Creation of ESOP Trust – Why complicate?

Many small sized organizations prefer to have the Board approving the grant of stock Options.  In large organizations, they either have a Compensation Committee or set up a Trust. Many Indian companies, including Infosys Limited, have used trust route to implement ESOP scheme.

We recommend startups opt the administration of ESOP by its Board of Directors rather than creation of a Trust (per Indian Trusts Act).  A startup recently approached us for cleaning up the mess they had created in their ESOP grants and wounds they had self-inflicted in creation of their ESOP Trust, which triggered this post.

A Trust for ESOP works as follows:

  1. A Trust is formed under the Indian Trusts Act, and the Trust Deed is registered with the jurisdictional Sub-Registrar.
  2. The ESOP Trust receives stock either from company by way of fresh allotment or by purchasing from existing shareholders in open market or the owner of the company may sell shares of his holding to the ESOP Trust.
  3. The ESOP Trust usually obtains its funds through a loan either from a financial institution or from the seller or a combination of institutions and seller. A company can extend loan to the Trust for purchasing the Shares. There is a specific provision in the Companies Act, which permits such loan. (Sec. 77(2) (b) and (c)

 The ESOP Trust then allots shares to employees on exercise of their right in exchange of cash and repays its loans.

 Additional Information, if the company is a listed entity:

 SEBI guidelines do not mention ESOP Trust and thus creation of trust to administer the ESOP scheme is optional. SEBI guidelines also do not specify any accounting principles to be followed in case of grant of options through a trust. A committee appointed by SEBI had recommended that since this is a consolidation issue rather than an ESOP issue, the ESOP trust should be consolidated with the company under AS 21 and the existing ESOP guidelines should be applied by the consolidated entity.

 TRUST SET BY THE COMPANY FOR THE BENEFIT OF EMPLOYEES:

 ESOP Trust (a Private Trust formed as a separate entity, but not being a charitable Trust) can be formed under the Indian Trust Act, 1882.

  1. Shares of the company can be held by the Trustees is held as beneficial owners. Hence Form 22-B declaring beneficial ownership has to be filed with ROC. (Sec 153 of Companies Act).
  2. Board of Trustees is controlled by the Company (indirectly by being nominated as trustees).
  3. Company may give loan to the trust to buy shares (earmarked for ESOP) (U/s 77 of Companies Act).
  4. Trust uses the funds to buy shares of the Company.
  5. Employees of the Company are granted Options by the company.  Decision to grant Options is controlled by the Compensation Committee of the Company.
  6. On exercise of the Options, the trust transfers shares (held by it) to the employee.
  7. While transferring the shares to the employees by the trust, the Share Transfer Form (Form 7B) has to be executed by the Trust and the employee.
  8. The share transfer form has to be approved in the Board Meeting (BM) of the company and then the employee becomes a shareholder of the company. After which they are issued share certificates and the Register of Members is updated accordingly by the Company.
  9. If the options lapse due to separation, the options remain with the Trust and Trust can issue fresh grant letters for the remaining options (based on the decision of the Compensation Committee).
  10. The cash received on exercise (by the employee) is used to repay loan taken by the Trust.
  11. Compensation cost to be recorded as if the Options were granted directly by the Company.

 Startups are you hearing us?

Disclaimer: This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.

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