ESOPs for Start-Ups

Indian Institute of Management - Bangalore, October 11, 2014

NEELA BADAMI

Overview

• This presentation will cover some legal aspects around the

issue of employee stock option plans (“ESOP”), including:

– Impact of the new Companies Act, 2013

– Securities Exchange Board of India (“SEBI”) Regulations

– Reserve Bank of India (“RBI”) regulations

– Some tax implications

– What sort of documentation is involved?

– (The focus will be on rules applicable to private companies, and references in this

PPT must be treated as such; unless otherwise mentioned in context of SEBI)

Company Law around ESOPs

• For private companies

– What is an ‘Employee Stock Option’?

– Who are ‘eligible employees’?

– Rules around pricing

– Rules around ‘grant’ and ‘vesting’

– ‘Lock in’ period

– Transfer of ESOPs?

• Corporate Compliances

– Shareholders special resolution required. Separate resolutions in some cases?

– Disclosures to be made in the explanatory statement to be attached to notice for EGM

– Disclosures to be made in Directors Report

“Employees’ Stock Option”

• S. 2(37) – “employees’ stock option” means the 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 pre-determined price;

“Employee’’means-

a) a permanent employee of the company who has been working in India or outside India; or

b) a director of the company, whether a whole time director or not but excluding an independent director; or

c) an employee as defined in clauses (a) or (b) of:

– a subsidiary, in India or outside India,

– Or of a holding company of the company or

– Of an associate company

but does not include-

(i) an employee who is a promoter or a person belonging to the promoter group; or

(ii) a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of the company.

“Grant,” “Vest,” & “Exercise”

• Grant – the process of options being issued to the employee.

– Minimum period of one year between grant and vesting.

• Vesting – occurs over a schedule.

• Exercise – the process of purchasing a share once the options have vested, by making an application for the issue of shares.

– For example, I can be granted 100 stock options today, of which 25 shall vest each year on October 11. After October 11 each year, I can “exercise” the option to purchase shares at a pre-determined price.

What “price”?

• Company is free to determine the exercise price in

conformity with applicable accounting policies, if any.

• Needs to disclose the method by which the company

proposes to value the options.

Can ESOPs be transferred? • No. Pledge / hypothecation etc. also are not allowed. • Once the options are exercised and the employee owns shares of the

company, such shares can be transferred subject to articles of association of the company.

• The company can specify lock-in restrictions in respect of the shares issued pursuant to exercise of the option.

• Only the employee can exercise the option. However: – In case of untimely death, options will vest in legal heirs /

nominees.– In case of incapacitation / disability, all options will vest in

employee on that date. – In case of resignation/ termination, all unvested options expire.

But, employee can exercise the options granted which have already vested, subject to applicable terms of the scheme.

Corporate Compliances

• Separate shareholders’ special resolution required to:

– Approve the ESOP Scheme

– Grant options to employees of subsidiaries or holding companies

– Grant options to any employee in excess of 1% of the issued

capital (excluding warrants and conversions)

– Approve any variation of the terms of the scheme; with respect to

options not yet exercised; and provided that such variation is not

prejudicial to the rights of the option holders.

Corporate Compliances• Company must make following disclosures in the Explanatory

Statement attached to the notice convening the extraordinary general meeting: – Total # of options– Classes of employees entitled to participate– Appraisal process to determine employee eligibility – Vesting requirements and period of vesting– Exercise price / formula, exercise period and process– Lock-in, if any– Maximum number of options per employee– Method of valuation of options– Conditions under which options may lapse, for example, termination

for cause– Time period within which employee must exercise the vested options in

case of proposed termination or resignation – Undertaking to comply with applicable accounting standards

Corporate Compliances• Board of Directors must disclose in the board’s report:

– Total number of options granted, vested, exercised or lapsed or outstanding

– Number of shares issued, exercise price, money realised by exercise of options,

– Variation of terms of options

– Employee-wise details of:

• options granted to Key Managerial Personnel (i.e. CEO / MD / Manager / Company Secretary / Whole Time Director / CFO)

• Any other employee who receives a grant of options in any one year ≥ 5% or more of options granted during that year.

• Identified employees who were granted options ≥ 1% of issued capital (excluding outstanding warrants and conversions) of the company at the time of grant

Corporate Compliances

• Maintain a Register of Employee Stock Options in

Form No. SH6,

• At the Registered Office or such other place as the

board may decide,

• To be authenticated by the company secretary or

any other authorised person.

Form No. SH-6

Register of Employee Stock Options

[Pursuant to clause (b) of sub-section (1) of section 62 of the Companies Act, 2013 and rule

12(10) the Companies

(Share Capital and Debentures) Rules 2014]

Name of Company

Registered office address

Date of special resolution …………….

Sl. No. Name of the

grantee

Number of

options granted

Date on which

options vested

Exercised period

1 2 3 4 5

Any variation of terms of the

scheme and its effects

Signature Remarks    

15 16 17

Folio No. of Register of

members having respective entry

Lock in period, if any

Option lapsed, if any

Total number of options in force

Amount forfeited/ refunded if option

is not exercised

10 11 12 13 14

Date on which options exercised

Options exercised Exercise price Number of shares arising as result of exercise of option

6 7 8 9

Impact of the new Companies Act, 2013

• Issuance of shares to Promoters has become unwieldy, since for the first time, sections on ESOPs have been introduced in the Act. ‘Promoters’ are specifically excluded from the definition of eligible employees.

ESOPs – Practice Notes

• What are the workarounds? – Issue Sweat Equity Shares (requires some structuring of

the ‘value add’ of the promoters; there could be tax / accounting implications; a valuation report is needed)

– Issue Warrants (this would attract Preferential Allotment + Private Placement compliance)

– Issue ESOPs to Employees in their capacity as directors (as long as they don’t hold more than 10% shareholding)

– Is a Promoter, really a ‘Promoter?’ or, to put it philosophically, who is a Promoter? (see next slide)

Who is a ‘Promoter’? • The 1956 Act did not define a ‘promoter,’ but the 2013 Act,

does, as follows. “Promoter” means a person—

(a) who has been named as such in a prospectus or is identified by the company in the annual return referred to in section 92; or

(b) who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or

(c) in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act (Provided that nothing in sub-clause (c) shall apply to a person who is acting merely in a professional capacity);

What is ‘control’?

“control” shall include the right to appoint majority of the directors

or to control the management or policy decisions exercisable by a

person or persons acting individually or in concert, directly or

indirectly, including by virtue of their shareholding or management

rights or shareholders agreements or voting agreements or in any other

manner.

Hence the question, is a ‘promoter’ really a “promoter”?! At least to

avail the benefit of ESOPs!

Issue of Shares to Consultants /Advisors

• Made procedurally difficult since any issuance has to

comply with private placement, preferential allotment,

rights issue, ESOP, or sweat equity shares!

• There are challenges with each of these routes.

• As a matter of practice, most PLCs have abandoned the

practice of issuing shares instead of cash, because of the

procedural compliances involved.

• Rights Issue is perhaps the best method.

ESOPs in Listed Companies

• The new Companies Act, 2013 has imported whole-sale

most of the compliances required of listed companies.

What is the wisdom of this?!

Foreign Exchange Issues

• Regulation 8 of FEMA 20 allows for Indian

companies to issue ESOPs to its employees or

employees of it’s JVs / WOS who are resident

outside India, provided:

– Compliance with SEBI Rules or Companies Act as

applicable

– Face value of shares does not exceed 5% of paid up capital

– Reporting to RBI

Indian residents and foreign ESOPs• Indian residents can acquire shares under cashless Employees Stock Option Programme

(ESOP) issued by a company outside India, provided it does not involve any remittance

from India;

• Indian residents can also purchase equity shares offered by a foreign company under its

ESOP Schemes, if they are employees, or, directors of:

• an Indian office or branch of a foreign company, or,

• of a subsidiary in India of a foreign company, or,

• an Indian company in which foreign equity holding, either direct or through a

holding company/Special Purpose Vehicle (SPV) irrespective of the percentage of

the direct or indirect equity stake in the Indian company.

Provided:

• The shares must be offered by the issuing company globally on a uniform basis,

• an Annual Return (Annex B) is submitted

Taxability of ESOPsTwo stages of taxability in the hands of the employee as follows:

• The first stage is when the options are exercised by the employee. The benefit,

which is the difference between the fair market value (“FMV”) of the shares on

the date of which the option is exercised and the amount at which the options were

granted to the employee, is treated as a perquisite as per Income Tax Act, 1961

(the “Act’).

• The second stage is when the shares are sold or transferred by the employee in

which case the difference between the sale consideration and the FMV of the

shares would be treated as capital gains and will be subject to capital gains tax.

• In the hands of the Company issuing the ESOPS, it is allowed to claim ESOP

costs as deductions.

Documents involved

• Board Resolutions• Shareholders Resolutions• Option Agreement / Letter of grant • Letter of Exercise• Share Certificates • ESOP Trust and related documents (Trust

Deed) – Optional

Questions?

Thank you!

Bangalore • Chennai • Mumbai • New DelhiSamvād: Partners is a partner-led, solution-oriented, full service law

firm, formed by the merger of Narasappa, Doraswamy & Raja and V Chambers of Law, having a deep and diverse international

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With offices in Bangalore, Chennai, Mumbai and New Delhi – comprising over 30 lawyers – the Firm’s partners (and its legacy

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The Partners of the Firm – Mr. Harish Narasappa, Ms. Poornima Hatti, Mr. Rohan K. George, Mr. Siddharth Raja, Ms. Vineetha M. G.,

Ms. Nivedita Nivargi and Ms. Neela Badami – are leaders in their respective fields of practice, having a rich mix of domestic and

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Neela Badami (neela@samvadpartners.com) # 62 / 1 Palace Road, Vasanth Nagar, Bangalore 560

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