Tag Archives: ESOP

Ten Frequently Asked Questions on Exercising Employee Stock Options in Private Limited Companies

Employee Stock Option or ESOP is a mechanism through which companies provide options to their employees to purchase equity shares and become stakeholders in the companies, at a pre-determined price, and upon “Exercise”. To read more on the basics of ESOPs please see here.

Over the last couple of years, we have advised many companies on setting up and implementing ESOP and in the process, we have received queries from both employers and employees on exercise of ESOPs, right time for exercising, tax incidences, etc. In this post, we have attempted to put them in the form of answers to Frequently Asked Questions.

  1. Why are ESOPs granted?

Stock options could be granted for various reasons, ranging from motivating employees to contribute to Company’s growth, to incentivizing employees, rewarding for optimal performance, and also attracting talent pool. In most cases of early stage ventures, ESOPs are used effectively as a compensation packaging.

  1. Who can companies grant ESOPs to?

All employees of a company (including employees of parent and subsidiary entities) can be granted ESOPs, other than promoters, independent directors and directors (holding more than 10% of the outstanding equity shareholding in a company, either directly or indirectly). Depending on the structure of the ESOP scheme adopted by a company the board of directors of such company or the trustees of an ESOP trust of such company, have the ability to formulate and identify certain category of employees, like senior management, performance based, etc., who shall be eligible to obtain grants of ESOPs in such companies.

A registered ‘start-up’ (as defined under the Start-up India Action Plan) can further issue stock options to promoters and even directors holding more than 10% of the outstanding equity shareholding.[1]

Consultants/ advisors, however, cannot be granted employee stock options, under the current legal framework.

  1. What does “Exercise” mean?

Exercise is an event through which an employee or ESOP holder actually exercises the right to purchase equity shares of the company, at a pre-determined price (“Exercise Price”), upon completion of vesting of granted ESOPs, or any portion thereof, and upon payment of the Exercise Price. The moment ESOPs are Exercised, the concerned employee becomes a shareholder in the company.

  1. What is “Exercise Price”?

Exercise Price, as explained above, means the purchase price payable by an employee for each equity share that he/she is entitled to get, upon Exercise of vested ESOPs. The Exercise Price could be a fixed number or formula driven, and such number/formula is required to be captured in the ESOP scheme.

  1. What is “Exercise Period” and when can an employee Exercise ESOPs?

The time period within which an employee can Exercise vested ESOPs, is known as “Exercise Period”. Typically, the Exercise Period would be captured in a company’s ESOP scheme, or in stock option agreements executed with employees.

The Exercise Period could be any time, once ESOPs are vested. Some of the instances of how an Exercise Period may be structured, are as follows:-

  • It could be an annual/semi-annual window in a given financial year, within which all employees with vested ESOPs may Exercise (vested ESOPs only);
  • It could be linked with termination/resignation, and any time within the notice period an employee may Exercise vested ESOPs;
  • It could also be at a merger, entity buy over, change of control situation in a company (considering the cash outflow of the Exercise Price by employees at the time of Exercise and tax incidence as discussed in Point No. 6 below).

However, it is recommended that only one of the above-mentioned options are chosen in order to avoid operational confusion. The ESOP scheme of many companies also provide that if vested ESOPs are not Exercised within an immediately next Exercise window, especially in case of termination/resignation, the vested ESOPs shall also lapse.

  1. What are the applicable Tax incidences upon an employee Exercising ESOPs?[2]

In the hands of an employee:

  • At Exercise: The difference between Exercise Price and fair market value of the shares of a company, at the time of Exercise, is taxable as ‘perquisite’ [Ref: Section 17 (2) (vi) of the Income Tax Act, 1961] under the head of ‘Salary’. The exact amount of tax payable would depend upon the relevant tax slab under which an individual employee falls.

The employer/ company has to deduct TDS on the perquisite amount.  For instance, if the Exercise Price per ESOP is INR 10/- and the fair market value of each share in a company, at the time of Exercise, is INR 100/-, the difference amount, i.e. INR 90/- (INR 100/- less INR 10/-) shall be taxable as ‘perquisite’ and TDS shall also have to be done.

  • During Transfer: At the time of transfer (sale/purchase) of shares obtained upon Exercise of ESOPs, the difference between transfer price and acquisition cost is taxable as capital gains and depending upon the tenure of holding of such shares, the capital gains on the concerned employee could be long term or short-term.

It may be noted that the holding period for calculation of capital gains starts from the date of Exercise.

In the hands of companies:

Discount given to an employee, if any, on the fair market value, at the time of Exercise, i.e. the difference between the Exercise Price and the fair market value, is a permissible deductible business expenditure [Ref: Section 37(1) of the Income Tax Act, 1971] in the hands of a company.

  1. What is the process of Exercise?

Depending on the terms and provisions contained in the ESOP scheme of a company, the Exercise process could be the function of an employee holding vested ESOPs, giving notice to the company in this regard, within the Exercise Period. The Exercise Price needs to be paid in full to the company prior to any Exercise. Post such payment, the Company either issues fresh equity shares to the employee (in case of a notional pool) or transfers the shares to the employee (in case of a trust driven pool). Relevant statutory filings and compliances have to be done for issuance or transfer of shares by the company, as the case may be.

  1. What if an employee leaves before Exercising the vested ESOPs?

This is closely linked with the Exercise Period, as discussed in Point No. 5 above. As such, upon termination/resignation, vested ESOPs may be Exercised by an employee, during the relevant notice period, or held on for Exercising during a merger, entity buy over, change of control situation in a company. Many a times, the way vested ESOPs could be Exercised, is also made dependent upon whether such termination or resignation is for a good reason or a bad reason.

Unvested ESOPs, however, under all circumstances, get cancelled, upon a resignation/termination.

  1. Can a company grant loan to its employees for Exercising vested ESOPs?

Rule 16 of the Companies (Share Capital and Debenture) Rules, 2014 allows companies to grant loan to its employees for the Exercise of vested ESOPs. However, such loan has to be granted in compliance with applicable provisions of the same.

  1. Can a company put restrictions on ESOPs / shares granted under ESOP schemes?

ESOPs cannot be transferred, pledged, hypothecated, mortgaged or otherwise encumbered in any manner.  Shares granted to an employee post Exercise may be subjected to transfer restrictions, and other shareholding rights and obligations as may be applicable in the charter documents of any particular company.

In case of Exercise, prior to the occurrence of a merger, entity buy over, change of control like situation, promoters may also evaluate having some control over such ESOP shareholding, such that, if required, ESOP shares can also be sold, seamlessly, of course subject to the same terms and conditions (including price) as available to other shareholders in such a situation.

Authors: Ms Ayushi Singh (Associate) and Ms Sohini Mandal (Junior Partner)

[1] Notification by Ministry of Corporate Affairs, dated 19 July 2016 available at:


[2] We are not tax experts and the contents captured hereinabove is a mere statement of the provisions. Separate tax advice shall be taken in this regard.


Amendments to Companies Act and some relief to Permitted Startups

With the ability to modify the guidelines quick and fast, Companies Act has become dynamic. On 19 July 2016, the Ministry of Corporate Affairs notified the Companies (Share Capital and Debentures) Third Amendment Rules 2016 (Amendment) to amend certain provisions of the Companies (Share Capital and Debentures) Rules 2014 (Rules). These Rules contain the procedures for issuance of shares and debentures and disclosures to be made.
Notes of the Amendments made:

1. Relaxation of preferential allotment process:
Earlier to these amendments, any securities issued through the ‘private placement’ process had to be fully paid up at the time of allotment. This infact was an anomaly, because, if the company chose a ‘right issue’ process, then it was possible to issue partly paid shares. The amendment now seeks to set this anomaly right and made it possible to issue partly-paid shares even through private placement process.

2. Determination of conversion price:
Earlier to these amendments, a company issuing convertible securities had to determine the conversion price at the time of issuance. This is true for any foreign direct investment as well. Now, companies may either determine the conversion price (a) upfront at the time of offering the convertible securities, or (b) not later than 30 days prior to the date the holder of convertible securities becomes entitled to convert such convertible securities, based on a valuation report of a registered valuer issued not later than 60 days prior to such date. The change in the foreign direct investment guidelines is still the same and it has to be notified to RBI at the time of issuance.

3. Issue of secured debentures:
Earlier to these amendments, a company could provide only its own assets and properties as a security for issuance of secured debentures. Now, the companies can issue secured debentures by creating a charge on the assets and properties of its subsidiaries, holding company or associate companies. The amendment expressly permits companies intending to redeem their debentures prematurely to transfer such amounts in excess of the limits specified under the Rules as may be necessary to the Debenture Redemption Reserve.

4. Issue of equity shares with differential rights:
Earlier, companies could not issue equity shares with differential rights if they defaulted in (a) the payment of dividends on preference shares, (b) the repayment of a term loan (or interest thereon) from specified institutions, (c) the payment of statutory dues relating to employees, or (d) crediting prescribed amounts in the Investor Education and Protection Fund. Now, such defaulting companies to issue equity shares with differential rights after 5 years from the end of the financial year in which they make good the default. It would have been nice, that a company could issue such shares immediately upon compliance.

5. Sweat equity shares by Permitted Start-ups:
Start-ups (as defined in notification number GSR 180(E) dated 17 February 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India – “Permitted Startups”) are now permitted to issue sweat equity shares up to 50% of their paid-up capital for the first 5 years from the date of their incorporation. For other companies, this limit continues to be 25%.

6. Stock options to promoters and shareholder-directors of the Permitted Start-ups:
Permitted Start-ups can issue stock options to their promoters and to directors who hold more than 10% of the start-up’s equity shares for the first 5 years from the date of their incorporation. The restriction on issuing stock options to promoters and such directors continues for all other companies, who are not Permitted Startups.

7. Form SH-7 by companies not having share capital:
The Amendment requires that Form SH-7, for intimating any alteration of a company’s authorised share capital, be filed by companies that do not have share capital in case of an increase in the number of members.

Author: Venkatesh Vempati, works as an Associate with the Compliance Team

ESOP Unplugged


Author – Geetika Chandel, Associate with NovoJuris.

Disclaimer:  There are many details that the Act prescribes, please speak with your attorney for advice. This is not a legal opinion and should not be construed as one.

Confused about ESOP versus Sweat Equity versus Shares against services?

Founders have this question and here is a comparative:


An Employee Stock Option Plan (ESOP) is an option given to the employees to buy the shares of the Company. Until the option is exercised and converts into a share, an option holder does not get any shareholder rights of voting, dividends and the like. An Option is valuable because it gives the right to purchase the shares at typically a pre-determined price, and therefore gives the employee an upside to the current value of the share.  Please read our 5 part blog series, which gives a complete overview here.

Basic glossary:

  •  Grant: Is the act of commitment by the employer through informing the employee of the eligibility for the Options under ESOP.
  •  Vesting: Vesting percentage is the portion of the total options Granted which can be exercised on completion of the Vesting Period.
  •  Exercise: Is the act of paying the Exercise Price to convert the Options into Shares
  •  Exercise Period: Any time after the Vesting Period within which the employee has to Exercise.
  •  Lapse of Options: After a certain period, typically termination, expiry of Exercise Period the Options lapse and cannot be converted to Shares.

An ESOP can be used for multiple purposes – as a talent retention tool, as an incentive, as a remuneration mechanism. Accordingly the parameters of the plan would be tailored, if retention, then probably the vesting period would be kept longer. If incentive, then probably the Exercise Price would be kept low, may be face value of shares, so that the employee enjoys a high upside, if remuneration tool, then the eligibility criteria would possibly be all employees. But typically, it is a combination of all of these factors and hence a good balance is required to be detailed in the Plan. An Option is different from Sweat Equity. Sweat Equity means Shares (not Options) granted “in lieu of” services, technology transfer etc. Also, tax treatment and accounting treatment is different compared to Options.

Tax Impact – ESOP:

Under ESOP, there is double incidence of tax on the employee. That is, first at the time of Exercise and second at the time of sale of shares by the employee.

At Exercise:

The tax incidence is calculated on the difference between the Exercise Price and Fair Market Value (FMV) of the Shares on the date of Exercise which shall be construed as perquisite in the hands of employee as a component of salary and taxed according to his/her taxability as per Income Tax Act’s slab rate.

The FMV of the shares shall be as determined by a merchant banker or a chartered accountant as per the Discounted Free Cash Flow method.

At Sale:

When an employee ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) FMV calculated at time of Exercise. Depending on when the sale is undertaken by the employee, the capital gains will be either Short term or Long term capital gains.  Sale within a period of 12 months is considered as Short term capital gain tax, and sale after 12month is considered as Long term capital gain tax.


Sweat Equity Shares – Companies Act, 1956

Issue of sweat equity shares is governed by the provisions of S. 79A of the Companies Act. Explanation II to the said Section defines the expression ‘sweat equity shares’ to “mean equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing the know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.” It is, therefore, necessary for the issue of sweat equity shares that the concerned person either provides the know-how, intellectual property or other value additions to the company.

In terms of the said Section, a company may issue sweat equity shares of a class of shares already issued, if the following conditions are satisfied:

(a) such issue is authorized by a special resolution of the company in the general meeting;

(b) such resolution specifies the number of shares, current market price, consideration, if any, and the class or classes of the directors or employees to whom such shares are to be issued;

(c) such issue is after expiry of one year from the date on which the company was entitled to commence business; and

(d) in the case of an unlisted company, such shares are issued in accordance with the guidelines as captured below.

Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 (Rules):

The guidelines referred to in S. 79A are the Rules issued by the Central Government, which need to be followed by unlisted companies. Rule 8 prescribes that the issue of sweat equity shares to employees and directors shall be at a fair price calculated by an independent valuer. As per Income Tax Act, valuation shall be determined as per Discounted Free Cash Flow method.

Rule 6 restricts the issue of sweat equity shares in a year to 15% of the total paid-up equity share capital or shares of a value up to Rs.5,00,00,000/- (Rupees five crores only), whichever is higher. If this limit is to be exceeded, the same is required to be done with the prior approval of the Central Government.

Rule 10 provides sweat equity shares issued to employees or directors shall be locked in for a period of three years from the date of allotment.

Taxation Impact:  Sweat Equity shares as per the Income Tax Act, 1961 has 2 aspects. > Salaries. > Capital Gains.

Salaries:  Whenever an employee receives a sweat equity shares, the value of such shares will be taxable as a perquisite under the head Salaries as per section 17 of IT Act.

Capital Gains:  When an person ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) FMV calculated at time of allotment of shares. As per the period of holding, Short term or Long term capital gains shall be applicable. <12 months – Short term capital gain tax, >12month – Long term capital gain tax.


When Shares are allotted against services rendered or towards know-how, IP etc., then there would be an invoice for the services against which shares are issued.

Taxation Impact:  TDS as applicable to the services (invoice).

Capital Gains:   When an person ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) acquisition price calculated at time of allotment of shares.

Process:  Shares allotted at the Board meeting and Forms 2 and 3 filed with ROC along with the relevant agreement for the services.

Disclaimer This is not a legal opinion and should not be considered as one.  Please check with your attorney before taking any actions.

ESOP to employees outside India – Part V of the Series

We’re probably making the startup founder an expert on ESOPs :).  Startups who work with us understand our obsession of making them a success.

In this post, we’ll discuss about legal aspects of ESOP to employees of the Indian company based outside of India and ESOP to employees of a foreign company based in India.

A private and unlisted Indian company can issue ESOP to employees, who are resident outside India, by being compliant not only to Companies Act but also the FDI Policy (Foreign Direct Investment).  The Indian company has to report to the Reserve Bank of India (RBI) with details of the issue of shares after the Exercise.

Also, there are no restrictions on the operationalization of the Plan, i.e. the shares can be issued directly by the company or through a Trust.

Care to be taken that the adjustments on bonus shares, rights shares, transfer of shares has compliances attached to it.

For a Listed company, the ESOP Plan has to be drawn in line with SEBI’s regulations and a limit of 5% of the total paid up capital.

ESOP to employees of a foreign company based in India

Automatic permission has been given for an Indian citizen (individual) to acquire shares under ‘cashless’ ESOP issued by a company outside of India.  I.e. no remittance from India is permitted.

To purchase equity shares offered by a foreign company under ESOP, an employee/ director of Indian subsidiary, the same can be done upto 51% through automatic permission route. Again, there are no restrictions on the operationalization of the Plan, through Trust or directly from the company or through a special purpose vehicle. There is also a need to ensure that the ESOP offered by the foreign company is on a uniform basis globally.

Remittance made by the Indian company for purchase of shares under ESOP has to be intimated to RBI.

Further, if an employee transfers the shares acquired then he has to repatriate the sale proceeds within 90 days to India.

The foreign company is also allowed to repurchase the shares issued under ESOP, but comes with compliance requirements.

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

De-mystifying ESOP Implementation – Part III of the series

It is nice to have you come back for more.

In this post, we’ll cover the nuances for implementing an Employee Stock Option Plan (ESOP) through a Trust (formed under the Indian Trusts Act)

This is a little complex compared to the Plan directly administered by the Board.  Here’s an overview of how this works:

  1. A Trust is formed under the Indian Trusts Act, and the Trust Deed is registered with the jurisdictional Sub-Registrar. In Karnataka, a stamp duty of 1% of the value of shares (including premium) is applicable.
  2. The ESOP Trust receives stock either from company by way of fresh allotment or by purchasing from existing shareholders in open market or one of the shareholder/founder may transfer his shares.
  3. In order to purchase the shares, the Trust can obtain a loan from a financial institution or the company can provide the loan as well.  There is a specific provision in the Companies Act, which permits such a loan. (Sec. 77(2) (b) and (c))
  4. The ESOP Trust then allots shares to employees on exercise of their right in exchange of cash and repays its loans.

Here are some teaser questions that your advisor needs to help you with.  If the shares are issued at a premium does the premium remain with the Trust?  Can the Trust also manage other activities like provident fund also? Who needs to be Trustees?  How do the Trustees and the Board of the Company work in tandem? What powers need to be granted to the Trustees?

This series on ESOP is meant for startups but just an additional point in the passing for a company listed on stock-exchanges (which are governed by SEBI’s regulations):  SEBI guidelines do not mention about ESOP Trust and thus creation of a Trust to administer the Plan is optional. SEBI guidelines also do not specify any accounting principles to be followed. 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 Accounting Standard 21 and the existing ESOP guidelines should be applied by the consolidated entity.

Below is our attempt to outline the how-to points.  We believe that the company might have to have a smart team to help implement this, could be in-house or outsourced.

  1. Structure the ESOP Trust Deed (a Private Trust formed under the Indian Trust Act, 1882).
  2. 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).
  3. Board of Trustees is controlled by the Company (indirectly by being nominated as trustees).
  4. Company may give loan to the trust to buy shares (earmarked for ESOP) (U/s 77 of Companies Act).
  5. Trust uses the funds to buy shares of the Company.
  6. Employees of the Company are granted Options.  Decision to grant Options is controlled by the Compensation Committee of the Company.
  7. On exercise of the Options, the Trust transfers shares (held by it) to the employee.
  8. 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.
  9. 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.
  10. If the options lapse due to separation, the options remain with the Trust.
  11. The cash received on exercise (by the employee) is used to repay loan taken by the Trust.

The idea of this Series is not to over-whelm the startup entrepreneur but to sensitize him on the various avenues available.

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

De-mystifying ESOP Implementation – Part II of the series.

The previous post covered the Basic Primer on Employee Stock Option Plan (ESOP/ Plan)

In this post, we’re going to chart out a clear ‘How To’ process for Startups.

Most startups know about ESOP Trust. May be, because amongst the top 10 Google search results is Infosys’ ESOP Trust  But in a small sized organization, following the Trust route might be onerous and expensive. An easier option would be, to have the Board of Directors (Board) administer the ESOP Plan. Here’s how:

  •  Structure a Plan and get it approved by the Board.
  •  Board identifies eligible employees and issues Grant Letters
  •  The chosen employees accept the Grant Letter and intimate so.
  •  After Vesting Period , the employee Exercises by paying the Exercise Price
  •  On receipt of money, the Board ‘allots’ the Shares and issues share certificates to the employee and files the ‘return of allotment’ with the Registrar of Companies.

Simple, isn’t it? Or is there a catch?

To make the implementation simple, the Plan has to be structured very well. The rule to structure a good Plan is to be clear, transparent and cover scenarios which ought to be, but at the same time balance the flexibility of administering the Plan.

The typical components of an ESOp Plan:

  •  Talk about who is an ‘eligible’ employee – all of them? On joining even during probationary period? On confirmation of employment? Part-timers?
  •  Pool size, i.e. the number of Options available for Grant.
  •  Vesting Period. Ah, here is where the knowledge of your expert comes into play. You don’t have to have the same Vesting Period for all.
  •  Exercise Price. It would be great if the Plan determines upfront. It provides clarity for employees but at times it would be hard for an employer to determine it and hence provide for a flexibility to defer the decision.
  •  Procedure for Exercise. Exercise period.
  •  Shareholder rights on issuance of shares.
  •  Exit opportunities for the shares held by the employees.
  •  Clarity on what happens to the granted Options on death, retirement, termination, resignation of an employee.
  •  A smart Plan will also cover details of, what happens should the founders sell 100% of the company, liquidity event and the like.

Here’s more effort to make it more simple for the startup entrepreneur – Tips for implementing !

  •  We believe that till about 75 to 100 employees, it is possible to have the Board or compensation committee of the Board to administer.
  •  An excel sheet of employees who have been Granted Options, Vesting Period, whether Exercised needs to be maintained.
  •  Templatize the letters to be issued to employees. Obviously, some time has to be set aside for issuing Grant Letters, collecting details from employees.
  •  If Vesting Period is annual, then the task of Exercise can be synchronized to be once in a year and hence allotment of shares can be made once in a year. But if the Vesting is on a monthly basis, then more time need to spent by the Board for allotments and filings with ROC.
  •  The accounts team has to be kept in the loop, so applicable TDS (tax deduction at source) can be made from the employee’s salary. But, get an expert help for ‘valuation’ of ESOPs.

In the next post, we’ll cover the implementation process if the ESOP has to be administered through a Trust. Stay tuned.

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