How to Set Up an ESOP?

Overview

ESOP plans are now increasingly being utilized by start-ups and companies to retain employees. ESOP plans are used as a powerful tool to motivate employees. ESOPs, when exercised by the employees, generate wealth for the employees but a crucial step in the exercise of ESOPs is the issue of ESOPs to employees. Issuing ESOPs can be a complex process for start-ups and companies not well-versed in the process. Consequently, there are two ways of setting up the ESOPs for the employees. But before that SEBI has also issued some guidelines in regards to setting up ESOPs (only for the listed companies).

SEBI Guidelines for issuing ESOP Plan

• The minimum net worth of the companies to create an ESOP pool should be Rs.10Cr.
• ESOP plans cannot be offered to employees unless shareholders’ approval is obtained by passing a special resolution in the general meeting.
• The vesting period should be a minimum of one year and a maximum of four years.
• The maximum limit of the ESOP pool is 10% of the issued capital of the company.
• In the event of resignation or termination of the employee, all the unvested options shall expire. However, the employee shall be entitled to retain the vested shares. 
• If the ESOP scheme is implemented through a trust, the same has to be decided upfront at the time of taking shareholders’ approval.
• The maximum number of shares that can be granted in the ESOP pool in a financial year is 5% of the total equity shares of the company.
• At the time of winding up, all monies and shares left with the trust shall be utilized either for payment of the loan or distributed to shareholders or subject to approval of shareholders, be transferred to another scheme under the regulations. 
• The ESOP trust deed shall cover the details of the trust such as name, object, details of the settlor, details of scheme(s) administered, sources of funds, and description of how the funds shall be used to meet the objects of trust, description of the classes of beneficiaries along with their rights and obligations and details of the trustee.
• The ESOP trust deed shall provide that it would be the duty of the trustee to work in the interests of the beneficiaries.
• All the details of the ESOP pool shall be disclosed to the shareholders in the annual reports.
• The company has the freedom to determine the exercise price to be granted under the ESOP plan subject to conforming to the prescribed accounting policies.
• In addition to the information that a company is required to disclose concerning employee benefits under the Companies Act, 2013 (18 of 2013), the Board of Directors of such a company shall also disclose the details of the scheme(s) being implemented, as specified in Part F of Schedule – I of these regulations.

As discussed earlier, setting up ESOPs has two methods i.e. Direct Route and Trust Route and before following any of these routes some necessary steps also have to be taken which are explained below:

Process of setting up ESOP: 

Step 1: Draft of ESOP Scheme

The first step to set up an ESOP plan is the creation of a draft of the ESOP Scheme. The scheme entails the legal clauses governing ESOP pool administration, number of stock options to be granted, class of employees, exercise period, vesting period, and other necessary information. The scheme is prepared in consultation with a lawyer or an ESOP attorney.

Step 2: Shareholders’ approval

The next step is to get shareholders’ approval through a special resolution in the general meeting to issue ESOPs to employees. This also involves alternation in the Articles of Association and Memorandum of Association through special resolution. 

Step 3: Submission of documents to IRS (Internal Revenue Services)

In order to be eligible for tax benefits allowed under ESOP taxation, the ESOP plan must be qualified under Section 401(a) and 4975(e)(7) of the Internal Revenue Code, a copy of plan documents has to be submitted by ESOP attorney to Internal Revenue Services (IRS) with an application for a determination from IRS that the plan meets the requirements for tax qualifications.

Once the above steps have taken place, then the company has two routes to grant/ offer the ESOPs to its employees i.e. Direct Route and Trust Route

Direct Route

The ESOP direct route involves granting shares directly to the employees. This route does not involve any middlemen or intermediary to grant the stock options thus, a direct dealing or one-to-one dealing between the company and the employee.

Procedure for Direct Route

• The Board of Directors (BOD) of the company prepares a ESOP Scheme and a resolution is passed for the same.
• Following this, ESOP the scheme is proposed to the Remuneration Committee for their approval.
• On receiving the approval, a meeting shall be called by the Board of Directors of its shareholders.
• The scheme is proposed to the shareholders in the meeting and a notice is supplied containing the details of the employees to whom ESOPs shall be issued and at what price ESOPs will be issued.
• After successful approvals, a letter of offer is issued by the board to its concerned employees.
• Once vesting period is over, the employees have the option to exercise the shares.
• If exercised, fresh shares are issued to the employees by the company.

Trust Route

Under the trust route, rather than issuing the ESOPs directly to the employees, a trust is created by the company for the purpose of issuing ESOPs to the employees. This route is preferred by the listed companies. Employees exercising their options at the end of the vesting period will be granted shares by the trust instead of the company. 

The trust is created in the name of ESOP trust and is funded by the company itself for the purchase of the shares of the company from the secondary market and when the employee pays the trust for the shares, the trust in return pays back the company. Additionally, when the employee wishes to sell the shares, the trust can purchase the shares from the employee to avoid transfer to any unknown person.

Procedure for Trust Route

• The Board of Directors prepare the ESOP scheme and pass a resolution for the same.

• The ESOP scheme is presented to the Remuneration Committee for their approval.

• Once approved, a meeting is convened by the board for its shareholders.

• The meeting is convened presenting the ESOP scheme and a special resolution is passed for the creation of the trust. The notice supplied in the meeting shall contain the details of the employees to whom ESOPs will be issued and at what price the ESOPs will be issued. 

• The offer letter is issued to employees after successful approvals have been obtained.

• A ESOP Trust Deed is then prepared under the Indian Trusts Act for the proposed trust.

• This ESOP Trust Deed is registered under the jurisdictional sub-registrar.

• An application is filed for obtaining the PAN for the trust and a Bank Account is opened using that PAN.

• The next step involves determination of the number of shares and their respective value which are to be allotted to the trust for further transfer of shares to the employees.

• (If the company is unlisted, then, a Valuation Report is obtained from the Registered Valuer for the purpose of the valuation of the shares.)

• Loan is provided to the Trust to purchase the required number of shares (only from the secondary market for the listed companies)

• The ESOP shares are allotted to the Trust.

• When employees exercise the options, trust transfers the shares to the employees upon receiving the exercise price.

• Trust repays the loan money back to the company via the exercise price received from the employees.

• (The total number of shares held by the Trust, at any time, shall not exceed 5% of the aggregate of the paid-up capital and free reserves of the company)
  
  

Compliances for Trust Route

• Board’s Report Disclosures: The company shall specify the details of the ESOP in the Board’s Report as per the provisions of the Companies Act. The details are to be disclosed for the year in which the scheme was initiated. 

• At of Trustees: Any person can be appointed as the Trustee of the ESOP Trust except for the following mentioned:

1. Directors, Key Managerial Personnel of the holding or subsidiary company of the parent company
2. Directors, Key Managerial Personnel of the company as well as their relatives.
3. Any beneficial owner holding more than 10% of the paid-up share capital of the company.

• Maintenance of ESOP Register: The company also has to maintain a separate register in the name of Register of Employee Stock Options under Form no. SH.6 and has to enter the details in the register pertaining to each ESOP granted. 

Conclusion

ESOP plans are a valuable tool for the start-ups and the companies for incentivizing the employees and maintaining an optimistic work environment in the organisation. However, a company must understand the routes, compliances and the prerequisites in setting the ESOP plans else the company may become prone to dangers or risks associated with non-compliance. Hence, it is imperative and suggested for every company to follow the procedure for issuing ESOP schemes to employees.