Employee Stock Option Plans (ESOPs) are one of the major tools to attract, motivate, and retain talent in startups, offering employees the option to purchase company stock at a future date at a pre-determined price. As an attractive employee retention tool, ESOPs align the interests of employees and founders by giving employees a stake in the company’s success. This practice has gained immense traction within the Indian startup ecosystem, encouraging long-term commitment and a culture of ownership.

Startups, often cash-strapped, use ESOPs to offer competitive compensation packages to attract top talent while preserving cash for growth. But how do ESOPs work under Indian regulations? In this GrowthX Article, we will explore the provisions under the Companies Act, 2013, that govern the issuance and management of ESOPs.

Evolution of ESOP under Indian Law

ESOPs have their roots in the U.S. but gradually became popular in India, especially after the economic liberalization of the 1990s. In India, ESOPs were initially regulated under the Companies Act, 1956, but over time, provisions were updated and consolidated under the Companies Act, 2013. This evolution came as the growing importance of startups in India’s economy and the necessity of providing them with regulatory clarity on incentivizing employees through stock options.

Before the Companies Act, 2013, startup founders had limited flexibility in designing employee compensation plans. The new law significantly broadened the legal framework, creating a conducive environment for issuing stock options and encouraging entrepreneurship. If you are a startup founder, it is recommended to have due diligence in place.

Importance of ESOP for Startups

For startups, the ability to offer ESOPs plays a key role in attracting and retaining talent. Employees also benefit by receiving equity in the company, which may significantly increase in value if the company performs well. ESOPs create a shared vision of success, bridging the gap between the company's financial growth and the personal wealth of its employees. The primary reasons why startups opt for ESOPs include:

• Attracting Top Talent: Startups compete with established companies for skilled employees. Offering ownership stakes via ESOPs adds a compelling long-term value proposition.
• Retention Tool: ESOPs typically come with a vesting schedule, encouraging employees to stay longer with the company.
• Aligning Employee Interests with Business Growth: Employees who own stock work toward increasing the company’s valuation.
• Financial Efficiency: Cash-poor startups can defer large salary payments by offering stock options instead.

Companies Act, 2013 and ESOP Regulations

The Companies Act, 2013 governs the issuance of ESOPs in India. Section 62(1)(b) of the Act allows companies to offer stock options to employees under specific conditions, subject to shareholder approval. Compliance with these legal provisions is crucial for startups to avoid penalties and protect the interests of both founders and employees. If you are a startup raising capital, having an ESOP policy beforehand shows that you care for your employees. 

Key provisions under the Act include:

• ESOPs can only be offered to employees, directors, or officers of the company, not to promoters or individuals owning more than 10% of the company’s equity. However, now there is an exception to this with DPIIT Notification.
• The issuance of ESOPs must be approved by shareholders through a special resolution.
• The terms and conditions of ESOPs must comply with the company's articles of association.

Eligibility to Issue ESOPs under the Companies Act, 2013

Under the Companies Act, 2013, a startup can issue ESOPs to specific groups of individuals. These typically include:

• Permanent Employees: Whether working in India or abroad.
• Directors: Excluding independent directors, who are not eligible.
• Officers: Employees who play key roles in the startup's strategic development.

Types of ESOPs Available for Startups

Different types of ESOPs cater to the varying needs of startups, and the Companies Act, 2013 allows for flexibility in structuring these plans. Some of the common ESOP variants include:

• Employee Stock Purchase Plans (ESPPs): Employees are allowed to buy company shares at a discounted price.
• Stock Appreciation Rights (SARs): Employees receive a bonus equivalent to the increase in the stock price over a set period.
• Restricted Stock Units (RSUs): Employees are granted stock after certain conditions are met (e.g., a performance milestone or duration with the company).

Procedure for Issuing ESOPs under the Companies Act, 2013

Issuing ESOPs involves a multi-step process under the Companies Act, 2013. Here's an outline:

1. Board Approval: The board of directors must approve the ESOP plan.
2. Shareholder Approval: A special resolution is required from the shareholders.
3. Drafting the ESOP Scheme: A detailed plan outlining eligibility, vesting periods, pricing, and other key terms must be prepared.
4. Filing Requirements: The company must file relevant forms with the Registrar of Companies (ROC).

Drafting an ESOP Policy

An effective ESOP policy is crucial for the success of the scheme. A well-drafted policy will typically cover:

• Vesting Periods: The time an employee must stay with the company before they can exercise their stock options.
• Exercise Price: The price at which employees can buy the shares.
• Lock-in Period: Restrictions on when employees can sell their shares.

ESOP Valuation and Pricing Guidelines

Determining the fair market value of the shares is a critical aspect of designing an ESOP. Startups often face challenges in valuing their shares due to fluctuating market conditions and lack of historical data. The valuation of ESOPs in India typically follows guidelines from the Institute of Chartered Accountants of India (ICAI) and other regulatory bodies like SEBI.

In addition to market valuation, startups must ensure that the exercise price is set at a fair level to maintain the attractiveness of the ESOP program while not diluting the ownership of founders too heavily.

Vesting and Exercising of ESOPs

The vesting period determines when employees can exercise their stock options. In most cases, startups opt for a gradual vesting schedule, where options vest over a series of years (e.g., 25% per year over four years). This method encourages long-term retention of key employees. Once vested, employees can choose to "exercise" their options, which means they buy the stock at the predetermined exercise price. However, exercising stock options comes with its own tax implications and regulatory requirements.

Taxation of ESOPs for Employees

The taxation of ESOPs can be complex, as employees are taxed at two different stages:

• At the time of exercise: The difference between the fair market value and the exercise price is taxed as perquisite income under salary.
• At the time of sale: Capital gains tax applies based on the holding period and the sale price of the shares.

Accounting Standards for ESOPs in Startups

For startups, the accounting treatment of ESOPs is a vital aspect that requires close attention to regulatory guidelines and standards. In India, the Institute of Chartered Accountants of India (ICAI) and Ind AS 102 (Indian Accounting Standard) provide the framework for the accounting of ESOPs. Ind AS 102, specifically aligned with International Financial Reporting Standards (IFRS), governs how stock-based compensation is recorded in financial statements. Our Virtual CFO services are designed to make it easier for you.

Under Ind AS 102, startups need to account for the fair value of stock options granted to employees as an expense over the vesting period. The key accounting steps include:

• Recognition of Expense: The fair value of stock options is calculated on the grant date and recognized as an expense in the profit and loss statement over the vesting period.
• Disclosure Requirements: Startups must disclose detailed information about their ESOP schemes in the financial statements, including the terms and conditions, number of options granted, exercised, or forfeited, and their impact on financial results.
• Impact on Profitability: ESOPs dilute a company’s earnings because the cost of the employee stock options is treated as a compensation expense, which impacts profitability.

Compliance Requirements for Startups

Issuing ESOPs involves several compliance obligations under Indian law, specifically under the Companies Act, 2013, and other associated regulations, including guidelines from the Securities and Exchange Board of India (SEBI) for listed companies. Failure to comply with these requirements may lead to penalties and legal consequences. Hence, startups must ensure that they adhere to the law while designing and implementing their ESOP schemes. For startups, the following compliance steps are crucial:

• Shareholder Approvals: ESOPs must be approved by a special resolution in a general meeting of shareholders, and the details of the scheme should be shared with shareholders before the meeting.
• Filing with the Registrar of Companies (RoC): Form MGT-14 is filed to notify the RoC about the special resolution passed for ESOP approval.
• Annual Disclosures: Startups need to disclose the status of ESOPs in their annual financial statements and reports. This includes the number of options granted, exercised, and remaining.
• Grant Letter: A formal grant letter should be issued to eligible employees, detailing the terms of the ESOP, including the number of options granted, vesting period, exercise price, and other conditions.

Common Pitfalls and Mistakes in Startup ESOP Policies

While ESOPs are a powerful tool for startups, many companies make mistakes in their design and implementation. Avoiding these mistakes requires thorough planning, sound legal advice, and transparent communication with all stakeholders involved in the ESOP scheme. Some common pitfalls include:

• Unrealistic Valuation Expectations: Startups often overvalue their shares, which can lead to employees becoming disillusioned when the company’s actual market value does not meet expectations. A business valuation does help here.
• Lack of Clear Communication: Many startups fail to clearly communicate the terms and conditions of the ESOP, including vesting schedules, tax implications, and lock-in periods, leading to confusion among employees.
• Inadequate Legal Documentation: Failure to comply with the regulatory requirements and not maintaining proper legal documentation, such as grant letters or shareholder resolutions, can lead to legal challenges.
• Over-Allocation of Shares: Startups may issue too many stock options early in their lifecycle, leading to excessive dilution of ownership for founders and early investors.

Exit Strategy and Liquidation Preferences

A critical aspect of any ESOP policy is how it is treated during an exit event, such as an IPO, acquisition, or liquidation. In such scenarios, ESOP holders need to understand their rights and how their options will be handled. Startups must outline these terms clearly in the ESOP policy, including:

• IPO: If the company goes public, ESOP holders will usually have the option to convert their vested options into shares and potentially sell them after any lock-in period post-IPO.
• Acquisition: In the event of a company acquisition, employees’ vested options may either be cashed out or converted into stock options of the acquiring company. It's crucial to specify these terms to avoid any confusion or disputes.
• Liquidation Preference: Startups often include provisions to protect investors by giving them priority in receiving payouts during liquidation. These preferences can affect the distribution of funds to ESOP holders, especially if the company’s valuation during liquidation is lower than expected.

Legal and Regulatory Changes in ESOPs

The regulatory environment for ESOPs is constantly evolving in India, especially with the increasing role of startups in the economy. Recent amendments to the Companies Act, 2013 and SEBI regulations have sought to make ESOPs more flexible and employee-friendly.

Some significant regulatory developments include:

• ESOPs for Startups Recognized by DPIIT: The Department for Promotion of Industry and Internal Trade (DPIIT) has introduced tax benefits for employees of DPIIT-recognized startups. The tax on ESOPs can now be deferred until the time of exit or five years, whichever is earlier.
• Relaxation in Compliance: Startups have been granted some relaxation in terms of reporting and compliance, especially during their early stages, to simplify the issuance of ESOPs.
• Future Regulatory Changes: As the Indian startup ecosystem grows, more regulatory updates are expected to ensure that ESOPs remain an attractive option for both employers and employees, encouraging innovation and retention.

Role of SEBI in ESOPs

The Securities and Exchange Board of India (SEBI) plays a significant role in regulating ESOPs, especially for listed companies. Although most startups fall outside SEBI’s purview until they list publicly, startups planning an IPO must be aware of SEBI’s guidelines.

SEBI’s regulations, such as the SEBI (Share Based Employee Benefits) Regulations, 2014, provide a framework for listed companies to issue ESOPs, focusing on aspects like:

• Disclosure: SEBI mandates detailed disclosures about ESOPs in the company’s prospectus and annual reports.
• Fair Pricing: SEBI ensures that ESOPs are fairly priced and not used as a means of diluting public shareholders’ equity.
• Employee Protection: SEBI’s guidelines ensure that employees' interests are safeguarded by providing transparency in the pricing, issuance, and exercise of stock options.

Case Studies of ESOP Success in Indian Startups

Several Indian startups have successfully implemented ESOP schemes, contributing to their growth and eventual success. Examples include:

• Flipkart: Before its acquisition by Walmart, Flipkart issued ESOPs extensively to attract and retain talent. Post-acquisition, many employees saw significant financial gains, making Flipkart’s ESOP program a benchmark for startups.
• Zomato: Zomato, which went public in 2021, offered ESOPs to employees, allowing them to participate in the company’s success during its IPO. Zomato’s ESOP program also included provisions for buying back employee shares, giving employees liquidity options before the public listing.
• Ola: The ride-hailing giant Ola has consistently used ESOPs as a retention tool. Employees who stayed with the company during its growth phase have benefited from the company’s increasing valuation, making Ola’s ESOP program highly lucrative.

FAQs on ESOPs for Startups

Q1. Can a startup issue ESOPs to promoters?

Earlier No. However as per the notification of DPIIT, now ESOPs can be issued to promoters or shareholders holding more than 10% of the company's equity up to 10 years of incorporation.

Q2. What is the typical vesting period for ESOPs in startups?

The vesting period generally ranges from 1 to 5 years, with a common structure being 25% vesting each year over four years.

Q3. Are ESOPs taxable for employees?

Yes, ESOPs are taxed at two stages: at the time of exercise (as perquisite income) and at the time of sale (capital gains tax).

Q4. How is the exercise price determined for ESOPs?

The exercise price is usually determined based on the fair market value of the company’s shares, which can be established through a valuation by an independent expert.

Q5. Can startups defer the tax on ESOPs for employees?

Yes, for DPIIT-recognized startups, employees can defer the payment of tax on ESOPs until they sell the shares or after five years, whichever is earlier.

Q6. How do ESOPs impact a startup’s valuation?

ESOPs can dilute the ownership of existing shareholders, but they also help retain key talent, which can lead to increased company value in the long term.

Conclusion

Employee Stock Option Plans (ESOPs) are an essential tool for startups to attract and retain talent while aligning employee interests with company growth. Under the Companies Act, 2013, the issuance of ESOPs is governed by clear regulations, ensuring that both startups and employees benefit from this equity-sharing mechanism.

For startups, ESOPs are not just about compensation; they are about building a culture of ownership and commitment. When designed and implemented correctly, ESOPs can drive long-term growth, innovation, and loyalty, making them a vital part of any startup’s strategy for success. Visit our ESOP Policy Services to learn what we offer at GenZCFO and if you have any questions, feel free to contact us.