Employee Stock Option Scheme for Unlisted Companies in India

Employee Stock Option Scheme for Unlisted company in India

For startups and growing businesses with limited cash flow, ESOPs (stock options) offer an attractive way to compensate employees by giving them a stake in the company’s future growth.

But how do ESOPs work in unlisted companies in India? Let's find out.

What is an Employee Stock Option Scheme (ESOS)/ Employee Stock Option Plan (ESOP)?

An Employee Stock Option Scheme (ESOS) and an Employee Stock Option Plan (ESOP) are essentially the same.

An ESOP is a program that allows employees to buy company shares at a predetermined price, typically lower than the market price, in the future. 

It gives employees a sense of ownership, aligning their interests with the company’s growth and success.

ESOPs are an effective method to retain talent, especially when there is a limited budget for salary increases. Instead of offering high cash compensation, companies can incentivize employees with the potential future value of the company’s shares.

How do ESOPs work in unlisted companies: legal framework and compliance in India

In India, the implementation of ESOPs and other forms of equity compensation for unlisted companies is governed by the Companies Act, 2013 and the Share Capital and Debenture Rules:

- Section 62(1)(b) of the Companies Act, 2013: This section allows unlisted companies to issue ESOPs through a special resolution passed by shareholders.

- Rule 12 of the Share Capital and Debenture Rules (2014): This rule outlines the procedures and conditions for offering ESOPs to employees in unlisted companies.

Employee stock option schemes in listed companies in India on the other hand are governed by SEBI’s ‘Share-Based Employee Benefits Regulations, 2014’.

Who is eligible for ESOPs in unlisted companies?

Not all employees are automatically eligible for ESOPs in unlisted companies. 

According to Indian regulations, ESOPs can only be granted to certain categories of employees:

•  Employees of parent company: Both Indian and foreign employees who are employed full-time by the parent company.

• Employees of subsidiaries:  Full-time Indian and foreign employees of the subsidiary companies.

• Directors: Whole-time and part-time directors. 

ESOPs cannot be granted to:

• Promoters or employees who are part of the promoter group. 
• A director who holds more than 10% of the company's total equity shares, either directly, through a corporate entity, or via a relative.
• Independent directors.

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.

How to issue ESOPs in an unlisted company?

Before launching an Employee Stock Option Plan (ESOP), a company must ensure that its Articles of Association (AoA) allow the issuance of shares under the scheme. If not, the company should hold an extraordinary general meeting to amend the AoA and then proceed.

Step 1: Formulating the Employee Stock Option Plan (ESOP)

The company needs to design a comprehensive employee stock option plan, which includes details like the total number of options to be granted, the exercise price, the vesting period, and other terms. 

This scheme must be approved by the company's board of directors.

Step 2: Shareholder approval

The employee option scheme must then be approved by the shareholders through a special resolution at the general meeting. 

The resolution must outline:

• the total number of stock options to be granted
• the types of employees who can take part in the ‘Employee Stock Option Scheme’
• how employees will be evaluated for eligibility in the scheme
• vesting requirements and vesting period. There shall be a minimum period of one year between the grant of options and vesting of options, also called a cliff.
• the maximum time frame for the options to vest
• The exercise price, or the formula to calculate it
• exercise period and the process of exercising
• whether there is any lock-in period
• the maximum number of options an employee can get
• how the company will determine the value of its options
• the conditions under which employees may lose their vested options (e.g., if they are fired for misconduct)
• the time period within which employees must exercise their vested options if they are about to leave the company
• a statement confirming that the company will follow the required accounting rules

To approve the ESOP (Employee Stock Option Plan), the company must pass a special resolution (ordinary in case of private companies). 

Additionally, if the company plans to:

• Give options to employees of its subsidiary or parent company, or
• Give options to specific employees where the total options granted in one year are equal to or greater than 1% of the company’s issued capital (excluding any outstanding warrants or conversions),

then the company must get approval from shareholders through a separate resolution.

Step 3: File form MGT-14

File form MGT-14 within 30 days of passing the resolution and grant options to eligible employees.

Step 4: Maintaining records

The company must keep a register of employee stock options in Form SH-6 and record the details of the options granted.

Step 4: Ongoing compliance

Once the ESOP is in place, the company must ensure compliance with all reporting and disclosure requirements, such as:

• Disclosing details in the ‘Director’s Report’.
• Filing the necessary forms, such as PAS-3, with the Registrar of Companies (RoC) when options are exercised.

Compliance and reporting obligations for ESOPs in unlisted companies

Like mentioned above, unlisted companies offering ESOPs must adhere to various compliance requirements, such as:

• Maintaining the ESOP Register in the prescribed format (Form SH-6).
• Filing the necessary forms with the RoC for ESOP-related transactions.
• Disclosures in the director’s report detailing the number of options granted, vesting period, and any changes in the scheme.

What are the challenges of implementing ESOPs in an unlisted company?

While ESOPs offer many advantages, they also present challenges for unlisted companies:

1. Share valuation

Valuing shares in an unlisted company can be tricky, as there is no public market for the shares. Companies typically rely on professional valuation services to determine a fair price for the shares.

2. Liquidity issues

Employees might face challenges when trying to sell their shares, as there is no liquid market for shares of unlisted companies. This issue can make ESOPs less attractive unless there is a clear exit strategy.

3. Legal and compliance complexity

Issuing ESOPs involves complying with various legal and regulatory requirements, including obtaining shareholder approval and maintaining detailed records.

How to calculate the ESOP value of an unlisted company?

In India, valuing shares for ESOPs in unlisted companies is governed by the Companies (Share Capital and Debentures) Rules, 2014 and SEBI guidelines.

The company must engage with a registered valuer who is approved by the Insolvency and Bankruptcy Board of India (IBBI). 

This professional is responsible for determining the fair market value (FMV) of the company's shares based on any of the following methods:

• Discounted Cash Flow (DCF) method: This is the most common method. It calculates the present value of the company’s projected future cash flows, considering factors like revenue growth, profitability, and risks.

• Market comparable method: This method compares the company's valuation with that of similar companies in the industry, especially if they have recently raised capital. The comparison could include revenue multiples, profit margins, etc.

• Asset-based approach: This method evaluates the value of both tangible and intangible assets, focusing on the company’s net worth, and is typically used for companies with significant assets.

Once the valuation is completed, the Fair Market Value (FMV) of the company’s shares is determined. This serves as the benchmark for setting the exercise price of the ESOPs.

FAQs

1. Can an unlisted company give ESOPs in India?

Yes, unlisted companies in India can offer employee stock options (ESOPs). The issuance of ESOPs by unlisted companies is governed by the Companies Act, 2013, and the Share Capital and Debenture Rules (2014).

2. What happens to vested ESOPs when you leave an unlisted company?

When an employee leaves an unlisted company, the treatment of their vested employee stock options (ESOPs) depends on the terms specified in the ESOP scheme.

Typically, there is a set period within which the employee must exercise their vested options. If not exercised within this period, the options may expire.

In certain cases, such as when the employee leaves due to misconduct or other specified reasons, the company may have the right to cancel the vested options or prevent the employee from exercising them.