We can call this the era of a startup because now and then, there is a new startup in the market. Along with the many decisions that the startup has to take, one is compensation to employees. Nowadays, while planning the incentives for their employees, businesses, especially startups, have to focus on some key objectives, namely cash flow maintenance, less employee turnover, more employee retention, better performance, tax benefits, etc. Can you think of any plan which fulfills all or is close to all of these objectives? We don't think so!

But there exists one scheme which, for all of these reasons, is gaining popularity like wildfire and it is better known as the Employee Stock Option Plan.

What is ESOP?

Before moving ahead to understand ESOP for startups, we should at least understand the basic meaning of ESOP.

Employee Stock Option Plan is an incentive plan for the employees under which employees of the company are given an option to buy a specific number of shares of the company at a later date at a price lower than the prevailing market price, also known as the exercise price. Through this scheme, employees are given a chance to take ownership of the company, and could there be anything better than that? But as specified, it is still an 'option'. There is no compulsory requirement for them to buy and they also either transfer or sell them off.

ESOPs for Startup

Now how are these attractive options for startup businesses? Here's the answer:

• Like the name says, when the business is a startup, it is in the starting up stage, i.e. Funds are not really in surplus, and whatever funds there are, they have to be used in the operations of the business. There are variable inflows but fixed outflows affecting the business's liquidity and cash flow position.

So, In this case, how do you make people work for you when you clearly can't offer lucrative salaries? By compensating their incentives through ESOP's. By giving them a chance to buy shares of the company and become shareholders instead, and in this process, there is no outflow of cash in the form of salaries. Are we not killing two birds with one stone?

• Well, not two birds but more than two.

We've already saved on cash outflow and made them the part owners. The next benefit comes in the form of retention of employees. When we are in the growing up stage, huge labor turnover can't be afforded, losing talent due to fewer salaries can't be afforded. So to retain the loyal, talented, and hardworking people on board, an option is given to them to buy shares at a later date. 

Later, it implies they cannot just go and buy these shares. Still, a specific vesting period has to be completed before the options become exercisable by the employees. For this period, they need to keep working for the company.

• Not the last, nor the least but a very important benefit in the form of employee performance. With employee stock options plans, the compensation has been directly linked to the performance of the employees. They would now constantly work towards the growth and profits of the company so that the market value and the market price of the company and share keep on rising. This way, they'll get better appreciation, share in the profits, and a better deal in the form of ESOPs because they would be buying it at a much lesser price than the market price then.

ESOP in India

If your startup is registered in India, you must follow the following steps to first get the scheme approved:

Before that, do not forget that the articles of association must authorize such a plan and in case they don't already, they need to be altered.

1. Work with a professional to prepare the ESOP scheme. This step is really important to get started because it is the headstart/ base for your entire plan.

The scheme must list down all the clauses ranging from exercise period, vesting, pool size, grants, ESOP administration, employee cessation.

1. For the next step, to move ahead with the ESOP scheme, we need to get it approved by the board.
2. Once the board approval is in place, the ESOP has to be approved by the shareholders.

      For this, an EGM must be conducted, and a special resolution must be passed.

1. Now the scheme has finally been approved, the board resolution and special resolution must be filed with the Registrar of Companies by visiting their respective website and filling form MGT 14. 
2. After you've completed all these steps, you're all set to grant these options to the employees.

Note: After this procedure, you do not need to raise the company's authorized share capital. This is because ESOP's are options and not shares, and once they are exercised, and shares are bought, that is when the share capital gets increased.

• After the scheme is approved, the procedure further is,

Granting the ESOP's

On the grant date, a grant letter which consists of all the details such as grant date, vesting details, exercise price has to be given to the specified employees to issue these share options.

Vesting of ESOPs

The options become exercisable only after they are vested, i.e. a specified period has passed from the grant date. It could be in terms of duration or even performance but is usually specified in the scheme itself.

Exercising the ESOP's

The date on which the employees buy, transfer or sell their vested options is known as the exercise date. If in case they buy the shares on the exercise price in this step, they are finally allowed the shares in the company.

Documents required for ESOP

1. ESOP Plan: This document lists down all the scheme's features, terms, and conditions.
2. Employment agreement: This agreement between the company and employees gives the company the right to grant the options as per its discretion by specifying the required clause here.
3. Grant Letter: The letter through which the options are issued to employees specifying all the necessary details such as number of shares, exercise price, vesting period, etc
4. Trust deed: This is required only if a trust administers the ESOP to create a trust to hold these shares.
5. Letter of acceptance: A letter through which employees accept and exercise their options.

ESOP from a startup's point of view.

Having understood all the generic details, now let us move forward and understand the details from the pov of a startup.

1. If the employees exercise the options, the ownership will get diluted, and in a startup, it is very necessary to have maximum power in hands to make quicker decisions.
2. The expenses related to the ESOPs in the form of:

• Fees are payable to the registered valuer and merchant banker to determine the right value of the shares.
• Consulting fees are payable for the implementation and supervision.
• Administration cost 

1. The taxability of ESOPs is also a major concern because there is no specific provision for deduction and constant differences as to what is deductible.

U/s 37 of Income Tax Act, the discount (market price- exercise price ) can be deducted as business expenditure.

ESOP's from the point of view of an employee

1. In case the ESOP valuation is incorrectly done, it doesn't just affect the company's EPS but also the tax payable by employees as a prerequisite; hence, to make sure the scheme doesn't become unattractive, the valuation and plan must be properly done and formulated.
2. ESOP comes with a stipulated time period attached, after which the employees can buy these shares and later monetize some or all of the shares. This makes them a tool of wealth creation as this can give them far better benefits as compared to their standard remuneration if the startup does well and is valued considerably well.

This way, from being mere employees with a standard salary, they move on to making wealth, becoming decision-makers, better performance with job security making them grow personally as well as professionally.

1. The taxation in the hands of the employees is even more important than taxation in the hands of the company and hence must be properly explained to the employees along with the scheme itself.

Various factors determine the treatment, such as the type of option when the option is granted or exercised and resigning of employees.

They are taxable at two instances which are:

• On exercise of options: Now, you would possibly question why are the options being taxed here when the employees aren't actually making any income, but instead, cash is flowing out of their pockets.

But the provision remains as to, when the options are exercised, and shares are allotted to the employees, the difference between the fair market value of the share at the exercise date and the exercise price at which they buy these shares becomes taxable as a prerequisite.

•  On selling these shares by the employee-  The difference between the FMV on the exercise date and selling price(i.e. the profit) of the allotted shares under ESOP is taxed under the head capital gains.

Tax on ESOP deferred for startups- A relief?

Budget 2020 deferred the payment of income tax on ESOPs to reduce the burden on the employees as well as the startup owners.

Only startups that are eligible as per section 80 IAC would be able to enjoy this benefit which is :

Deferred deduction of tax at source

For the employees:

The tax liability would  arise only  within 14 days of any of the following events, but obviously, the earliest one:

1. After 48 months have passed from the end of the relevant assessment year
2. From the date when the assessee sells the ESOP  shares
3. From the date when the taxpayer is no longer the employee of the company who has allocated these ESOP shares to him.

Acceptance of ESOP's from a startup

Before an employee decides to accept ESOP's from a startup, he must consider the following factors:

1. The terms of the issue include the number of shares, exercise price, vesting period, expiration date, and cliff period. All this would help him determine whether it is a good profitable deal or not.
2. Fundamentals of the startup: 

Whether or not there are prospects for growth, stability, and profitability for the startup in the future.

1. The idea behind the startup: Whether the idea around which the business is being built is here to stay in the market.
2. Tax implications: very important to understand the tax burden that these ESOP's bring along to not fall under a bigger tax burden than necessary.
3. Terms of employment: the agreement that binds the parties together should be understood well to know all the rights and obligations in the case of winning and losing in the near future.
4. Money: Always remember, salary is what you shall get in hand now, whereas ESOP's are shares you can acquire in the future, which brings in no cash in hand. You must be able to understand what is better as per your perspective and goals to decide whether or not to accept ESOP's

Regulatory Framework in India

Startups in India can only issue ESOPs if they follow certain rules and regulations laid down by laws applicable in the country, such as:

• Companies Act, 2013
• Income Tax Act, 1961
• SEBI Regulations, 2014
• ICDR Regulations 2021
• FEMA,1999 
• IFRS 2 and IND AS 102

What can Especia do for you?

Deciding on the best ESOP scheme for your business could be a really difficult deal if you try to do everything yourself. You need to retain people and save cash outflow, but also make sure you do not end up giving too much equity in the hands of the employees. To make sure all the information and factors are properly understood and taken into consideration, a proper plan is formulated and executed equally well; you must have people on board who are proficient in understanding the basics and complexities of ESOP. To serve your purpose, you can have Especia do it for you who have constantly been working in this field and providing their clients with the best possible ESOP advisory services for their respective businesses.