What is ESOP Meaning, Benefits & How do ESOPs Work?

In today’s competitive world, companies attract & retain their talented employees by using multiple ways and methods. ESOP (Employee stock ownership plan) is one of the ways to retain employees in the organization. ESOP or Employee stock ownership plan is not just about rewarding their employees but also an initiative to make them stakeholders in their company or startups. This initiative encourages the employees to work harder for their company’s success but also offers an extra income to the employees. In this blog we will discuss in detail about ESOPs, its benefits for employees & employers and how ESOP works. 

ESOPs Meaning 

ESOPs or Employee Stock Ownership Plan is a benefit offered to employees to own a part of a company for which they work for. Employee stock ownership plans can be issued in the form of direct stock, profit sharing plans or bonuses. However, the employer has the freedom to decide who can avail these options. For distributing ESOPs to the employees, there are some rules and regulations under Companies rules that must be followed by the employer. ESOPs help both employees and employers with certain benefits, let’s discuss benefits of employee stock ownership plan in detail. 

Benefits of Employee Stock Ownership Plan 

Employee Stock Ownership Plan offers numerous benefits to the organization and the employees both. Advantages of ESOPs to the employers and the employees are as follows:

Advantages of ESOPs for Employees: 

• ESOPs help employees to get a chance of gaining ownership in the company they are working for
• ESOPs offer employees an extra income other than their monthly salary in the form of dividend income 
• Employees get a chance to purchase the company’s share at a discounted price or at fair market value helping them financial advantage 

Advantages of ESOPs for Employers: 

• ESOPs helps companies to attract long-term employees or retain talented employees 
• ESOPs helps employers to get enhanced productivity as the ownership brings motivation & commitments among employees 
• ESOPs offer high retention and engagement which directly improves the company valuation. 

ESOP Distribution Structure

Companies usually distribute ESOPs in two different ways either directly or through Trust. Both structures have their own significant differences. Let’s understand both structure in detail: 

1. Direct Route: Direct route is a method of distributing ESOPs directly by the company to their employees. In this structure companies offer grant options and later at the time of exercise, new freshly issued equity allocated to eligible employees. Once the employee exercises the option, they become a shareholder of the company.  
2. Trust Route: Companies use to set up a trust who manage ESOP schemes and distribute shares among employees by themselves. Trust works as a mediator between companies and its employees while maintaining a smooth ESOP process. Once the employees exercise the options, the trust first acquires shares from the secondary market and then transfers them to employees. 

Let’s discuss some major differences between ESOP Direct Route Structure & ESOP Trust Route Structures: 

How does an Employee Stock Ownership Plan (ESOPs) Work? 

Employee Stock Ownership Plan follows a systematic process to work depending on its structure. We will discuss the process of ESOP in detail through Direct Route and Trust Route: 

ESOP Process through Direct Route: 

• Step 01: Draft ESOP Structure: In order to set up ESOP in India through direct route, startups need to draft an ESOP scheme. It must include the total number of grant options, eligibility criteria, right of employees, exercise price and vesting period. 
• Step 02: Article of Association: Once the well-structured ESOP scheme is drafted, check AOA of the company whether there is a power to create ESOP or not. In case if AoA is not drafted then amend AoA first to incorporate the clause with respect to ESOPs. 
• Step 03: Board Approval: Next startups need to take board approval for the scheme they have drafted. This is one of the major steps to move forward and must be completed in a board meeting. 
• Step 04: Shareholder Resolution: Next, startups need to pass a special shareholder resolution which should include an appraisal process for selection, vesting and exercise price details and conditions for lapsing or transfer, etc. 
• Step 05: File MGT-14: Next, startups need to file MGT-14 to comply with regulatory authority. This form must be filed to ROC within 30 days of passing the special shareholder resolution.
• Step 06: Maintain ESOP Register: Startups need to maintain a SH-6 register including all the information related to granted, vested and exercised options along with the date of issuance and the name of the employee. This register helps to maintain and track all the data within the company.
• Step 07: Grants of Option: Now, startups can offer grant letters to their employees clearly mentioning the term & conditions along with grant options. This letter helps to maintain a clear and transparent communication between employer and the employees. 
• Step 08: Acceptance & Vesting Period: When the eligible employees accept the grant options, an ESOP agreement must be signed with each eligible employee. All employees who signed the agreement then need to complete their vesting period as decided by the company. 
• Step 09: Exercise of Options: After Vesting period, employees can exercise their ESOP grant options whenever they wish as now they are eligible for ESOP. 
• Step 10: Sale of Share: In case of retirement or leaving the company, employees can sell their share back to the company. Companies have to buy-back these shares at fair market value.  

ESOP Process through Trust Route: 

Step 01: Board Approval & Trust Creation: Company’s Board of Directors must approve the proposal of ESOP Trust creation, Trust deed, trustees and ESOP Scheme. They are required to appoint trustees and authorised a signatory along with arranging a general meeting to seek shareholders approval. 

This step also includes taking major decisions on choosing if the Trust will subscribe to fresh shares or acquire existing ones and finalize the approach for allocation, etc. 

Step 02: Drafting Trust Deed: Prepare the trust deed including its purpose, trustee powers, funding rules, acquisition mechanism, transfer/allotment process, dissolution clauses. Along with these details, confirm the legal structure of your trust. Make sure trustees can not be directors/KMP/promoters/their relatives or any 10%+ holder of share capital.  

Step 03: Stamp Duty: Before executing the Trust deed, pay the stamp duty as per State Stamp Act. Make sure the stamp duty is correct as per the state to avoid penalties. In Karnataka, the stamp duty will be paid via Kaveri 2.0 portal after registering on it.

Step 04: Execution & Registration: The trust deed is signed by the company (Settlor) and Trustees along with two witnesses. The stamped deed must be registered with the Sub-registrar. To register this submit documents including ID proofs, resolution and stamp duty proof. Once the registration process is completed, open a Trust bank account and apply for its PAN. 

Step 05: ESOP Implementation via Trust: Ensure movement of funds must be documented properly. For unlisted companies, comply with Section 62 of the Companies Act, 2013, while for listed companies check SEBI regulations.

Step 06: Share Allocation: ESOP Trust allocate the shares between their employees on the basis of their job role, salary and time spent within the company. This division ensures the fair chance of getting the share and ownership across different levels of workspace. 

Step 07: Vesting Period: Employees of the company must complete the vesting period to enjoy the benefits of ESOPs. The vesting period is usually of 3-5 years and it ensures employees stay longer. 

Step 08: Buy Shares: Employees can purchase shares within the company after successfully completing the vesting period. Shares are usually offered at exercise price which are comparatively lower than the market value. 

Step 09: Exit or Sale: At the time of retirement or leaving the company, employees have the option to sell their shares and the company must buy back the shares at fair market value. The sale of ESOPs shares requires financial planning and helps in ensuring liquidity. However, some companies usually maintain a specific budget annually to repurchase the shares. 

It is the responsibility of the trustees to ensure to remain compliant including annual audits, financials and follow the terms of the Trust Deed.

Conclusion 

ESOPs or Employee Stock Ownership Plan is a benefit offered to employees of a company working for a specific time period. ESOPs offer a chance to buy the share of the company to their employees providing them a part of ownership within the company they are working for. To avail ESOPs benefit, employees must complete the vesting period which is usually of 3- 5 years depending on the company you are working. 

ESOP offers benefits not only to the employees of the company but also the employer. The benefits of ESOP for employees include ownership & motivation, extra income, sense of belonging while the benefits for employers include top performers, reduced attrition, enhanced productivity, etc. Employee Stock Ownership Plan works on certain fixed steps for the employer including setting up ESOP trust, share allocation, vesting period, sell of shares, buy-back of shares.