EMPLOYEE STOCK OPTION SCHEME

Introduction

Employee stock option scheme or Employee Stock Option Plan is almost 7 decades old scheme through which the company grants option to its employees to become the owner of the company. The first ESOS was introduced in the United States of America by pharmaceutical giant Pfizer. 

In the last 7 decades, ESOS has become more and more popular among corporates around the globe and for two fundamental reasons, first it gives employees a sense of ownership in the company which in turn increases the employees’ commitment towards the company and brings stability and reduces employees’ turnover ratio. Second, it does not involve huge cash flow so even the start-ups can use this method to retain good talent.

In India, the ESOS is governed by the Companies Act, 2013 and SEBI’s Employee Stock Option Scheme Guidelines. However, here I am focusing on the provisions of the Companies Act, 2013. Under the Companies Act, 2013, Section 62(1)(b) and Section 67(2), Rule 12, Rule 16 and Rule 18 of the Companies ( Capital and Debenture) Rules, 2014 (hereinafter called as the rules) are applicable.

The entire provisions under the Companies Act, 2013 concerning ESOS can be divided into two parts; one that deals with the issue of option, vesting period, vesting of the option and exercise of the option and subsequent allotment of the shares to the employee who has exercised the option and conditions attached to such allotment that is to say lock-in period, and the other part deal with the provisioning of the amount to purchase or subscribe the shares to allot it to those employees who has exercised the option.

Where the first part is governed by the Rule 12 of the rules the second part is governed by Section 62(1)(b), Section 67(2), and Rule 16 and Rule 18 of the rule.

So before moving further with the provision, let us understand the few terms which we are going to use repeatedly.

Employees Stock Option Scheme

Under Section 2 clause (37) of the Companies Act, 2013, the ESOS, as an “option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a predetermined price;

Since it is an option like any other option it gives its owner right not an obligation to its owner (Employee in this case) to purchase the underlying asset (Shares of the Company or its holding company) at a predetermined price.

As per the definition, we can understand that it is given to employees, director and officer of the company, its holding company, and subsidiary company. Now we need to know who all employees, director and officer are included in the definition.

To understand the term employees, director, and officer we have to go to Rule 12 of the Rules, As per Rule 12 Sub-rule 1’s explanation employee means;

1.   Employee means a permanent employee of the company, word permanent employee is not defined under the Companies Act, 2013, however, in general parlance, we can understand that it does not include employees who are temporarily working in the company, employees under probation, and employees under third party contract.

Further, employee who is a promoter or belonging to the promoter group cannot participate in the scheme. As per Section 2 clause 69, promoter means the person named as such in the prospectus, or name as such in Annual Return (MGT-7) filed under Section 92, who has control over the affair of the company directly or indirectly as shareholders, director or otherwise, or on whose direction Board of Directors are accustomed to act, excluding the advice of the person given under professional capacity.

The above limitation is not applicable for the start-up companies for the 10 years from the date of incorporation.

2.   All the Directors are eligible for the ESOS whether executive or non-executive, except following;

●     Independent Director

●     Directors who himself or through his relative or any body corporate directly or indirectly holds more than 10% of the outstanding equity shares of the company.

It is to be noted that such limitation is only for the equity shares not if the director holds preference share capital. It is also important that the rule itself is not clear about the relationship between director and body corporate to calculate the threshold limit of 10%, however, it is safe to assume that it will only be clubbed when Director enjoys any kind of significant influence over such body corporate. Directors’ holding to be added with the holding of their relative, relative is defined under Section 2 Clause 77,

The above limitation is not applicable for the start-up companies for the 10 years from the date of incorporation.

"relative", with reference to any person, means any one who is related to another, if

(i) they are members of a Hindu Undivided Family;

(ii) they are husband and wife; or

(iii) one person is related to the other in such manner as may be prescribed.

1.   Father/ Step Father

2.   Mother/ Step-Mother

3.   Son/ Step-Son

4.    Son’s Wife.

5.   Daughter.

6.   Daughter’s Husband.

7.   Brother/ Step-Brother

8.   Sister/ Step-Sister

The entity is considered as a start-up

1.   Entity should be Private Company, LLP, or Partnership firm at the time of incorporation, entity remain start-up for 10 years from date of incorporation.

2.   Turnover of the entiy since incorporation/registration not exceed 100 cr. Rupees.

3.   Entity should working towards invoation and capable of generating employment and wealth creation.

Any entity created through reconstruction existing business won’t be eligible for being start-up.

Few important point from the definition of ESOS

1. The scheme is limited to the employees of the company itself or of its holding and subsidiary company and therefore the employees of the associate company can’t be included in the scheme.
2. The individual needs to be the Director or employee of the company at the time of the grant of the option but not at the time of exercise of the option, however, the company is free to put such conditions/restrictions as it deems fit for the vesting of the option.

Vesting Period and Lock-in Period

Vesting period in time between the grant of an option and date on which employee can exercise that option to purchase the shares at a predetermined price. However, as per the Companies Act, 2013 and rule made thereunder, there should be a gap of at least 1 year between granting of an option and exercise of an option and this period of one year is called vesting period. However, in case of merger and reconstruction, in calculating the vesting period in a case where the option has been granted to the employees of the merged company in exchange of their option in the merged company the period of one year shall be reduced by such period by which they have held the option of the merged company.

For example, suppose A Ltd granted the option to its employee on 1 January, 2020, and on 1st June, 2020 A Ltd merged with B Ltd, and B Ltd grant option to the employees of A Ltd in exchange of the option of A Ltd then vesting period for the option of B Ltd will be reduced by six months.

The company is free to determine the lock-in period as it deems fit, the lock-in period is that period in which shares can’t be transacted in any way.

Procedure for Issue of ESOS

Provisions related to issue of ESOS is in Rule 12 of the Companies (Share Capital and Debenture) Rules, 2014, however, these provisions are not applicable in the case where shares are listed in any recognized stock exchange as in this case SEBI’s guidelines on the issue of ESOS will be applicable.

Before granting an option to the employees, the company also needs to make two decisions, first, about the mechanism to implement the scheme. There are two ways in which company can implement the scheme the one is the direct way that is the direct issue of shares to the employee once he or she exercises his or her option and second option is to implement the scheme through the trust, in this case the company can issue shares to the trust and trust will further issue shares to the employee whenever they exercise the option.  

The second decision that company is supposed to make is whether the company will issue new shares under Section 62(1)(b) or to buy the shares from the existing shareholders and allot it to the employees who exercised his or her option.

Whatever the route may be, whether direct, or trust route, issue of new shares, or purchase of shares from existing shareholders, the provisions of Rule 16 of the Companies (Shares and Debenture) Rules, 2014 will be applicable. It is to be noted that where the Rule 12 is not applicable in case of the company whose shares are listed in the recognized stock exchange but Rule 16 “Provision of money by company for purchase of its own shares by employees or by trustee for the benefit of the employees” applies to all the companies coming up with the scheme.

The broad procedure to implement ESOS will be as follows subject to the deviation resulting from the decision whether the company coming up with new shares or buying it from existing shareholders. 

Calling of the Board Meeting: The Company will first call the board meeting to decide the entire mechanism for the ESOS, a notice of such board meeting must be given 7 days before such meeting and shorter notice is possible subject to conditions specified under Section 173. In the same board meeting, the company will fix the date, day, time, place and agenda of the general meeting and approve the notice of the general meeting along with an explanatory statement as per section 101 and 102 of the company.

The company need to pass two (2) special resolution one under rule 12 and other under rule 16, and one (1) special or ordinary resolution based on the fact that whether the company is public or private, in case company choose to issue new shares under section 62(1)(b) and one ordinary resolution if the company is offering shares to:-

●     the employees of holding or subsidiary company, or

●     the identified employees in excess in aggregate during the year one (1) percent of the issued capital (excluding any warrant or convertibles) at the time of grant of the option.

Sending Notice and Explanatory Statement: The Company will send notice to the auditor, directors and members as per Section 101, shorter notice possible as per the condition laid down in section 101. Along with notice the company will also send the explanatory statement since it is the special business, the explanatory statement in this case, need to have particulars as specified under Rule 12, Rule 16 and Rule 18. 

Particular to be included in the explanatory statement as per Rule 12 is as follows;

a)    the total number of stock options to be granted;

b)    identification of classes of employees entitled to participate in the Employees Stock Option Scheme;

c)    the appraisal process for determining the eligibility of employees to the Employees Stock Option Scheme;

d)    the requirements of vesting and period of vesting;

e)    the maximum period within which the options shall be vested;

f)     the exercise price or the formula for arriving at the same;

g)    the exercise period and process of exercise;

h)    the Lock-in period, if any ;

i)     the maximum number of options to be granted per employee and in aggregate;

j)     the method which the company shall use to value its options;

k)    the conditions under which option vested in employees may lapse e.g. in case of termination of employment for misconduct;

l)     the specified time period within which the employee shall exercise the vested options in the event of a proposed termination of employment or resignation of employee; and

m)  a statement to the effect that the company shall comply with the applicable accounting standards.

Particular to be included in the explanatory statement as per Rule 16 is as follows;

a)    the class of employees for whose benefit the scheme is being implemented and money is being provided for the purchase of or subscription to shares;

b)    the particulars of the trustee or employees in whose favor such shares are to be registered;

c)    the particulars of trust and name, address, occupation and nationality of trustees and their relationship with the promoters, directors or key managerial personnel, if any;

d)    the any interest of key managerial personnel, directors or promoters in such scheme or trust and effect thereof;

e)    the detailed particulars of benefits which will accrue to the employees from the implementation of the scheme;

f)     the details about who would exercise and how the voting rights in respect of the shares to be purchased or subscribed under the scheme would be exercised;

The company shall also include the detail as specified in the sub-rule (1) of Rule 18 which primarily include detail about the trustee, in this case, detail of the trustee of the trust created for the implementation of the scheme.

Calling of General Meeting: In the general meeting the following resolution will be passed;

1. Special Resolution for approving the scheme of the employee stock option.
2. Special Resolution approving the provision of the money for the purchase or subscription of the shares, as the case may be.
3. In case the company is issuing new shares under section 62(1)(b) then the public company has to pass a special resolution and a private company will pass the ordinary resolution.
4. In case the company is extending the scheme to the employee of the subsidiary or holding company or identified employee getting one (1) percent or more of the paid-up share capital aggregate in one year excluding warrant and convertible. The company also needs to pass an ordinary resolution.

Post General Meeting Compliances; The company after getting approvals through Special Resolutions and Ordinary Resolutions, as the case may be, shall file all the applicable forms to the registrar. For the Special Resolutions, the company needs to file MGT-14 within 30 days as per Section 117. In case, the company issues shares under Section 62(1)(b) then the company needs to file PAS-3 within 30 days under section 39(3). The Company needs to maintain the detail of options granted in Form SH-6. In case the company is choosing a trust route then the company needs to constitute a private trust. However, the following persons cannot be appointed as trustee.

1. The Promoter, Director and KMP of the company, its holding, subsidiary, and associate company and relative of such Promoter, Director, and KMP.
2. Beneficially (Include both Direct and Indirect) hold 10% or more of the paid-up share capital.

Valuation of the option and shares: There is no requirement of any kind for the valuation of the option and the company can issue it at such value as it deems fit. However, when a company allot shares to the employee by purchasing it from the existing shareholders, then the company which is listed has to purchase shares from the recognized stock exchange but if the shares are not listed then the company needs to get shares valued from the registered valuer. However, if the company issuing new shares under Section 62(1) (b) then there is no need for a valuation.

Maximum Provisioning of Money for ESOS: There is no limit on the grant of option by the company to its employees, however, there is the limit for the maximum amount of provisioning that can be made and that is 5% of Paid-up share capital plus free reserve for the subscription or purchase of shares plus money provided by the company (Loan given by the company to its employees for the purchase of shares).

Variation in Terms of ESOS

The company can vary the term of the ESOS, yet not exercised, in general meeting by passing Special Resolution, the company needs to call the general meeting by sending notice along with explanatory statement and explanatory statement to have the detail of such variation, the rationale behind such variation etc. However, such variation should not be prejudicial to the employees.

Forfeiture of the Amount

Any amount paid by the employee at the time of grant of the option may be;

1. Forfeited if the option is not exercised within the prescribed time specified in the scheme, or
2. Refunded if the option does not vest with the employee, in case the employee does not fulfil the criteria for the vesting of the option. 

Voting Right w.r.t. Option and Shares held trust

As per Rule 12, the holder of the option does not have any right with regard to the dividend or voting. However, once the option is exercised and shares are allotted to him then he or she has all the right associated with shares.

Rule 16 provides that where the voting power w.r.t. shares under the scheme are not exercised by the employee then Board shall disclose in the Board Report following.

The name of the employee who doesn’t vote directly, the reason for not voting directly, the person who exercised voting power in his behalf, number and percentage of total share held by such employees.

Transferability of Option

The option granted to employees is non-transferable, neither option can be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner. The option can be exercised by the employee to whom it is granted except in case of death of the employee while in employment where all the options granted to the employee till his date of death will be vested to the legal hire. If the employee suffers a permanent incapacity while in employment, all the options granted to him as on the date of permanent incapacitation, shall vest in him on that day.

In the event of resignation or termination of employment, all options not vested in the employee as on that day shall expire. However, the employee can exercise the options granted to him which are vested within the period specified in this behalf, subject to the terms and conditions under the scheme granting such options as approved by the Board.

Board Report

The Board Report shall have detail as provided under Rule 12, such as option granted, vested, lapsed and exercised, no. of shares issued under scheme, the money realised etc.

Penal Provisions

Penal provision will be governed by Section 450, Section 67, and Section 39 sub-section (5). Section 62 does not provide any specific penalty to Section 450 will be applicable. In case of non-compliance, the Company and every officer in default shall be punishable with fine up to Rupees Ten Thousand (Rs. 10,000). In case of continuous default Rupees One thousand per day, till such default continues.

If company issue new shares and PAS-3 within 30 days then the penalty will be imposed as per sub-section (5) of Section 39 and the company and its officer who is in default shall be liable to a penalty, for each default, of one thousand rupees for each day during which such default continues or one lakh rupees, whichever is less.

In case of breach of provisions of Section 67, the sub-section 5 provides that that company shall be punishable with fine minimum 1 Lakh and maximum 25 Lakh. Every officer in default shall be punishable with imprisonment upto three years and fine minimum 1 Lakh and maximum upto 25 Lakhs.

CS. Nishant Mishra

Compliance Companion

E-mail: [email protected]

Mobile No. 9899864768