With more and more startups getting registered in India, there has been a rise in the new jobs that these companies are creating. In July this year, the government said in Parliament that startups have created 7.68 lakh jobs in the last six years.
Very often startups offer equity based compensation to their employees as part of the salary package. There are three reasons why companies do this:
- Instil ownership in employees
- Retain employees
- Boost the compensation package
- Increase their subscribed capital
According to the Companies Act, 2013, Employee Stock Option Scheme (ESOP) and Sweat Equity Shares are the two ways a company can issue shares to its employees.
In this article, we discern the difference between ESOPs and equity shares.
What is ESOP?
When a company offers ESOPs to its employees, it’s essentially agreeing to share its profits with them. In a way, ESOP holders are sort of co-owners of the company.
Interesting Read: How to Start a Startup Company in India in 9 Steps
Section 2(37) of the Companies Act, 2013, defines the ESOP scheme as “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 predetermined price.”
In simple words, a company provides ESOP as an option to its employees, which they can purchase or subscribe to the shares of the company at a predestined rate.
Employees can exercise these ESOPs only after a certain number of years as determined by the company at the time of offering ESOPs.
What is Equity Share?
Section 2(88) of the Companies Act defines Equity Share as “shares issued by a company to its directors or employees for non-cash consideration or at a discount for making rights available in the nature of intellectual property rights or providing know-hows or providing any intellectual value additions to the company in any form.”
Interesting Read: What Is a Partnership Firm And How To Write Partnership Deed?
Rule 8 of Companies (Share Capital and Debentures) Rules, 2014 regulates the procedure of issue of sweat equity shares.
Difference between ESOP and Equity Share
ESOP | Equity Share |
| Companies offer ESOPs to employees to show them their value and motivate them to stay with the company. | Companies issue equity shares to those employees or directors who have specific know-how or can provide intellectual property, which adds value to the company. |
| Employees can exercise their ESOPs by purchasing the shares at a predetermined discounted price on a future date. A company will allot shares to employees or directors only after they exercise their option of the ESOP grant. | Companies allot sweat equity shares directly to their employees or directors at a discount. |
| ESOP must be paid in cash. | The consideration for sweat equity shares is other than cash or at a discount which may be a mix of cash and non-cash. |
| There is no restriction on the company for issuing or granting ESOPs to their employees. | A company can issue sweat equity shares of either 15% of the existing paid-up equity capital or shares worth Rs.5 crores in a year, whichever is higher. At any point in time, it cannot issue sweat equity shares of more than 25% of the paid-up equity capital. |
| There is no fixed lock-in period for exercising ESOPs. It is decided by the company. | Equity shares have a mandatory lock-in period of three years as per the Companies (Share Capital and Debentures) Rules, 2014. |
| The Companies (Share Capital and Debentures) Rules, 2014 has no say in deciding the price of ESOPs. It is decided by the company. | A registered valuer determines pricing guidelines. |
What is the procedure to offer ESOPs?
Step 1: Board Members’ Approval
The first thing a company needs to do is draft an ESOP scheme and get it approved by the board of directors. The ESOP Scheme has the following important clauses –
- Administration of the ESOP
- Employees’ exercise period and vesting period
- The size of the equity pool
- Employee cessation
Step 2: Approval in the EGM
The next step is to call for an Extraordinary General Meeting (EGM) by sending a notice to the board members within the stipulated time period, along with the meeting’s agenda. The ESOP scheme must get shareholders’ approval by passing a special resolution at this EGM.
Step 3: Informing Registrar of Companies (RoC)
The company has to fill up Form MGT – 14 and attach the board’s approval and the special resolution passed in the EGM.
Step 4: Approval from the RoC
As soon as the ESOP Scheme is approved by the RoC, employees will receive their stock options as decided by the company. The vesting time should be at least one year from the date of issuing the ESOPs.
Frequently Asked Questions
Question: What is a vesting period?
Answer: When employees are granted ESOPs, they have to remain with the company as an employee for a fixed period of time until they can exercise their ESOPs. The time for which the employee has to keep working with the company is called a vesting period.
Question: What happens if the employee leaves the company before the vesting period?
Answer: In such a scenario, the company has to buy back those ESOPs at a fair market price within 60 days.
Question: What are the tax implications of ESOPs?
Answer: Employees have to pay taxes at the time of exercising their ESOPs by buying the shares from the company as well as when they sell the shares.
Question: What are Restricted Stock Units (RSU)?
Answer: RSU is also a type of equity-based compensation that companies offer their employees. Typically, it happens when the company goes public. Unlike an ESOP, employees don’t have to buy these shares after the vesting period is over. It automatically acts like any share traded in the stock market.
