Articles

Esops and sars
Reference Date |  Version March 31, 2024 | 1.0
Keywords Employee Stock Option, Stock Appreciation Right, Ownership, Vesting Period, Employee Incentives
Legislation(s)
  • The Companies Act, 2013
  • Companies (Share Capital and Debentures) Rules, 2014
  • Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021
  • Income Tax Act, 1961
Jurisdiction India

Introduction

Louis Ortho Kelso, a political economist and lawyer, back in 1956,  created the first employee stock ownership scheme based on his belief that the ownership of a company should ultimately vest with its employees as they are the ones responsible for the company’s success.

Procter & Gamble and Sears Roebuck were among the first to introduce Employee Stock Option Schemes (‘ESOS’). In India, the concept of Employee Stock Options (‘ESOPs’) was introduced in the Companies Act 1956, vide the Companies (Amendment) Act, 2000.

Today, ESOPs are commonplace. From a company perspective (especially Start-ups), ESOPs are a tool to incentivize and retain employees by providing them with an opportunity to purchase company shares at a pre-determined price at a certain point in the future based on factors such as performance and/or lapse of a specific time period. From an employee perspective, while a sense of ownership is valuable, the immediate availability of funds is often better appreciated. This, among other considerations, paved the path for incentives linked to stock appreciation, commonly referred to as Stock Appreciation Rights (‘SARS’).

This article discusses the concepts of ESOPs and SARs in the context of the regulatory regime in India.

Conceptual Understanding

ESOPs

ESOPs are options a company offers to its directors, officers or employees to provide them with a benefit or right to purchase or subscribe to its shares in the future at a pre-determined price.

ESOPs are issued under a scheme commonly referred to as the Employee Stock Option Scheme (‘ESOS’). Terminology found in ESOS include;

  • ‘Grant’ – the process of issuing options. ‘Option’ is nothing but a right to receive shares, of course, conditional on fulfilling certain specified criteria.
  • ‘Vesting’- process by which employees become entitled to receive the benefit of the Grant
  • ‘Vesting Period’- period during which vesting of options takes place, i.e., the gap between Grant and Vesting.
  • ‘Exercise’- application made by employees to the company or trust, as the case may be, for issuance of shares against vested options.
  • ‘Exercise Period’- the time period after Vesting within which employees can exercise the right to apply for shares against vested options.

Unlisted companies are required to follow applicable provisions of the  Companies Act, 2013 (‘Companies Act’) read with the Companies (Share Capital and Debentures) Rules, 2014 (‘2014 Company Rules’) for issuance of ESOPs.

Listed companies are required to follow the applicable provisions of the Companies Act, 2013, read with the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (‘2021 Regulations’), for issuance of ESOPs.

SARs

SARs, as the name suggests, is a right granted to employees and directors entitling them to receive appreciation for a specified number of  company shares. Such appreciation can be settled either by cash payment or  company shares.

Presently, SARs are only covered under the 2021 Regulations. Therefore, listed companies are required to follow provisions of the 2021 Regulations for the Grant of SARs, which are to be settled by way of shares.

In the case of listed companies, SARs are issued much in the same way as ESOPs. SARs are issued under a scheme commonly called Stock Appreciation Rights Scheme (‘SAR Scheme’). Terminology found in the SAR Scheme includes;

  • ‘Grant’- the process of issuing SARs.
  • ‘Vesting’ – the process by which employees become entitled to receive the benefit of GrantGrant under the SAR Scheme.
  • ‘Vesting Period’- period during which Vesting of SARs takes place.
  • ‘Exercise’- application made by employees to the company or trust, as the case may be, for the issue of appreciation in the form of cash or shares against vested SARs.
  • ‘Exercise Period’- the time period within which employees can exercise the right to apply for appreciation against vested SARs.

Relevant Considerations for Issuance of Options and SARs

 (i) Entitlement to options /SARs

Listed companies: Options/SARs may be issued to directors, officers or permanent employees (working in or outside India) of a company. The following are not entitled to Options/SARS:

  • Independent director or a director who, through himself or his relative or any body corporate, directly or indirectly, holds more than 10% of the outstanding equity of the company and
  • an employee who is a promoter or person belonging to the promoter group.

The above restrictions do not apply to start-ups up to 10 years from the date of incorporation or registration.

Unlisted companies: Unlisted companies may issue Options to employees, directors or officers as applicable to listed companies. Unlisted companies have the freedom to issue SARs to any employee, any director or officer.

Cross-border ESOPs are permitted under the applicable Foreign Exchange Management legislation.

A resident individual who is an employee or a director of an office in India or branch of an overseas entity or a subsidiary in India of an overseas entity or of an Indian entity in which the overseas entity has direct or indirect equity holding is permitted to acquire shares or interest under ESOS issued by an overseas entity, without any limit. Such ESOS has to be offered by the overseas entity globally on a uniform basis.

An Indian entity is permitted to offer ESOPs to employees/directors who are residents outside India, provided that:

  • ESOPs comply with a sectoral cap as applicable to the issuing company;
  • The issue of ESOPs requires prior government approval if issued by a company where investment by a resident outside India is under the approval route.

An individual shall hold the shares (acquired on exercising ESOPs) on a non-repatriation basis if, at the time of issuance of such ESOPs, that individual was a  resident  of India.

(ii) Special Resolution

Listed companies: ESOS /SARs Scheme(s) can be implemented by a company either directly or by setting up a trust. No scheme may be offered to the employees of a company unless the shareholders approve the same by passing a special resolution in the general meeting. The explanatory statement annexed to the notice for passing the said resolution shall contain information as specified in Schedule-I Part C of the 2021 Regulations.

The terms of the ESOS/SARs scheme may be varied, provided that such variation is not prejudicial to the interests of the employees. A special resolution   must be passed to vary the terms of the ESOS/SARs scheme unless such variation is done to meet any regulatory requirement.

A listed company may reprice the Options/SARs (which are not exercised) if the ESOS/SARs schemes are rendered unattractive due to a fall in the price of the shares in the stock market. However, the company  must ensure that such repricing is not detrimental to the interests of the employees. For repricing Options/SARs, shareholders’ approval through special resolution  must be obtained.

Unlisted companies: ESOS may be issued by the company after the shareholders have approved it by passing a special resolution. The company must make a list of disclosures in the explanatory statement annexed to the notice for passing the said special resolution as prescribed under Rule 12(2) of the 2014 Company Rules. A company can implement the scheme directly or by setting up a trust. The terms of the ESOS, not yet exercised (i.e., not affecting the Options already exercised), may be varied by passing a special resolution, provided that such variation is not prejudicial to the interest of the employees.

The Companies Act does not prescribe any procedure for GrantGrant or settlement of SARs.

For both listed and unlisted companies, approval of shareholders by way of a separate special resolution has to be obtained in case the GrantGrant of Options (and also SARs in case of listed companies) during a given year equals to or exceeds 1% of the issued capital (excluding outstanding warrants and conversions) at the time of Grant of Option.

(iii) Exercise Price

Listed companies: Companies have the freedom to determine the exercise price of Options/SARs. Such exercise price shall conform to the accounting policies specified in the 2021 Regulations.

Unlisted companies: Unlisted companies have the freedom to determine the exercise price of Options, subject to applicable accounting policies, if any.

The general rule under the Companies Act is that a company is not permitted to extend a loan or any financial assistance to any person for the purchase or subscription of shares in the company. This rule does not apply in case of the provision by a company of money in accordance with any scheme approved by the company through special resolution and in accordance with such requirements as may be prescribed for the purchase of, or subscription for, fully paid-up shares in the company or its holding company, if the purchase of, or the subscription for, the shares held by trustees for the benefit of the employees or such shares held by the employee of the company.

(iv) Gap between Granting and Vesting of Options/SARs (i.e., vesting period)

Listed companies: There shall be a minimum vesting period of 1 year.

Unlisted companies: There shall be a minimum vesting period of 1 year concerning options. The question of the vesting period in the case of SARs does not arise as there is no provision governing SARS concerning unlisted companies under the Companies Act.

(v) Lock-in Period

Listed companies: The companies may specify the lock-in period for shares issued under the exercise of Option under ESOS. There is no similar provision applicable to SARs.

Unlisted companies: Companies have the freedom to specify the lock-in period for shares issued pursuant to the exercise of Option.

(vi) Rights of Option/SAR holders

Listed companies: Holders of Options or SARs are not entitled to receive dividends or votes or  enjoy the benefits of a shareholder  untill the issuance of shares on exercise of such Options (or SARs, where SARs are settled by way of shares).

Unlisted companies: In the case of Options, the same restrictions apply as applicable to listed companies. There is no provision for SARs under the Companies Act.

(vii) Transferability

Listed companies: Options/SARs granted are not transferable. Options/SARs cannot be pledged, hypothecated, mortgaged or otherwise alienated in any other manner. No person other than the employees to whom Options/SARs are granted shall be entitled to exercise the Options/SARs. However, in case of death or permanent incapacity of an employee, all Options/SARs granted shall vest on such date with the deceased employee’s legal heir or nominees. The minimum vesting period of 1 year does not apply in the event of death or permanent incapacity of an employee.

Unlisted companies: The same provisions apply regarding Options as applicable to Listed Companies. There is no provision under the Companies Act for SARs.

(viii) Failure to exercise Options

Listed companies: If any amount is paid by an employee at the time of GrantGrant or vesting or exercise:

  • The employee shall stand forfeited of such amount if the employee fails to exercise the Options within the exercise period.
  • The company is required to refund the employees such an amount if Options did not vest due to non-fulfilment of conditions as provided in ESOS in relation to vesting.

Unlisted companies: If any amount is paid by an employee at the time of GrantGrant:

  • The employee shall stand forfeited of such amount if the employee fails to exercise the Options within the exercise period.
  • The company must refund the employees such an amount if Options did not vest due to non-fulfilment of conditions as provided in ESOS concerning vesting.

(ix ) Consequence of termination of employment

Listed companies: Options/SARs not vested shall expire in the event of employee resignation or termination of employment. However, in case of cessation of employment due to retirement or superannuation, Options/SARs granted will continue to vest even after retirement or superannuation. Employees shall be entitled to retain all vested Options/SARs subject to the terms and conditions of the ESOS/SARs scheme formulated by the Compensation Committee.

For administration and superintendence of the ESOS/SARs schemes, either a compensation committee has to be constituted, or the nomination and remuneration committee may be designated as a compensation committee for the purposes of the 2021 Regulations.

Unlisted companies: In case of employee resignation or termination of employment, Options not vested shall expire. However, employees may exercise such Options that are vested within the specified period, subject to the terms and conditions of the ESOS.

(x) Disclosure Document

Listed companies: No ESOPs/SARs shall be offered unless disclosures as specified in 2021 Regulations are made by the company to prospective Option/SAR grantees.

The Disclosure Document, as provided in the 2021 Regulations, is divided into 3 parts:

  • Statement of Risks in the manner specified.
  • Information about the company under specified heads.
  • Salient features of the ESOS/SARs scheme, unless the salient features were already provided to the employee in connection with the previous Grant and nothing has changed since in the ESOS/SARs scheme.

(xi) Managerial Remuneration

Listed companies: The board of directors is required to recommend all fees or compensation, if any, paid to non-executive directors, and the board shall require the approval of shareholders in a general meeting. Such shareholders’ approval shall also specify the limits for the maximum number of stock options that may be granted to non-executive directors in any financial year and aggregate.

If the annual  remuneration payable to a single non-executive director exceeds 50% of the total annual  remuneration payable to all non-executive directors, then approval of shareholders by special resolution has to be obtained.

‘Remuneration’, under the Companies Act, is defined as any money or its equivalent given to any person for services rendered by him, and it includes perquisites as defined under the Income Tax Act, 1961. ‘Perquisites’ under the Income Tax Act include the value of any ‘specified security’ or ‘sweat equity shares’ allotted or transferred directly or indirectly by an employer.

It may be noted here that under the 2021 Regulations, sweat equity shares are to be treated as part of Managerial Remuneration as provided under the Companies Act only in case such shares are issued to a director or manager and issued for non-cash consideration which does not take the form of an asset.

Unlisted companies: For reasons explained above with reference to listed companies, ESOPs granted under ESOS form part of ‘specified security’. Thus, ESOPs are treated as a part of remuneration.

In the case of public companies, Managerial Remuneration payable to directors, including Managing Director and  Full-Time Director and managers, shall not exceed 11% of the company’s net profits in any given financial year. Provided that the company in general meeting may, with the approval of the Central Government, authorize the payment of remuneration exceeding 11% of the company’s net profits, subject to the provisions of Schedule V of the Companies Act, 2013.

Viewpoint

In the case of private limited companies, an ESOS does sound attractive and displays confidence that the company would eventually be listed, and there will be an occasion for the option holder to monetize the assets. Zomato is an example of where ESOPs were used as a retention tool and issued to employees since Zomato operated as a start-up. ESOPs issued to employees turned out to be a powerful tool for employees in terms of generating wealth when Zomato was successfully listed in 2021.

There are many instances where the company remains unlisted for the foreseeable future and finds itself dealing with a bunch of minority shareholders.

This is not to say that ESOPs are not desirable or do not serve a purpose – the timing of the ESOP launch is essential.

In certain situations, SARs offer a distinct advantage over ESOPs.While ESOPs grant ownership, SARs extend the benefit of stock appreciation. Arguably, in the case of a start-up, SARs may not hold relevance in the immediate future.

In the case of unlisted companies with steady financial growth, employees may value SARs settled with cash as it gives them liquidity to make investments as they please.

Whether ESOPs or SARs – the value is realized by the holder only when the company is in good financial health. In the ultimate analysis, two factors stand out. First, the circumstances of the employee financial position and long-term plans; and second, the confidence of the employee in the vision of the company and the ability of the founders to realize its vision.

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