I. INTRODUCTION

Private limited companies extend a variety of benefits to their employees, ranging from insurance coverage and housing allowances to bonus payments. Among these perks, a notable benefit is the provision of Employee Stock Option Plans (“ESOPs”). Through ESOPs, companies grant options to employees, allowing them to convert these options into equity shares in the company upon meeting specific criteria outlined in the relevant regulations governing ESOPs in India. After receiving options, employees hold the opportunity to become shareholders in the company. While this right is exercisable at the discretion of the employee, there is no obligation on the employees to compulsorily exercise their options.

II. APPLICABLE LAWS

The laws governing the issuance of ESOPs by private limited companies in India (“Company”, or “Companies”) are detailed in the Companies Act, 2013 (“Act”) and Companies (Share Capital and Debenture) Rules, 2014 (“Rules”). In order to issue ESOPs, a company is required to formulate and adopt an Employee Stock Option Scheme (“ESOP Scheme”) upon passing relevant resolutions and obtaining the necessary approvals from the existing shareholders of the company.

III. RELEVANT CLAUSES UNDER THE ACT AND RULES

A. Formulating an ESOP Scheme

The “employee stock option plan”, alternatively called the ESOP Scheme is defined as ‘the option given to directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price’, as per Section 2(37) of the Act . While the definition seems exhaustive, there are a) specific restrictions on the eligibility of class of employees, and b) compliances to be undertaken by a Company, under the Act and Rules.

Section 62 of the Act details the different classes of persons to whom a Company can issue additional shares in order to increase the subscribed capital of the company. Further issuance of shares can be offered to: a) existing equity shareholders; b) employees under the employees’ stock option plan; and b) other specified persons, upon receiving authorization by passing a special resolution. This provision in the Act allows and enables the issuance of shares in a Company to its employees, by way of complying with the terms and conditions set out in detail in the ESOP Scheme.

B. Eligibility of Employees

To understand the scope of “employees” eligible to receive options under an ESOP Scheme, the ambit of employees extends to: a) permanent employees ; b) directors ; and c) permanent employee or directors of a subsidiary company. However, in companies other than a startup company, the promoters and directors holding more than 10 (Ten) percent of the equity shares in the Company , shall not be eligible to receive ESOPs. This restriction is temporarily lifted for start-up companies during their initial ten years of operation , from the date of incorporation.

C. Compliance requirements for adoption of ESOP

Rule 12 of the Rules outlines a detailed set of regulatory requirements that a Company must fulfill prior to issuance of ESOPs. The key compliance mandates required to be complied are set out below: (i). Notice for passing of special resolution: The notice for passing special resolution to authorize the issuance of options should contain specific disclosures in the explanatory statement . (ii). Passing of special resolution: A special resolution has to be passed by the shareholders of the Company to authorize the issuance of options under the ESOP Scheme. (iii). Passing of separate resolutions for special circumstances: Shareholders’ meeting to pass a separate resolution is required to be obtained in the event the options are granted to a) Employees of the subsidiary or holding company; or b) Specified employees (where grant is equal to or exceeding 1% (One Percent) of the issued capital of the company.

D.Key considerations in an ESOP Scheme:

(i). Pricing: Companies offering options to employees under an ESOP Scheme generally have the flexibility to set the exercise price according to their relevant accounting policies.

(ii). Minimum vesting period: A minimum of 1 (One) year is required be completed between the date of vesting of options and the date of grant to the employees.

(iii). Lock-in period: A lock-in restriction can be imposed on the shares received by the employees.

(iv). Amendment to the ESOP Scheme: The terms of an ESOP Scheme can be altered by way of passing a special resolution. Such revisions to the ESOP Scheme is required to be effected prior to exercise of the options by the option holders and such revisions should not be prejudicial to the interests of the option holders.

(v). Maintenance of register for ESOPs: Companies issuing options to its employees are required maintain a register of employee stock options in the Form No.SH.6, at the registered office of the company or at any other place identified by the board.

(vi). Transferability of ESOPs: ESOPs are non-transferable, and cannot be pledged, hypothecated, mortgaged, encumbered or alienated in any manner. However, in the event of exigencies, different treatment is observed.

a) Death of an employee – options granted to the deceased employee shall vest in the legal heirs or nominees of the deceased employee.

b) Permanent incapacity during employment – options granted to the incapacitated employee shall become vested on the day of such incapacitation.

c) Resignation/Termination of employment – in the case of resignation or termination of an employee, all unvested options as on the date of resignation or termination shall expire on the same day. However, the vested options can be exercisable by the employees within a certain time period as specified in the ESOP Scheme.

E. Rights of ESOP holders

Typically, the employees holding certain options in a Company can only avail the rights and benefits accrued to shareholders’ in the company upon exercising the options and following the issuance of shares in the company. Such converting employees would be required to execute a deed of adherence to the previously executed shareholders’ agreement, executed amongst the shareholders of the company. The flow of rights from the shareholders’ agreement would award them the right to receive dividends and obtain voting rights – these rights are not extended at the stage where employees are mere option holders in the company.

IV. MECHANISM OF ESOPS

The Company executes a grant letter with each of the employees holding ESOPs in the Company. Upon receiving ESOPs, the options typically undergoes a period of vesting. On completion of the vesting period, the employees can exercise these options to receive shares in the Company. The vested options can be exercised by the employees within the exercise period. On completion the specified pre-requisites, the employees shall be eligible for allotment of equity shares in the Company. Depending on the class of shares being allotted to ESOP holders, these equity shares would rank pari passu with other shares in the same class.

V. PHANTOM STOCKS OPTION PLANS (PSOP) AND MANAGEMENT STOCK OPTION PLANS (MSOP)

A recent trend in issuance of alternative stock option plans is developing in India, by the issuance of MSOPs and PSOPs. Phantom stock in India refers to a form of employee compensation that does not involve actual equity ownership but rather provides employees with a cash bonus tied to the company’s performance. In PSOPs, units issued to employees are tied to the company’s stock price and upon vesting, employees receive a cash payout equivalent to the appreciation in the company’s stock price during the vesting period. Similarly, a line of stock option plans for persons in the management of the company is offered by MSOPs. Similar to PSOP for employees, MSOP is a form of equity compensation used by companies to incentivize and retain management-level employees.

VI. CONCLUSION

The implementation of an ESOP Scheme is recognized as a strategic mechanism that offers advantages to both employees and companies. ESOPs aim to instill a sense of ownership among employees, fostering a personal stake in the company’s prosperity. While the emergence of PSOPs and MSOPs have heightened the focus on talent retention within companies, the legal framework surrounding these instruments remains in a phase of ongoing development.