Employee Stock Options Plan - ESOP

An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy stock. ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes including a number of large publicly traded corporations.

Since ESOP shares are part of the employees' remuneration package, companies can use ESOPs to keep plan participants focused on corporate performance and share price appreciation. By giving plan participants an interest in seeing the company's stock perform well, these plans supposedly encourage participants to do what's best for shareholders, since the participants themselves are shareholders.

An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. The 2017 tax bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, at which point the limit decreases to 30% of EBIT (not EBITDA). In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.

New leveraged ESOPs where the company borrows an amount that is large relative to its EBITDA may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change. This change will not affect 100%-ESOP owned S corporations because they don't pay tax.

Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote all issues.

Stock ownership plans provide packages that act as additional benefits for employees to prevent hostility and keep a specific corporate culture that company managements want to maintain.

Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights. Direct-purchase plans let employees purchase shares of their respective companies with their personal after-tax money. Some countries provide special tax-qualified plans that let employees purchase company stock at discounted prices. 

Restricted stock gives the employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets. Stock options provide employees with the opportunity to buy shares at a fixed price for a set period, while phantom stock provides cash bonuses for good employee performance.

These bonuses equate to the value of a particular number of shares. Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.

ESOPs have a number of significant tax benefits, the most important of which are:

1. Contributions of stock are tax-deductible: That means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, albeit this means existing owners will be diluted.
2. Cash contributions are deductible: A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.
3. Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible: The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.
4. Sellers in a C corporation can get a tax deferral: In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
5. In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
6. Dividends are tax-deductible: Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
7. Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates: The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.

Note that all contribution limits are subject to certain limitations, although these rarely pose a problem for companies.

At the very outset, every employee should ask his/her employer for a copy of the ESOP scheme whenever he/she is granted stock options. This scheme will give a detailed insight into the terms and conditions associated with ESOPs. Once stock options are granted, there is a one-year cliff period. Any kind of vesting, i.e. the right to convert the stock options into equity, will only take place once the cliff period has lapsed. Thereafter, subject to the vesting schedule, i.e. how the vesting ought to take place, the employee will have a right to exercise his vested options by paying an exercise price to the employer. The exercise price is typically the face value of the shares. The entire exercise mechanism can be kept cashless as well, i.e. the vested options may be exercised and converted into equity without paying anything. All this information will be highlighted in the ESOP scheme and/or the Letter of Grant issued by the employer.

Let us explain the above with a simple example:

On September 01, 2015, a company grants its employee 100 options with a vesting period of two years and an exercise period of seven years at an exercise price of Rs 10 per share. Under the Company Rules, there is a one-year cliff period. This implies that the vesting will not commence till September 01, 2016. Since the vesting period is two years, half of the options (i.e. 50) will vest on September 01, 2016 and the remaining half on September 01, 2017. The exercise period of the vested options is seven years. This means that that the employee can convert his 50 options (that vested upon him on September 01, 2016) anytime before September 01, 2023. For the remaining 50 options that vested in 2017, the employee can exercise his right any time before September 01, 2024.

Let us now assume that on December 01, 2019, the employee decides to exercise his/her right to convert 70 options into common stock. At that stage, an Exercise Application will be addressed to the company. Assuming the exercise price was Rs 10 per share, the employee will pay Rs 700 (70 options * Rs 10 per share) to the company and the company will allot the employee 70 equity shares.

It is also pertinent to understand that in case an employee resigns, any unvested options (i.e. those that have not yet vested) will lapse. In case some options have already vested on the date of resignation, their treatment will be determined as per the terms of the ESOP scheme. Therefore, it is crucial that all employees who have been granted options read the terms of their company’s ESOP scheme very carefully.

In the end, I’d like to state that ESOPs are a great incentive for employees to put their heart and soul into an organisation. However, grant of options in itself does not mean that the employee will walk out of that organisation with millions in his bank account and employees should be conscious of this fact. Most young employees have only heard positive stories about ESOPs and often do not do their own diligence to understand the key terms governing their options. Some startups ask their legal advisors to make a presentation for their entire staff explaining how ESOPs work and how it can benefit them. This, in my view, is extremely beneficial. Failure to understand the intricacies is likely to leave you highly disappointed when you resign to move on to your next job.

A. INTRODUCTION:

With the growing job opportunities and the increase in competition, companies have to ensure that there is a minimization of attenuation and attrition of employees. For the purpose of ensuring the same, the companies offer incentives to their employees in the form of stock options and shares to ensure that the employees are well-motivated and retained by the company for a longer time period. The most popular form of incentive provided to the employees is employee stock options. However, few other forms of incentives are also available to the employees such as the offering of sweat equity shares and phantom stocks.

In this article, we will be discussing in detail the comparative analysis of employee stock options, sweat equity shares and phantom stocks.

B. EMPLOYEE STOCK OPTIONS:

An employee stock option is one form of incentive which is provided to an identified group of employees. The main purpose is to motivate the employees through ownership in the company by way of issuing equity shares to them. The directors, employees or officers are given the right to purchase or subscribe to the shares of the company at a price which is pre-determined and at a future date as mentioned in the grant letter. The options are granted to the employees in accordance with the employee stock option scheme and upon the completion of a minimum period of 1 year from the date of grant of options, the employee shall have the right to exercise the options. The date on which the employee becomes entitled to exercise the right to acquire the shares of the company shall be referred to as vesting date. The terms and conditions with regard to the grant and the exercise of options shall be clearly laid down in the employee stock option scheme and in the grant letter which the company shall provide to the employee. Upon the exercise of the options by the employee after the completion of the specific timelines, the company shall issue shares to the employee.

C. SWEAT EQUITY:

Sweat Equity shares are shares issued by the company to the directors or the employees of the company at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions. In accordance with Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014, value addition shall mean actual or anticipated economic benefits derived or to be derived by the company from an expert or a professional for providing knowhow or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is being issued for which the consideration is not paid or included in the normal remuneration payable under the contract of employment, in the case of an employee.

D. PHANTOM STOCKS:

A Phantom Stock Option is one form of stock option plan wherein the underlying value of the shares of the company is provided to the non-employee/employee i.e. the non-employee/employee is provided with a cash entitlement upon the occurrence of certain events and completion of certain timelines. This is a performance-based incentive which is provided to the non-employee/employees for the purpose of effective performance and the retention of the non-employee/employees in the organization. The cash entitlement which becomes payable to the non-employee/employees is linked to the share value. In the event, there is a hike in the price of the shares there is a likelihood for the non-employee/employee to get a higher cash entitlement. There is no dilution of the share capital in phantom stocks as shares are not issued to the non-employee/employees, as the underlying value of the share is provided, which is payable in the form of cash.

There are two kinds of phantom stocks i.e. full value and appreciation only. A full value phantom stock shall entitle the non-employee/employee to receive the value at which the stock is worth at the time of the cash settlement. In the appreciation only method, the non-employee/employee would not be provided with the cash settlement at the current value of the stock but at a value i.e. the difference between the value at which the stock was granted to the non-employee/employee and the current value of the stock. For the purpose of issuance of phantom stock, an agreement shall be entered into between the non-employee/employee and the company. The phantom stocks are granted to the non-employee/employees as per the terms and conditions as laid down in the agreement. The number of units along with the specific timeline is detailed out in the agreement. The starting value of the unit shall be mentioned in the agreement and similar to the non-employee/employee stock options, the vesting schedule, the events of payment such as liquidation event such as infusion of funds, merger, acquisition, change in control, strategic investment in the company etc. or any other mechanism shall be clearly laid down in the agreement.

There is no law which governs the issuance of phantom stocks and the same are usually governed by the agreement entered into between the non-employee/employees and the company. The Companies Act, 2013 does not have any provisions which would govern the phantom stocks.