The basics of 'Employee Stock Options'

In recent weeks, my interaction with start-up entrepreneurs has thrown some light on the lacunae that exists in their minds regarding employee stock options (ESOPs). Here’s hoping this article serves a primer:The new Companies Act has defined ESOPs to mean options that are provided to officers, directors, or employees of a company, or of its holding company, or subsidiary company or companies, if any, that gives such directors, officers or employees the right or benefit to purchase or subscribe for the shares at a future date at a pre-determined price.

A company must familiarize itself three terms when it is mulling the issue of ESOPs: granting, vesting and exercising. Granting of the stock options refers to the issue of stocks to the employee. Vesting refers to the right of the employee to apply for the shares granted to him. Exercising refers to the actual conversion of the employee’s rights to owning the stock.

The law to issue stock options is governed by Section 62 (1)(b) if the new Companies Act and by Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

As per the Act, in order to constitute a stock option scheme, the company needs to obtain a shareholder approval through a special resolution. The Rule prescribes aspects including who constitute an employee, and the details that go into the explanatory statement when passing a resolution including the total number of stock options to be granted, identification of the class of employees entitled to participate, vesting period, exercise price, period and process, among others. If a company wishes to issue ESOPs for the subsidiary or holding company, it will have to obtain a separate resolution. Likewise, if the grant of options in a year exceeds 1% of the issued capital.

A company has two options when it considers ESOPs. One is the direct route wherein an employee can be allotted fresh shares as and when it is exercised. The other option is to create a welfare trust through which the shares can be transferred.

On the basis of the future path of companies, some opt to constitute a compensation committee consisting of the board of directors. Most often this is the case with companies that are looking to get listed on the exchange in the near future. For such companies, the issue of ESOPs is also governed by the SEBI (Share Based Employee Benefits) Regulations, 2014.

The creation of the trust structure is usually not recommended for companies that are looking at a listing owing to SEBI’s guard over fraudulent and unfair trade practices especially since the circular it had issued last year effectively amending the guidelines.

A good way to acquaint oneself about ESOPs is to perhaps first answer the following questions. Once this exercise is complete (with no ambiguity), the steps that follow are fairly straightforward.

Things to be answered:

1. What is the size of the option pool that the company would like to set aside?
2. Will it be through an issue of fresh shares or would it involve the transfer of existing shares? Identify the sellers if it’s a transfer of shares.
3. Have you identified the eligible employees?
4. What should be the vesting period of the stocks and related conditions?
5. What should be the process involved to exercise the stocks?

If you have any specific questions, please drop them in the comments.