Tag Archives: ESOP

Advisors in Start-ups and Early Stage Companies

India is witnessing a high growth in the number of start-ups in the country and is also amongst the top start-up ecosystems in the world. The government has provided a few benefits to startups as well, through the Startup India Action Plan.

However, only a few of these start-ups actually succeed. It is a treacherous path with a lot of unknowns. An advisor or an advisory board in a start-up might help the early stage companies to atleast know some of those unknowns. Financial investors certainly add value, sometimes domain expertise even. The comfort of speaking with an advisor where they bring in the expert views, advice and sheer experience onto the table is very valuable. As the saying goes, ‘Experience is the best teacher’.

Who are these Advisors and what role do they play?

An advisor is a person who brings in his unique skill sets and expert opinion on the business of the company, operational or otherwise. They are the people ‘who have been there and done that’. They can play a major role, especially if the founders and the team are new to the industry and do not have much experience. There are celebrity advisors even, who by being called as an advisor adds value to the startup.

Advisors can play different roles, for example, advisors who bring in their expertise in a particular domain or area; help with their networks and can introduce potential clients, employees or investors; or scaling up teams; expansion to new geo. It is not just having the advisors but also heeding to their advice. Therefore, advisors need to be chosen very wisely, so that their advice can be relied and executed upon.

How to choose the right Advisor?

Hiring an advisor who does not add much value or provides incorrect advice to the company may turn out to be counter-productive or disastrous. The advisors bringing in complementary skills or “deeper” skills which the founding team has a gap would be great. Identify the areas where the founders lack expertise or sufficient industry knowledge, where they face difficulties or have faced difficulties in the past or any area where they would require expert advice. Once there is clarity on where and why advisors are required, do some research and talk to people who can introduce you to some advisors. Discussing the same with the existing investors (if any) might also be a good idea as they might be able to connect the founders with the relevant people. And since the investors have invested in the company, they would ensure that the advisor will be someone who can add value to the company.

Ensure that they are people with the relevant expertise and knowledge, proven track record, good communication skills, networking skills, etc. Advisors should be individuals who would invest their time for the growth of the company and who can provide support to the founders where there is lack of expertise or knowledge.

Engaging with the advisor

An advisor may be compensated in cash, equity etc. Many a time, the advisor is interested in just giving back to the eco-system. One should evaluate if the advisor has time to provide support to the startup, whether the advisor is associated with other companies which the startup may have conflict / competition.  Maintaining a good rapport, having regular discussions and candid conversations, updating the advisor on a regular basis about the business and other relevant aspects of the business can go a long way. The most important factor is to ensure that there is trust between the parties.

Some startups look for a small investment by the advisors into the company, as a test to ensure that the advisor believes in the idea, startup, founders etc.

Compensation for Advisors

Let us now evaluate some of the ways to compensate advisors for the value-add they bring to the company.

Start-ups, more often than not, compensate advisors by giving a percentage of equity in the company since they may not have the finances to give cash compensation (unless well-funded). New shares can be issued to the advisors or shares can be transferred from the founders. Such issuance or transfer should ideally happen at the face value of the shares since it is a compensation for the services rendered by the advisors and the advisors would not want to pay the full price of the shares. As the same is being issued/transferred at face value instead of the fair market value, tax implications need to be evaluated since any issuance/transfer of shares below the fair market value will fall under the ambit of the Income Tax Act, 1961. Also, the percentage holding of the founders needs to be taken into account so that their shareholding percentage does not get diluted to a large extent considering that there will be future investments, where the shareholding will get diluted further. Another aspect to be considered is that, an issuance of shares will dilute the shareholding of all shareholders (including investors if any) whereas the transfer of shares from founders will dilute only the founders’ shareholding.

Another way of compensating the advisors is by issuing shares to them by way of consideration other than cash under section 62 (1) (c) of the Companies Act, 2013 (“Act”) read with rule 13 of Companies (Shares Capital and Debenture) Rules, 2014. The private placement process under section 42 of the Act will have to be followed for this purpose. The advisors have to raise invoice for the services rendered which will be commensurate with the fair market value of the advisory shares. Company will be responsible for TDS which will be a cash out on the Company. Further, the entire amount shall be taxed in the hands of the Investor as income from other sources, at the applicable tax slab.

Yet another option could be granting phantom stock options (“PSOs”) to the advisors. These are options which are settled by way of cash settlement. It a performance-based incentive plan through which the advisors will be entitled to receive cash payments after a specific period of time or upon reaching a specific target. A separate agreement can be entered into for capturing the details. This is directly linked to the value of the company’s share price. For example, the advisors could have promise of ‘x’ number of shares at ‘y’ price at grant. At exercise, the appreciation in the value of the share price, is handed out as cash incentive. Tax will be applicable at the time of payout. However, unlike employee stock options, which is recognized under the Act, PSOs by private limited companies does not fall under the ambit of the Act and therefore, will be in the nature of contractual right. Please see our previous post on  Phantom Stock Options to know more about this.

It has to be noted that advisors are not eligible for employee stock options (ESOPs) as ESOPs can be given only to employees and directors subject to the restrictions under the Act and relevant Rules.

Advisory shares to Non-Residents:

It becomes a little more complex when the advisor is a non-resident since the shares issued/transferred to a non-resident needs to be in compliance with the pricing guidelines as provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FDI Regulations“). As per the pricing guidelines, capital instruments which are issued or transferred to a non-resident has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a SEBI registered merchant banker, in case of an unlisted company. Considering these rules, granting of advisory shares to a non-resident can be a very tricky situation. PSOs may be a better option in this case.

Formal Agreement with Advisors

The engagement with the advisors should be fruitful for the company and help in its growth. It is advisable to enter into a formal agreement with the advisors which captures all important terms regarding the engagement which will be beneficial for both the company and the advisors. This will help in keeping track of the contribution of the advisors and also if in future, any differences arise between the company/founders and the advisors, it will always help to have a formal agreement. The exact role of the advisor and deliverables, vesting schedule, time commitments, compensation, non-compete, confidentiality, exit related provisions, etc. should be captured in such agreements. Specific milestones may also be included in these agreements. Once the milestones are satisfactorily completed, compensation as agreed can be given.

Once the advisors become shareholders in the company, depending on the shareholders’ agreement (if any), the advisor might need to enter into a deed of adherence, so that the rights of the shares are captured.

Author: Paul Albert

 

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ESOP vesting: Can it be paused during maternity leave?

Employee Stock Option Schemes (“ESOPs”) are structured by companies such that the employees are granted options which is a right that vests over a period of time. Upon vesting the employee can ‘exercise’ and shares are allotted by the company (or transferred by the Trust, if the ESOP is administered by a Trust).

The question is, can the vesting be paused / stopped for reasons such as sabbatical, unauthorized leave, garden leave, maternity leave etc.?

Sabbaticals, garden leave is usually a program / policy that a company would have and they spell out treatment of full pay, partial pay, benefits and the like.

Unauthorized leave is usually treated as mis-conduct and is treated per company’s policies.

However, maternity leave is a statutory right and the pay and other benefits cannot be stopped or paused during this period.

The United Nations Convention on the Elimination of all forms of Discrimination Against Women (“UNCEDAW“), which India is a signatory to, mandates under Article 11 that State Parties are required to ensure that the female employees would have a right to pay or comparable benefits without loss of employment, seniority or social allowances.

India being a signatory to the UNCEDAW is bound under the obligation of pacta sund servanda Article 26 and Article 18 providing for the obligation not to defeat the object and purpose of a treaty of the Vienna Convention on the Law of Treaties (“VCLT”).

Vesting of ESOP during Maternity Leave

The vesting of options stays in effect as long as the employee remains in the employment of the company. A female employee’s employment, during maternity leave, cannot be terminated in accordance with Section 12 of the Maternity Benefit Act 1981 and it shall be unlawful for her employer to discharge or dismiss her during or on account of such absence.

The said position has been upheld in the case of Neera Mathur v Life Insurance Corporation of India[1] where it was held that the employment of a female employee shall be protected and it would be wrongful on part of the employer to terminate the employment of the female employee during the period of maternity leave. The same position was upheld in the case of Bharti Gupta (Mrs.) v. Rail India Technical and Economical Services Limited and Ors[2] wherein it was held that Section 12 of the Act underscores the independent and inflexible nature of the liability to mandate that no woman employee can be dismissed on account of her pregnancy. It is the right of the employee to get medical benefits since such grant of maternity benefit is according to the mandate of the law.

Section 5 of the Maternity Benefit Act 1981 states that female employees cannot be denied the emoluments such as continuation of employment and payment of wages on account of being on maternity leave. This position has been upheld by the Supreme Court in the case of Municipal Corporation of Delhi v. Female Workers (Muster Roll) and Ors[3].

ESOP taxation is treated as a perquisite. Ie. at the time of exercise, the difference to exercise price and fair market value is taxed as perquisite. Shares when sold are subject to capital gains tax.

An inference can be drawn from the above, that vesting of ESOP cannot be suspended, paused during maternity leave.

Author: Mr. Spandan Saxena

[1] AIR 1992 SC 392

[2] 2005 VII AD (Delhi) 435

[3] AIR 2000 SC 1274.

Basics of capital table and different capital instruments

The capital table is a reflection of the shareholding pattern of a company, shareholder names, percentage of shareholding.  This shareholding should ideally reflect the voting percentage in the company. But does it? What if the ESOP percentage has to be included while there is no voting on ESOP?

Founders should also consider the number of people on the capital table, though the maximum number in a private limited is 200, for various reasons including logistics of execution of documents, distribution of the annual accounts & annual report etc.

In this post, we have captured some of the key aspects to be considered while structuring the capital table.

At the time of Incorporation: It may be noted that the subscription of shares at the time of incorporation will be at face value and cannot be issued at a premium. The initial subscribers are usually the founders themselves.

The shareholding pattern amongst the founders is a function of many factors, such as roles and responsibilities and what each of them would bring to the table, whether investment is in cash or in terms of performance and service, for example, as a technical expert or a marketing expert. It certainly helps in decision making if one of the founders have majority shareholding. It is highly recommended that the founders enter into a founders’ agreement wherein the number of shares, percentage shareholding, future investment, vesting schedule, if any; roles and responsibilities of each founder, treatment of shares upon termination, etc. This would help in setting expectations as well as helpful in easing the founder terminations / resignations.

Employees Stock Option Pool (“ESOP”): A great team is instrumental and vital to the growth of an early stage company. However, the company may not have the finances to compensate with market salary to its employees at early stages (unless well funded). Thus, issuing stock options becomes very attractive – not only as compensation mechanism but also as building ownership and responsibility in the company. Stock options are notional unless they are exercised and shares are allotted. They represent a right to purchase a specified number of shares at a specific (exercise) price. When an employee exercises the Options and issued shares, then they became part owners in the company and can also sell the shares. Stock Options cannot be transferred or sold. Please see our previous post on Ten Frequently Asked Questions on Exercising Employee Stock Options in Private Limited Companies for more details in this regard.

Though Stock Options are not shares yet, it still forms a part of the capital table. External investments into the company, be it angel or institutional investment, are on a fully diluted basis. Ie. a shareholding pattern, as if all the outstanding share allotments regardless of vesting, assuming all stock options are converted, assuming all convertible securities are converted into common shares. Hence, Stock Options also form part of the capital table. In such a scenario, the percentage captured in the cap table is not necessarily the percentage of voting.

At the time of Investment: Whenever new investors subscribe to the shares of the company, the capital table undergoes a change. All the earlier shareholders’ percentage holding dilute, while the number of shares that they hold remains. If ESOP is set aside before the new investors coming in, then ESOP percentage dilutes, while the number of options set aside, remain the same.

Issuance to Advisors: Issuance of shares has to be at fair market value. Many a time, it is convenient for the founders to transfer their shares to the advisors. However, tax impact has to be evaluated for such transfers.

In India, we have different kinds of shares:
Equity share capital (common stock): (i) with voting (ii) with differential rights, such as dividend or voting. Founders typically have equity shares. ESOP is also typically granted as equity share class.

Preference share capital, which carry a preferential right over the equity shares to be paid dividend and a preference for repayment of capital in case of winding up. Investors typically have preference shares.

Preference shares can be:
Cumulative preference shares, which means that the holders are entitled to receive dividend even when a company does not make (adequate) profit, in which case the dividend is accumulated and paid when the company does have sufficient profits.
In Non-cumulative preference shares, the holders get the dividend only when a company makes sufficient profits, else the dividend lapses and cannot be carried forward.
Participating preference shares, means that the holders are eligible to receive surplus profits or dividends in addition to being entitled to their fixed dividend.
In Non-participating preference shares, the dividend paid is only to the extent of the agreed fixed dividend.
Convertible preference shares are those that are converted into equity within the maximum period of 20 years. Non-convertible preferences are those that do not get converted into equity shares.
Redeemable preference shares or optionally redeemable preference shares are those that have to be paid back within the maximum period of 20 years. We don’t have irredeemable preference shares.

The other form of investment is as debentures, which is primarily a debt. But the debt can convert into shares through the issuance of Compulsorily Convertible Debentures (CCD). You can read our post on CCD on the nuances related to its issuance. https://novojuris.com/2018/03/21/nuances-associated-with-issuance-of-compulsorily-convertible-debentures/

Investors also invest through CCD, especially when the valuation of the company is not clear. Here’s how it is done https://novojuris.com/2015/12/21/raising-of-funds-through-compulsorily-convertible-debentures/

You can share your thoughts or email your questions to relationships@novojuris.com

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:

http://www.dhc.co.in/uploadedfile/1/2/-1/Companies%20(Share%20Capital%20and%20Debentures)%20Third%20Amendment%20Rules%202016.pdf

[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:

ESOP AND TAX IMPACT

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

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.

 ALLOTMENT OF SHARES FOR CONSIDERATION OTHER THAN CASH

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.