Employee Stock Options in the Context of a Private Limited Company in India

Introduction

The Employee stock option plan (“ESOP”) is a scheme or plan that provides an option/ right to the directors, officers or employees of a company or of its holding company or subsidiary company to purchase or to subscribe to the shares of the company at a future date at a pre-determined price. The person to whom such option has been granted by a company has an option to exercise such right to subscribe shares of the company at a future date, but not before a year from the date of grant of such option. The pre-determined price is arrived at after the valuation of shares of the company has been conducted by a SEBI Registered Merchant Banker – Category I.

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Eligibility

In terms of the Companies Act, 2013, a company may grant options to subscribe to the shares of the company to the following person:

• a permanent employee of the company who has been working in India or outside India; or
• a director of the company, whether a whole-time director or not but excluding an independent director; or
• an employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company, in India or outside India. (“Eligible Employee”)

The Eligible Employee shall not include:

• an employee who is a promoter or a person belonging to the promoter group; or
• a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% (ten percent) of the outstanding equity shares of the company. (collectively, the “Exclusions”)

However, where ESOP has been adopted by a Startup Company[1] (being a private company), as defined by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India, the Exclusions shall not apply upto 10 (ten) years from the date of its incorporation or registration. In the event where the options are granted to the Eligible Employees outside India, the applicable provisions of the Foreign Exchange Management Act, 1999 shall also apply.

Comparison between the ESOP Scheme and ESOP Trust

Any company intending to grant options to Eligible Employees may either adopt an ESOP Scheme (“Scheme”) or create an ESOP Trust (“Trust”) to administer the options and exercise of such options by Eligible Employees of the company.

The private companies registered in India usually prefer to adopt an ESOP Scheme as it is convenient and easy to administer as compared to the formation of an ESOP Trust. The formation of an ESOP Trust is considered to be a cumbersome process in India.

The private companies in India usually restrict the transferability of shares by the Eligible Employees, to whom the shares have been allotted pursuant to ESOP, to any third party. In such a situation, the company or the promoters of the company buy-back/ purchase such shares from the Eligible Employees. However, if the company has set up ESOP Trust, the shares from Eligible Employee are transferred to the ESOP Trust at the time of their exit, when the transferability of shares has been restricted.

A company may nominate any person as a trustee of the ESOP Trust except:

• the directors and key managerial personnel of the company, its holding, subsidiary or association company or any relative of such directors or key managerial personnel;

• any person beneficially holding more than 10% of the paid-up share capital of the company.

Process for creation of ESOP Scheme/ESOP Trust

The general process followed by the private limited companies in India, to set up ESOP has been set out below:

• The company will have to identify the Eligible Employees and the eligibility criteria for the grant of options to the Eligible Employees of the company. The eligibility criteria could be based on milestones or seniority or any other factor as may be deemed fit by the company;
• The company will have to draft the ESOP Scheme or ESOP Trust deed. Such Scheme/ Trust deed should lay down the process of grant of options, Eligible Employees, eligibility criteria, vesting period, process in case of failure to exercise options, transfer and buying back options in case of termination of employment of the Eligible Employee etc.;
• The company will be required to take approval of board and the shareholders of the company for the proposed ESOP Scheme/ Trust deed;
• The company will be required to file necessary forms with the Registrar of Companies;
• Where the Trust deed has been approved by the company:

1. an ESOP Trust has to be formed under the Indian Trust Act, 1882;
2. the company will allot shares to the ESOP Trust so that the same may be further allotted to the Eligible Employees. The company may also grant a loan to the ESOP Trust to enable the ESOP Trust to purchase shares in the company. Such loan may be granted by the company after according approval of its shareholders through a special resolution;

• The ESOP Trust shall then administer the grant of options, Eligible Employees, eligibility criteria, vesting period, process in case of failure to exercise options, transfer and buying back options in case of termination of employment of the Eligible Employee etc.
• Where the ESOP Scheme has been approved by the company, grant of options, Eligible Employees, eligibility criteria, vesting period, process in case of failure to exercise options etc. shall be administered by the administrator appointed by the company in terms of the ESOP Scheme. The company may appoint any person, including directors or key managerial personnel, as the administrator of the ESOP Scheme or otherwise, the company may form an ESOP committee to administer ESOP Scheme.

Conclusion

Surveys conducted by various national and international organisations demonstrate that almost 90% of the enterprises in India consider equity based appreciation rights such as ESOPs as a better tool to reward their employees, as compared to other modes such as cash incentives. The trust of industry leaders over ESOPs has been built over a period of time. The industry giant Tata Motors issued options for around half a percent of its equity to its employees through ESOPs for the first time in its history of 150 years in the year 2018-19.[2]

The size of ESOPs has also increased considerably in the recent past. Hiveloop Technology Private Limited founded by Amod Malviya, Sujeet Kumar and Vaibhav Gupta (ex- Flipkart employees) offered their initial employees, salaries that were more than 50% lower than their previous jobs, in lieu of a large award of ESOPs.[3] The ESOP trends in the industry are increasing and have been improving.

The views and opinions expressed in this article belong solely to the author and do not reflect the position of Tatva Legal, Hyderabad.

[1] A private limited company shall be considered as a Startup Company:

• Upto a period of 10 (ten) years from the date of incorporation/registration;
• The turnover of the entity for any of the financial years since incorporation/ registration has not exceeded Rs. 100,00,00,000/- (Rupees One Hundred Crores only);
• The entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

[2] TaMo first Tata flagship entity to offer stock options to employees, available at, https://timesofindia.indiatimes.com/business/india-business/tamo-first-tata-flagship-entity-to-offer-esops/articleshow/64325544.cms.

[3] The pitfalls of ESOP lifelines at startups, available at https://www.livemint.com/industry/retail/the-pitfalls-of-esop-lifelines-at-startups-11592322029892.html.