What is ESOP?
An ESOP is an employee benefit plan which offers employees ownership interest in the organization. Companies offer ESOPs to employees with an objective to retain them for long-term, and also to make them the stakeholders of their company. Under an ESOP scheme, employees are granted options, which allows them to buy the stock at a rate below the prevailing market value of the stock or the employee is provided certain percentage of his / her remuneration in stocks of the company.
Modes of Issuance of ESOPs
1. Direct route
- In Direct route, the company grants the options to the employees directly.
- At the time of exercise, fresh equity shares are allotted to the eligible employees which make them the shareholders of the company.
- Direct route is generally preferred by unlisted companies.
2. Trust route
- In the Trust route, the company creates a Trust specifically for the purpose of running the ESOP scheme
- The company grants a loan to the ESOP Trust to acquire shares. Since the ESOP Trust is not a business trust; therefore, the ESOP Trust on its own will not have funds to be able to acquire the shares from the secondary market. It is specifically created with the objective of issuance of ESOPs to the employees.
- At the time of exercise by the employees, the ESOP Trust first acquires the shares from the secondary market/ company and then it transfers the shares in the name of the eligible employee.
- When the employee leaves the company, they have an option of selling back the shares to the ESOP Trust or the secondary market.
- Trust route is generally preferred by the listed companies.
Mechanism of ESOP Trust
Trust route is a method of issuing shares pursuant to the adoption of ESOP scheme. An ESOP Trust is specifically created and registered for the purpose of implementing ESOP Plan. A company drafts a scheme and gets it approved from the members of the company.
Simultaneously, an ESOP Trust is formed as per the provisions of Indian Trust Act, 1882 and registered to act as an intermediary between the company and employees. As and when options are exercised by the option holders, the ESOP Trust is responsible for issuing shares to employees.
Under the ESOP Trust route, the company does not have to dilute its existing capital base and therefore the ESOP Trust route mechanism is preferred by the listed companies for secondary market acquisition of shares.
The exit route for the employees is also easier in case of ESOP Trust mechanism than in case of ESOP Direct route structures. Thereby, it provides liquidity to the employees once the options are exercised by them.
Parties to ESOP Trust formation
There are three parties to the ESOP Trust formation which are mentioned below:
Settlor It refers to the company who has created an ESOP Trust. Settlor is also, known as Trustor or Grantor
Trustee The owner who is under an obligation to use his ownership for the benefit of another. Any person can be appointed as the trustee of the ESOP Trust, except for the following:
The directors, Key Managerial Personnel and their relatives of the company, its holding, subsidiary company, or associate company Any person beneficially holding more than 10% of the paid-up share capital of the company.
- Beneficiary The owner who enjoys the benefit of the Trust property, i.e. the employees of the company.
Benefits of ESOP Trust
There could be numerous factors that may drive companies to use the ESOP Trust structure for management of its employee stock options, some of them are as under
- Better governance and implementation by an independent entity.
- It can provide a simple route for encashment for employees of unlisted companies as there is no market for their securities.
- From an employer perspective, it provides a secure and flexible platform to implement the stock option schemes to encourage and retain the talent, which in turn also saves the costs of time and human capital for administration.
- From an employee perspective, an ESOP Trust can motivate the employees by way of an autonomous and independent structure with transparent rules, which minimizes the conflicts between shareholders of the employer and the employees.
Comparison of ESOP Trust route and ESOP Direct route
There are some aspects which need to be considered by the company before deciding whether to issue ESOP through direct route or to form an ESOP Trust. Some of the key aspects are mentioned below:
Factors to be considered while creating ESOP Trust
There are several factors that must be kept in mind before adopting a Trust structure, some of these include –
- ESOP Trust would need to be funded by the Company for subscription to the shares of the Company. The scheme of provision of money is required to be approved by passing a special resolution in a general meeting. In case of a listed company, purchase to be made from recognized stock exchange.
- In case of unlisted Company, valuation of the shares purchased by the trust shall be done by an Independent Registered valuer.
- It is also important to be mindful of the fact as to who can act as a trustee of the ESOP Trust, as there are certain prohibitions on directors, key managerial personnel and their relatives, person beneficially holding more than 10% of the paid-up share capital to act as a trustee.
- For listed companies, additional conditions / compliances are applicable based on the SEBI regulations with respect to secondary acquisition, value of shares to be purchased, explanatory statement to notice of general meeting, voting rights etc.
- ESOP Trust route is more complex and require legal compliances to be fulfilled such as ESOP Trust registration, ESOP Trust PAN registration, executing ESOP Trust Deed etc.
ESOPs can be considered as a long-term strategy to retain employees as it gives a sense of ownership in company. A number of start-ups in initial years requires support and care to flourish their business - ESOPs help them in meeting targets in case of cash crunch.
Formation and regulation of ESOPs requires lots of consideration. Both Direct route and Trust route have their advantages and complexities and therefore a prudent decision would need to be undertaken keeping in mind the objectives and requirement of the Company.
Authored by Smita Goel, Partner-Tax, Barkha Tahiliani, Principal Associate-Tax and Tanupriya Goyal, Senior Associate-Tax
For any ESOP related query or assistance in structuring, implementing, or managing your ESOP plans, reach out to us at: email@example.com This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.