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ESOPs – Legal and Procedural Aspects

In this write up we shall be discussing various aspects of the Employee Share Based
Payments (ESBPs) that are offered by the companies and provide a holistic view on the
regulatory, accounting and taxation aspects of the ESBPs.

Most ESBPs are in the form of shares. One of the ESBPs is Employees Stock Options Plan
(ESOPs). Under ESOP employees have the right to acquire shares of the company in future
at a pre-determined price. The right to acquisition of shares (known as “option”) is provided
under a scheme (known as “grant of option”) and the option may be exercised after a certain
number of years (known as “vesting period”) at pre-determined price (known as “exercise
price”). Therefore if the company over the period performs well, the employees will be able
to encash of the increment in wealth of the company by acquiring shares and earning the
gains i.e. the difference between exercise price and then value of shares.

Typical process flow in-case of ESOP issuance:

Formation of ESOP Plan

Grant of Option

Acceptance of Option

Vesting of option

Exercise of option

Sale of Shares

Types of ESBP Plans:

Employee Stock Option Employee Stock Stock Appreciation

Plans (ESOPs) Purchase Plans (ESPPs) Rights (SARs)
•ESOP is a contract that •ESPP is a plan under •SARs are rights that
gives employees the which the company entitle the employees
right, but not offers shares to its to receive cash or
obligation, to purchase employees at a shares for an amount
or subscribe to a discaounted price as a equivalent to the
specified number of part of public issue or excess of market price
shares of the company otherwise. on exercise date over a
at a fixed price, i.e. stated price.
exercise price. Exercise
price remains constant
even of the market
price of the shares rise
in future.

The most common of the above is ESOP. We shall discuss the same further.
ESOPs – Legal and Procedural Aspects
Why do companies opt for ESOPs?

 ESOPs can be used to attract, retain, motivate and reward employees.

 Options reward tangible contributions that increase corporate valuation by giving
employees a slice of that value.
 Options typically pay off only in a liquidity or exit event, thus pushing employees to
build the company for a long term success.
 By making employees the equity owners, options align incentives with the long term
goals of the company.
 ESOPs by virtue of equity enhance job satisfaction among employees.
 For the companies facing cash shortage / early stage start up companies, ESOPs serve
as tools for deferred compensation strategy.

ESOPs for Start Ups:

 Unlike larger corporations, employee ownership is an essential element of the start up

 High risk / high reward start ups use options to align employee compensation with the
risk prone mentality of the business.
 Start ups seeing to achieve “big exit” use options to align employees to drive towards
the desired outcome.
 For many Venture Capitalists, establishing a stock option pool is a pre requisite to
closing a deal.
 When budgets are tight for start ups, competitive packages may not be possible and
thus options can be used as a lucrative tool for compensating employees.
 Best time to issue ESOPs is between pre seed and early VC stage.


ESOPs typically are issued by companies directly or are done through trust route. Each of the
structure is explained below.

ESOPs – Legal and Procedural Aspects
In-case of direct route, the company grants the option and the time of exercise, fresh equity
issuance is undertaken to allocate equity to eligible employees. When the employee decides
to exercise option, the employee becomes shareholder of the company.

Direct route is generally preferred by unlisted companies . The only issue with direct route
is that as and when the employee intends to monetize the shares, the company may have to
buy-back the shares, specifically so in case of private limited companies or wait for the
company to go for a public offering to get an exit from the company.

Fresh issue of shares on every exercise of options by eligible employees lead to dilution of the
existing capital base.


The trust route brings in several complexities in the ESOP structures.

In the trust route structures, the company creates a trust specifically for the purpose of
running the ESOP schemes. Where the employees decide to exercise the option to acquire
the shares, the trust would first acquire the shares from the company or the secondary
market and the transfer the shares in the name of the employees.

Under the trust route, the company does not have to dilute its existing capital base and the
structure is largely preferred by listed entities for secondary market acquisition of the shares.

The employee welfare trusts are funded by the company under section 67 of the Companies
Act 2013 and Rule 16 of the Companies (Share Capital and Debenture) Rules 2014. In
essence the company indirectly funds the acquisition of shares for the employees.

When the employees leave the company, the employees have the option of selling the shares
back to the trust / the company / in the secondary market thus monetizing the wealth
ESOPs – Legal and Procedural Aspects
Exit route is far easier in case if trust route than in case of the direct route.

Trust route is mandatory is the scheme involves secondary acquisition or gift or both.

Governing Statutes:

1. Companies Act 2013 and allied rules.

2. FEMA 1999 (in case of Foreign employees)
3. Income Tax Act, 1961
4. SEBI (in case of listed entities)
5. ICDR Regulations, 2009 (in case of listed entities).

Tax implications in case of Trust route:

On Company: No Tax Liability

On Trust: Capital Gain / Loss at the time trust transfers shares to employees.

On Employees: Perquisite tax at the time of exercise of options.

Capital gains tax at the time of sale of shares.

Trust Route – Other Aspects

1. Trust will be shown in Non Promoter Non Public Category in the share holding
pattern of the company.
2. Any person can be a trustee of the trust in case of ESOP trust of private company.
There is a separate criterion for non eligibility of certain persons for being trustees in
case of a trust of unlisted / listed public company.
ESOPs – Legal and Procedural Aspects
3. Conditions for funding:
 special resolution to be passed in general meeting for provision of funding
 valuation of shares to be done by independent registered valuer
 total value of shares in trust not to exceed 5% of the aggregate paid up capital
and free reserves.
4. Trustees to ensure appropriate approvals from shareholders are obtained.
5. Trustees shall not be entitled to vote in representative capacity.
6. The trust shall not deal in derivatives.

ESOP Procedures and Eligibility:

Eligibility: ESOPs criterion can be laid down by the companies subject to rules laid down
under Companies (Share Capital and Debentures) Rules, 2014.


Once the company has identified employees who shall be eligible for the benefits under
ESOPs, the company shall carry out following:

 Prepare and approve ESOP Scheme.

 Grant Letter of Offer to Eligible Employees.
 Prepare a Trust Deed under the Indian Trusts Act and Register the same with the
jurisdictional Sub-Registrar.
 Obtain PAN for the Trust and Open Bank Account.
 Determine the value of the shares required to be allotted to the Trust for subsequent
transfer to the employees.
 Obtain Valuation Report from a Registered Valuer for the value of the Shares.
 Provide Loan from the Company to the Trust to enable purchase of the required
number of Shares at the pre-determined price.
 Allotment of Shares to the Trust.
 Transfer/Sale to Shares from the Trust to the eligible employees respectively at the
Exercise Price as determined in accordance with the ESOP Scheme.
 On receipt of Exercise Price, repayment of Loan from the Trust to the Company.
 For winding up of scheme implemented through trust, the company to meet all
outstanding obligations and the excess money / shares remaining with the trust
thereafter shall be utilized for repayment of loan or by way of distribution to

Vesting Schedule:

Vesting schedule is the timetable over which the employee accrues the right to keep the
option that is awarded. Vesting protects the company and keeps the employee motivated for
a long term. Standard vesting period used by most of the companies is 4 years. Vesting
period may also include a cliff. (Cliff is the trial period during which no vesting occurs.
Vesting accrues but options are earned immediately after cliff period).
ESOPs – Legal and Procedural Aspects
Pricing Criteria:

Option packages can be communicated to employees either as:

 Percentage of ownership in the company

 a rupee value based on current valuation.

Lock in Period:

Generally the locked-in period is for a minimum period of one year from the date of
allotment. In case of merger or amalgamation the period already undergone in respect of
shares of the transferor company shall be adjusted against the lock in period as aforesaid.

If ESBP is part of a public issue and the shares are issued to employees at the same price as
in the public issue, the shares issued to employees pursuant to ESBP shall not be subject to

Accounting Aspects:

In respect of options granted during any accounting period, the Accounting Value of options
shall be treated as another form of employee compensation in the financial statements of the

Ind AS 102 – Share Based Payments

ICAI guidance note 18 ‘Guidance Note on Accounting for Employee Share Based

Employee Compensation expenses = Market Value – Exercise Price.

Direct impact should be taken on Profit & Loss Account during the vesting period. The
Company shall make relevant disclosures in the financial statements.

Guidance note by ICAI allows option to measure valuation using fair value or intrinsic value
method. However, Ind AS 102 allows only fair value method on date of grant.
ESOPs – Legal and Procedural Aspects
Tax Treatment for Companies:

The Company has no tax liability. It has to book compensation expenses in the P&L Account.

Decided judgements:

CIT vs. Lemon tree Hotels Ltd. , August, 2015: It was decided that expense incurred
by employer is allowable & can be debited from P&L account of company.

CIT(A) vs. People Interactive India Pvt. Ltd. , October, 2015: It was decided that
discount under ESOP is in the nature of employee cost and hence is deductible during the
vesting period.

Exit Mechanism: