Tag Archives: ESOP

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.

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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.

All about ESOPs – Part I of the series

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, so that an employee gets to benefit from an upside to the value.
The transparency, quality and consistency of the ESOP including messaging by the company’s leadership determines the employees’ enthusiasm, indifference or cynicism.

This blog post is the first of a series of 5.

  •  This one is a Basic Primer and covers: Terms used, what makes it attractive and  a little bit about taxation and valuation.
  •  How to Implement, nuances of implementing
  •  Foreign companies reaching out to employees in India and vice versa
  •  And round off with the implications of ESOP, timings when there is an external investment due in the company.

Basic glossary:

  •  Grant: Is the act of commitment by the employer through informing the employee of the eligibility for the Options under ESOP.
  •  Vesting: Has two parts- 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 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. Sweat Equity because it is a Share and will have shareholder rights. Also, tax treatment and accounting treatment is different compared to Options.

What makes Options attractive is that the Exercise Price to be paid by the employee is usually lesser than market price. But taxation kind of spoils the party.

Here’s a little about ESOP taxation for private and unlisted companies. (Please consult an expert before implementing. Tax rates, tax incidence keep changing):

a. Until 2009 ESOPs attracted Fringe Benefit Tax. With FBT now removed, ESOPs are taxed as a perquisite provided by the employer to the employee.

b. The tax incidence is when an employee Exercises the Grant by paying the Exercise Price.

c. The perquisite value for tax is calculated as Fair Market Value (FMV) of the Shares on the date of Exercise (less) Exercise Price. Calculation of FMV is detailed in Direct Tax Notification No. 23 dated 8 April 2010. Care to be taken if there is any prior VC funding etc. because that price might be considered as FMV.

d. When an employee ‘sells’ the Shares, then he further pays capital gains tax on the sale price (less) price arrived at point c above.

(This might be a little over-whelming, but that is why the experts!)

This then raises a question as to when is the ideal time to Exercise. Any time after Vesting, the employee has a choice based on his personal financial strategy, his visibility of the movement, of the Share price can Exercise, also keeping in mind the tax pay-out.
Coming up next is the process of implementing and nuances around it.

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

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.