What are ESOPS?

Companies grant stock options to their employees as a part of their compensation package. These options give employees the right, but not the obligation, to purchase a specific number of company shares at a fixed price. This fixed price is usually set at the current market value of the company’s stock at the time of granting the options.

To encourage employee loyalty and commitment, ESOPs often come with a vesting period. This means that employees need to stay with the company for a certain period of time before they can exercise their stock options. Vesting periods can vary and might include cliff vesting (where employees need to stay for a certain period before any options vest) or gradual vesting (where options vest gradually over time).

After the vesting period, employees can choose to exercise their vested stock options. Exercising means purchasing the company shares at the predetermined exercise price. If the current market price is higher than the exercise price, employees can buy the shares at a discount. This provides them with an opportunity for financial gain.

ESOPs are often used as a tool to motivate employees by tying their financial interests to the company’s performance. When employees become partial owners of the company, they are more likely to work harder and contribute to the company’s success. This feeling of ownership can lead to increased engagement, improved performance, and a stronger commitment to the company’s goals.

As you mentioned, ESOPs can also foster a sense of belonging and loyalty among employees. When they have a stake in the company’s success, they tend to feel more connected to its overall mission and vision. This can lead to a positive work environment and higher morale.

The tax treatment of ESOPs can vary depending on the jurisdiction and specific plan details. In some cases, there might be tax advantages for both the company and the employees. However, it’s important for employees to understand the tax implications of exercising their options, as they might be subject to taxation upon exercise and further taxation upon selling the shares.

ESOPs can be a win-win situation for both employees and companies. Employees have the potential to benefit financially from the company’s growth, and companies can use ESOPs to retain and motivate talented employees while aligning their interests with the company’s success.

What does Companies Act, 2013 say about ESOPs?

Chapter IV The Companies (Share Capital and Debentures) Rules, 2014 – Rule 12 : Issue of Employee Stock options

A company, other than a listed company, which is not required to comply with Securities and Exchange Board of India Employee Stock Option Scheme Guidelines shall not offer shares to its employees under a scheme of employees’ stock option (hereinafter referred to as “Employees Stock Option Scheme”), unless it complies with the following requirements, namely:-


Explanation: For the purposes of clause (b) of sub-section (1) of section 62 and this rule “Employee” means-

  • (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 ten percent of the outstanding equity shares of the company.
  • [“Provided that in case of a startup company, as defined in notification number 3[G.S.R. 127(E), dated 19th February 2019 issued by the Department for Promotion of industry and Internal Trade], Ministry of Commerce and Industry Government of India, Government of India, the conditions mentioned in sub-clause (i) and (ii) shall not apply up to 4[ten years] from the date of its incorporation or registration.”]
  • (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 .
  • (a) grant of option to employees of subsidiary or holding company; or
  • (b) grant of option to identified employees, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option.
  • (b) The notice for passing special resolution for variation of terms of Employees Stock Option Scheme shall disclose full of the variation, the rationale therefor, and the details of the employees who are beneficiaries of such variation.
  • Provided that in a case where options are granted by a company under its Employees Stock Option Scheme in lieu of options held by the same person under an Employees Stock Option Scheme in another company, which has merged or amalgamated with the first mentioned company, the period during which the options granted by the merging or amalgamating company were held by him shall be adjusted against the minimum vesting period required under this clause;
  • (b) The company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.
  • (c) The Employees shall not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to them, till shares are issued on exercise of option.
  • (a) may be forfeited by the company if the option is not exercised by the employees within the exercise period; or
  • (b) the amount may be refunded to the employees if the options are not vested due to non-fulfillment of conditions relating to vesting of option as per the Employees Stock Option Scheme.
  • (b) The option granted to the employees shall not be pledged, hypothecated, mortgaged or otherwise encumbered or alienated in any other manner.
  • (c) Subject to clause (d), no person other than the employees to whom the option is granted shall be entitled to exercise the option.
  • (d) In the event of the death of employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.
  • (e) In case 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.
  • (f) 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.
  • (a) options granted;
  • (b) options vested;
  • (c) options exercised;
  • (d) the total number of shares arising as a result of exercise of option;
  • (e) options lapsed;
  • (f) the exercise price;
  • (g) variation of terms of options;
  • (h) money realized by exercise of options;
  • (i) total number of options in force;
  • (j) employee wise details of options granted to;-
  • (i) key managerial personnel;
  • (ii) any other employee who receives a grant of options in any one year of option amounting to five percent or more of options granted during that year.
  • (iii) identified employees who were granted option, during any one year, equal to or exceeding one percent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant;
  • (b) The Register of Employee Stock Options shall be maintained at the registered office of the company or such other place as the Board may decide.
  • (c) The entries in the register shall be authenticated by the company secretary of the company or by any other person authorized by the Board for the purpose.

Requirement for Valuation of ESOPs

Obtaining accurate ESOP (Employee Stock Option Plan) valuations is crucial for several reasons, primarily for accounting and taxation purposes. Let's delve into the reasons why obtaining ESOP valuations is so important:

ESOP valuations are necessary for proper accounting treatment. When a company grants stock options to employees, it incurs a compensation expense that needs to be recognized on its financial statements over the vesting period. The valuation of ESOPs determines the fair value of these options at the time of grant. This valuation directly impacts the company’s income statement by affecting its reported earnings and reducing its earnings per share (EPS).

As employees’ stock options vest over time, the company needs to account for the corresponding compensation expense. This expense is recognized based on the fair value of the options granted. Accurate ESOP valuations help companies accurately record this expense, ensuring compliance with accounting standards and providing transparency in financial reporting.

ESOP valuations are critical for taxation purposes, both for the company and its employees. For the company, the valuation affects the tax deduction it can claim related to the compensation expense associated with the ESOPs. For employees, the difference between the market price of the company’s shares at the time of exercise and the exercise price is subject to taxation as a perquisite (a form of non-salary benefit). Accurate valuations ensure that the correct amount of tax is assessed and paid by both the company and its employees.

The perceived value of ESOPs is a significant factor in attracting and retaining talent. Employees are more likely to view ESOPs positively if they believe the options have a reasonable and accurate valuation. Properly valued ESOPs increase employee satisfaction and motivation, which can positively impact company performance.

Valuations play a critical role in designing and planning ESOPs. A thorough valuation analysis helps the company set appropriate exercise prices, vesting schedules, and overall ESOP terms. This ensures that the ESOP aligns with the company’s goals, maximizes its benefits, and avoids any unintended negative consequences.

Various accounting standards and tax regulations dictate how ESOPs should be valued. Accurate valuations are essential for regulatory compliance and to avoid potential legal and financial repercussions.

For publicly-traded companies, accurate ESOP valuations contribute to transparency and investor confidence. Investors rely on accurate financial reporting to make informed decisions about their investments.

In summary, ESOP valuations serve as the foundation for accurate financial reporting, proper tax assessment, employee engagement, and overall effective ESOP management. Given their wide-ranging implications, companies should engage qualified professionals to conduct thorough and accurate valuations to ensure compliance and to make well-informed decisions about their ESOP programs.

Approaches and Methodologies for ESOPs Valuation

The intrinsic value method calculates the value of ESOPs based on the difference between the current market price of the company’s shares and the exercise price of the options. This method is often used when ESOPs are issued at or near the market price, making the intrinsic value significant. It’s relatively straightforward but might not accurately capture the full value of the options, especially if they are granted below market price.

This approach estimates the value of ESOPs based on the present value of expected future cash flows generated by the company. Discounted Cash Flow (DCF) analysis is a common method within this approach.

The asset-based approach calculates the value of ESOPs by determining the company’s net asset value, subtracting liabilities. This method might be appropriate for companies with substantial tangible assets.

The market approach involves comparing the company’s financial metrics and market prices to those of comparable publicly-traded companies. This approach relies on market multiples such as price-to-earnings (P/E) ratios, price-to-sales (P/S) ratios, and others.

The fair value method involves using option pricing models to determine the value of ESOPs. This method is often preferred because it considers various factors that affect option value and provides a more comprehensive valuation.

The Black-Scholes model is a widely used option pricing model that takes into account factors such as the current stock price, exercise price, time to expiration, volatility, and risk-free interest rate. It’s commonly used for valuing European-style options.

The binomial model is another option pricing model that considers the discrete nature of time and allows for greater flexibility in modeling early exercise options or other complex scenarios.

Disclosure Requirements: As you mentioned, SEBI norms and accounting standards often require transparency in the valuation process. Even if a listed company isn't using the fair value method, it may need to disclose the financial impact of using option pricing methods in its financial statements' notes. This ensures stakeholders have insight into the potential value of ESOPs and their impact on the company's financials.

Ind-AS 102: Indian Accounting Standards (Ind-AS) 102 provides guidelines for accounting for share-based payments, including ESOPs. It requires the application of fair value for accounting purposes, aligning with international standards.

In conclusion, the choice of valuation method depends on various factors including the company's circumstances, the complexity of the ESOP structure, regulatory requirements, and the level of accuracy desired. Engaging qualified professionals with expertise in valuation and regulatory compliance is essential to ensure that the valuation is accurate, compliant, and appropriate for the company's specific situation.

Taxation of ESOPs 

Income tax should be paid in two situations 

The tax should be paid in the year of the sale of ESOP. 

Disadvantages of ESOPs The main concern for ESOPs is dilution. With every share granted to the employee the shareholders share gets diluted. Conclusion ESOPs have proved to be very effective tools for both big companies and start-ups. Companies use these to retain their workforce and the talent whereas start-ups use these tools to hire fresh talent and to attract more workforce. These work as a boon for companies which cannot afford to pay high salary. Besides this the sense of ownership acts as a motivation for the employees to work hard and diligently.

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