capital Gain on the employee’s hand.
  • On exercise: There is a difference between the prevailing market price and the selling price. In the case of FMV, unlisted shares as on the exercise date will be taxable as Capital Gain on the employee’s hand.

Benefits of Stock Options

Here we discuss various benefits of the list of companies offering ESOP in India stock options:

  • It helps the company to pay without any deduction in profit books;
  • It supports the company in employee retention and makes sure of better performance in the workplace.
  • Employees have a sense of belongingness and ownership as they feel like they are working for themselves and not for a company.
  • It is a non-cash technique thus it supports in starting days of startups with less profit to attract high talent with low cash payment.
  • It helps employees as well to encourage them as they own a stock, in which they will perform well for the company. It leads to great returns to themselves as their stock is in the company.

Other options than Employee Stock Ownership Plans Startups

Here are some other options than ESOP Startups, which are quite popular:

  • Stock Appreciation Rights (SAR): It is like a phantom stock, which offers the monetary rights to increase the value of an appropriate number of shares, over a period. It is paid in case there is no option to pay in shares.
  • Phantom Stock Plans: In this, employees have phantom units that seem like real stock options. This stock value is directly associated with the value/ price of the company’s stock. In this plan, employees do not have any actual shares of the company, unlike Employee Stock Ownership Plans. It is generally a plan that promises employees a bonus in terms of the company’s share value at the time employees sell back their phantom units.

Final Thoughts

The ESOP startup is a significant instrument for a startup business, providing unique incentives that foster employee involvement, and loyalty, and go with the company’s target. It attracts great talented employees along the potential equity can be an important element. Through the article, you get to know how to successfully execute the ESOP Startup with appropriate planning, communication as well as management. ESOP Startups Company shall examine the complexities of equity distribution, regulatory compliance, and valuation to make sure their ESOPs provide development rather than a source of confusion or contention.

CS Urvashi Jain is an associate member of the Institute of Company Secretaries of India. Her expertise, inter-alia, is in regulatory approvals, licenses, registrations for any organization set up in India. She posse’s good exposure to compliance management system, legal due diligence, drafting and vetting of various legal agreements. She has good command in drafting manuals, blogs, guides, interpretations and providing opinions on the different core areas of companies act, intellectual properties and taxation.

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