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Case study on Employee Stock Ownership Plans

By Garima Saxena, 3EA
Case study on Employee Stock Ownership Plans

Compensation is a way leadership of the organization communicates its vision, its way through its strategy and roles and expectations from its employees. This also help in telling employees how the organization will reward the effort (incentives) employees put it to achieve the vision. Long-term incentives are an effective way of rewarding those who create value that contributes to company growth. The plan requires a business to envision the future of an organization and the key elements that need to be transformed for that growth to occur. The long-term incentive plan is then built around the behaviors and results that need to be achieved if that future company vision is to be realized. Therefore, compensation plans of long term incentives should not be viewed as an additional expense.

How Employee Stock Ownership Plans or ESOPs work?
The employer offers the employee an option to buy a certain number of stocks at a predetermined price, also called the Exercise Price. The employee can exercise the option only if he is with the company for the period mentioned in the ESOP agreement. The exercise price can be either the market price or the price which is less than the market price. Under ESOPs, the company can offer stocks to employees either directly or through a trust

ESOPs are taxed in 2 parts:

  • When you exercise the option, the difference between the exercise price and the market value of the stock is considered income from salary and taxed as per the tax slab
  • When you sell the shares, the profits are considered as capital gains and taxed accordingly

What are the guidelines of SEBI for Employee Stock Option Scheme & Employee Stock Purchase Scheme?

1. Employee Stock Option Scheme (ESOS)
An employee shall be eligible to participate in ESOS of the company. The Compensation Committee shall be a Committee of the Board of directors consisting of a majority of independent directors. The Compensation Committee shall formulate the detailed terms and conditions of the ESOS and frame suitable policies and systems to ensure that there is no violation of:

  1. Securities and Exchange Board of India (Insider Trading) Regulations, 1992; and
  2. Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 1995, by any employee

No ESOS can be offered to employees of a company unless the shareholders of the company approve ESOS by passing a special resolution in the general meeting. The company shall not vary the terms of the ESOS in any manner, which may be detrimental to the interests of the employees. The companies will have the freedom to determine the exercise price subject to conforming to the accounting policies and to specify the lock-in period for the shares issued pursuant to exercise of option. There shall be a minimum period of one year between the grant of options and vesting of option.The amount payable by the employee, if any, at the time of grant of option:

  1. may be forfeited by the company if the option is not exercised by the employee within the exercise period; or
  2. the amount may be refunded to the employee if the option is not vested due to non-fulfillment of condition relating to vesting of option as per the ESOS

Option granted to an employee shall not be transferable to any person. In the event of the death of employee while in employment, all the option granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.In the event of resignation or termination of the employee, all options not vested as on that day shall expire

2. Employee Stock Purchase Scheme (ESPS)
An employee shall be eligible to participate in the ESPS. An employee who is a promoter or belongs to the promoter group shall not be eligible to participate in the ESPS. A director who either by himself or through his relatives or through any corporate body, directly or indirectly holds more than 10% of the outstanding equity shares of the company shall not be eligible to participate in the ESPS. No ESPS shall be offered to employees of the company unless the shareholders of the company approve ESPS by passing special resolution in the meeting of the general body of the shareholders.

The company shall have the freedom to determine price of shares to be issued under an ESPS, provided they conform to the provisions of clause. Shares issued under an ESPS shall be locked in for a minimum period of one year from the date of allotment.

What are the recent advancements in Employee Stock Options Plan?

The Securities and Exchange Board of India (SEBI) has notified Share-Based Employee Benefits Regulations 2014 on October 28, 2014 replacing the existing ESOP guidelines that were in place since 1999:

  • To improve the governance and transparency of such schemes
  • To facilitate smooth operation of such schemes, prevent any malpractices carried out in the name of ESOP and align the provisions with the Companies Act, 2013

The thrust of the New Regulations is on the conditions under which the share based schemes can be implemented through a trust. Widened the coverage of the types of schemes to include the Stock Appreciation Rights Scheme, General Employee Benefits Scheme and Retirement Benefits Scheme in addition to the traditional Employee Stock Option Scheme and Employee Stock Purchase Scheme.

The company may implement the scheme either directly or by an irrevocable trust. If the scheme involves secondary acquisition and / or gift, then it is mandatory for the company to implement such scheme through a trust and such an implementation has to be decided upfront at the time of taking shareholders approval for setting up the scheme.A company may implement several schemes as permitted under these regulations through a single trust. Companies using secondary shares will have to use the Trust route. SEBI may specify the minimum provisions to be included in the trust deed.

Companies using Trust route will need to appoint independent Trustees. The shareholding of the trust shall be shown as 'non-promoter and non-public shareholding for disclosure purpose to the stock exchange.Secondary acquisition in a financial year by the trust shall not exceed two per cent of the paid up equity capital as at the end of the previous financial year.Limits for the total number of shares under secondary acquisition held by the trust. The un-appropriated inventory of shares to be appropriated by the end of subsequent financial year. The trust shall be required to hold the shares acquired through secondary acquisition for a minimum period of six months except under specified circumstances.

The trust can undertake off-market transfer of shares only under the following circumstances:

  • transfer to the employees pursuant to the scheme;
  • when participating in an open offer under regulation7 specified by the SEBI, or when participating in buy-back, delisting or any other exit offered by the company generally to its shareholders.

Our experts from HR Advisory team recently designed an ESOP scheme for the employees of a leading pharmaceutical company. The following details were a part of Scheme Coverage:

  • Employees who have completed one year of service and are in Grade 7 and above.
  • Employees who have completed three years of service and are in Grade 8, 9 and 10
  • Aggregate number of shares issued and allotted under the ESOP Scheme shall not exceed 160000.
  • No employee shall be issued options during any one year, equal to or exceeding 1% of the issued capital of the Company
  • Option Exercise Price: The options would be issued at a price not less than 85% of the prevailing market value of the shares on the date of grant of options
  • Vesting Period and Exercise Period: The Options granted by the ECC shall vest over a period of 4 years in the following manner:
    • 30% of the options at the end of one year from the date of grant.
    • 30% of the options at the end of the two years from the date of grant.
    • 20% of the Options at the end of the three years from the date of grant.
    • 20% of the Options at the end of four years from the date of grant.
  • The maximum period within which the options shall be vested is upon the completion of 5 years from the date of Grant of Options and the exercise period shall lapse not later than 10 years from the date of the final vesting period.

A long-term incentive plan is a reward system designed to improve employees long-term performance by providing rewards that may not be tied to the company's share price. Any company that has a plan for growth should have a long-term incentive plan that strategically communicates that goal to employees. An effectively designed long-term incentive plan can focus key employees on the performance factors that will drive the growth of the business while simultaneously helping to retain that talent. A company needs to know how to determine the one that best suits the ends it needs to achieve and promotes the behavior desired.

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Article by: Garima Saxena, 3EA