Employee Stock Option Scheme for Listed Companies in India

In India, issuing employee stock option schemes for listed companies is not as simple as offering a few stock options. 

The Securities and Exchange Board of India (SEBI) governs the process, ensuring companies comply with stringent regulations designed to protect both shareholders and employees.

How do Employee Stock Option Schemes (ESOS) work in India?

An Employee Stock Option Plan (ESOP) or Employee Stock Option Scheme (ESOS) is a structured program through which companies incentivize their employees. 

It grants them the right to purchase a specified number of company shares at a predetermined price, typically lower than the market value.

This is how it works:

1. Grant issuance

The company identifies eligible employees and offers them stock options under the employee stock option scheme. These options are not shares yet but represent the right to acquire shares in the future, subject to certain conditions like performance or tenure.

2. Vesting

Over a defined period, employees earn the right to exercise their stock options. This vesting period, often spanning 4 years, may be structured in stages, such as 25% vesting each year.

3. Exercise

Once vested, employees can "exercise" their options by purchasing the shares at the pre-agreed price, known as the exercise price.

4. Sale

After acquiring the shares, employees can sell them on the stock exchange, usually after completing a lock-in period (if applicable). 

How to set up an ESOP (Employee Stock Option Plan) or issue employee stock options in listed companies?

Setting up an Employee Stock Option Plan (ESOP) for a listed company in India requires careful planning and compliance with legal frameworks.

Step 1: Board and shareholder approval

The first step is to get approval for the ESOP at both the Board of Directors' meeting and shareholders' meeting. 

A resolution must be passed, outlining the key aspects of the plan. 

This may include the total number of shares available for allocation under the scheme, the eligibility criteria, and the vesting schedule.

Step 2: Draft the ESOP scheme

After obtaining approval, the next step is to draft the ESOP policy or scheme. This document should define crucial terms such as:

- eligibility

- vesting period

- exercise period

Step 3: Compliance checks

It is important to ensure that the ESOP complies with the regulations outlined by SEBI, the Companies Act, 2013, and other applicable laws.

SEBI’s ‘Share-Based Employee Benefits And Sweat Equity Regulations’ outline specific guidelines for listed companies, such as transparent valuation methods, mandatory disclosures, and restrictions on granting options to independent directors.

Additionally, the Companies Act sets out approval and reporting requirements for issuing stock options.

Step:4  Implementation

Once the plan/scheme is approved, it's time to implement it. 

This involves communicating the ESOP scheme to employees and issuing grant letters.

SEBI regulation for ‘Share-Based Employee Benefits And Sweat Equity’ 

The Securities and Exchange Board of India (SEBI) regulates the issuance and management of Employee Stock Option Plans (ESOPs) for listed companies in India.

SEBI's ‘Share-Based Employee Benefits And Swear Equity’ regulations, 2021 defines the compliance framework, covering:

1. ESOP eligibility

SEBI defines who can participate in ESOPs:

• Permanent employees of the company, including those of subsidiaries, in India or abroad.

• Directors of the company, including, whole-time and part-time directors.

Notably, independent directors, promoters and employees belonging to the promoter group are excluded from receiving ESOPs.‍

2. Pricing of options

The exercise price, which is the price at which employees can purchase shares, must be determined by a formula or parameters approved by shareholders during the ESOP resolution.

This price is usually set below the market price to make the ESOPs attractive, but it must:

• Reflect the fair market value of shares.
• Be based on transparent pricing methods that protect shareholder interests.
• Adhere to the disclosure requirements set out in the Accounting Standards prescribed by the Central Government under Section 133 of the Companies Act, 2013, as well as any 'Guidance Note on Accounting for Employee Share-Based Payments' issued periodically.

3. Vesting period

SEBI mandates a minimum vesting period of one year. 

Companies have the flexibility to set longer vesting periods or structure vesting based on individual or company milestones.

Special provisions:

• In the event of an employee’s death or permanent incapacity, the benefits are transferred to the employee’s legal heirs without any vesting requirement.
• During a merger or amalgamation, companies must outline how unvested or unexercised options will be handled, ensuring employees are not negatively impacted.

4. Disclosures to be made while issuing ESOPs in a listed company

i. Disclosures in the board’s report

As per the Companies Act, 2013, the board’s report must include:

• Total number of stock options approved under the scheme.
• Options granted, vested, exercised, and lapsed during the year.
• Exercise price and details of any variation in the terms of the ESOPs.
• Total number of shares arising as a result of option exercises.
• Employee-wise details of significant beneficiaries, such as key managerial personnel and employees granted more than 1% of the issued capital.

This ensures comprehensive reporting of the ESOP scheme’s implementation and impact.

ii. Disclosures in financial statements

SEBI mandates companies to provide ESOP-related information in their financial statements, including:

• The method and assumptions used for estimating the fair value of options, such as volatility, risk-free rate, and expected life.
• The impact on profits due to the cost of ESOPs, calculated as per the applicable accounting standards (Ind AS 102).
• Reconciliation of the number of options outstanding at the beginning and end of the financial year.

These disclosures help investors assess the financial implications of the ESOP scheme.

iii. Stock exchange filings

Listed companies must file periodic disclosures with the stock exchanges, including:

• Details of grants, exercises, lapses, and cancellations during the reporting period.
• The current outstanding options pool under the ESOP scheme.
• Material changes to the ESOP scheme, if any, approved by shareholders.

This ensures ongoing transparency and compliance with SEBI guidelines.

iv. Disclosures in shareholder resolutions

When seeking shareholder approval for an ESOP scheme or its amendments, companies must disclose:

• Total number of stock options to be granted.
• Eligibility criteria for employees.
• Vesting schedule and exercise price or formula.
• Maximum quantum of benefits for any single employee.

These details enable shareholders to make informed decisions about the ESOP plan’s adoption or modification.

v. Disclosures in annual reports

The company’s annual report must include:  

• A summary of the ESOP scheme’s status, covering grants, vesting, and exercises.
• Information on the equity dilution caused by ESOP exercises.
• Key changes in the scheme, if any, during the reporting period.

vi. Regulatory filings and compliance

To meet SEBI and other regulatory requirements, companies must disclose:

• Compliance with the SEBI (Share-Based Employee Benefits) Regulations, 2014.
• Any deviation from earlier approved terms, along with the rationale.
• Details of auditors’ observations, if any, on ESOP-related accounting practices.

5. Restrictions and compliance

SEBI imposes certain restrictions on the issuance of ESOPs:

• ESOPs cannot be issued to independent directors or promoters like mentioned above.
• The total number of options granted must be within the limits approved by shareholders.
• Companies using an ESOP trust must follow additional regulations, such as restrictions on acquiring shares from the secondary market.

6. Administration of ESOPs, either directly or through a trust

Companies can administer ESOPs directly or through an ESOP trust. 

If a trust is used:

• It must comply with additional regulations, including maintaining an audit trail.
• When a scheme is wound up, any excess money or shares in the trust may be transferred to other schemes, subject to shareholder approval.

The trust cannot be used for trading shares in the secondary market, except in specific cases, such as:

• To help employees pay the exercise price of their stock options.
• To cover the taxes employees owe when exercising their options.
• To handle other related expenses tied to exercising options granted under the ESOP.

To whom can the ESOPs be issued?

SEBI guidelines provide a clear framework on the eligibility criteria for ESOP issuance:

1. Permanent employees of the company or its subsidiaries

ESOPs can be granted to permanent employees of the parent company and its subsidiaries whether in India or abroad.

2. Directors (excluding independent directors)

Both full-time and part-time directors are eligible for ESOPs, provided they:

• Are not categorized as independent directors, as SEBI guidelines exclude this category to avoid conflicts of interest.
• Actively contribute to the company’s decision-making, strategic planning, or operations.

3. Consultants or advisors (if approved by shareholders)

Certain identified personnel, such as consultants, advisors, or contractors, may also be eligible for ESOPs under specific conditions:

1. Their contribution to the company must be substantial and quantifiable, such as advising on critical projects or driving innovation.
2. The ESOP issuance must be explicitly approved by shareholders through a resolution, outlining the rationale for including these individuals.

A company cannot issue ESOPs to:

• Individuals classified as promoters or part of the promoter group.
• Directors who directly or indirectly through a corporate entity, or via a relative hold more than 10% of the company’s total equity shares.

Note: These conditions don't apply to startups under the "Startup India Initiative" for 10 years from incorporation.

A startup is a company with an annual turnover under ₹100 crore with a focus on innovation, intellectual property, and the development of new products with significant potential for creating jobs.

Are ESOPs allowed under the Companies Act?

Yes, Employee Stock Option Plans (ESOPs) are allowed under the Companies Act, 2013, as outlined in Section 62(1)(b). 

This provision permits companies to issue shares to employees through ESOP, subject to specific conditions and regulatory requirements.

Before implementing an ESOP, companies must obtain approval from their shareholders through a special resolution passed in a general meeting. The resolution ensures that stakeholders are informed about and agree to the potential equity dilution resulting from the ESOP.

For listed companies, the SEBI (Share-Based Employee Benefits) Regulations, 2014 take precedence, supplementing the Companies Act’s provisions. These guidelines ensure that listed entities adhere to additional standards, such as stock exchange disclosures, fair pricing practices, and investor protections.

Are ESOPs only for listed companies?

No, ESOPs are not limited to listed companies. 

Unlisted companies can also offer ESOPs to their employees. 

However, ESOPs differ between listed and unlisted companies in terms of liquidity, valuation, and regulatory compliance.

Here’s a detailed comparison:

1. Liquidity

Listed companies: Employees in listed companies enjoy immediate liquidity, as they can sell their shares on stock exchanges once the options are exercised. This ease of exit makes ESOPs highly attractive in these companies.

Unlisted companies: Liquidity is more complex. Employees rely on buyback programs or secondary sales to cash out, which may not be readily available and often depend on the company’s growth stage or funding cycles.

2. Valuation

Listed companies: Shares have a transparent market value, determined by real-time trading on stock exchanges. Employees and the company have a clear understanding of the ESOP's monetary worth.

Unlisted companies: Share valuation depends on external valuations conducted by experts, often during funding rounds. The lack of daily price discovery makes the value less predictable and harder to benchmark.

‍3. Regulatory framework

In India, employee stock option schemes (ESOS) for both listed and unlisted companies are regulated by the Companies Act, 2013. This Act establishes a broad framework of rules that complement other specific regulations.

Listed companies: For listed companies, the SEBI (Share Based Employee Benefit & Sweat Equity) Regulations, 2021, apply.

Unlisted companies: On the other hand, unlisted companies are governed by the Companies (Share Capital and Debentures) Rules, 2014, instead of the SEBI regulations.

4. ESOP taxation

Listed companies: Employees face taxation at the time of exercise (as a perquisite under salary) and sale (capital gains).

Unlisted companies: They also have similar tax implications for employees as listed companies.