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Insight into Employee Stock Option Plans

CA Sachin Miniyar

21st January 2012


Contents

Ø What is ESOP? Ø Need of ESOP Ø Features of ESOP Ø Types of ESOP Ø Applicable Rules and Regulations Ø Accounting of ESOPs


What is ESOP?

Indian Perspective E – Employee S – Stock O – Option P – Plan

US Perspective E – Employee S – Stock O – Ownership P – Plan


What is Stock Option?

•  Stock Option is a right given to an employee to buy certain number of shares of the company at a fixed pre-determined price over a period of time.

•  It has 3 main characteristics: –  It is a right and not an obligation. –  The price is pre-determined. –  The right is available over a period of time.


Need Of ESOP

•  Owners of the company have a basic problem : How do they get their employees to make decisions that are in the interest of the company?

•  ESOPs are a powerful motivators because pay offs are linked to market price.

•  ESOPs are used as a substitute for cash variable pay.

•  Commonly used as an incentive to retain and attract talent.


ESOP Terminologies

•  Grant Price / Exercise Price – The price at which shares are offered to the employees.

•  Vesting Period – The period after which the options can be converted into shares.

•  Exercise – The action of paying the price and converting the options into shares.

•  Exercise Period - The period after vesting within which the employee has to take the decision of exercising Options.


ESOP Lifecycle

Conceptualizing & Designing

Legal Compliance

Employee Communications

Implementation

Administration


ESOP Lifecycle

Company Grants Options

Granted Options

Vest

Employee Exercises

Vested Options

Sale of Exercised Options


ESOP Lifecycle

Grant Vesting Exercise Selling

Vesting Period

Exercise Period


Year 1 Year 2 Year 3

500 450 400 350 300 250 200 150 100

Share Price Curve

Benefit per share

Exercise Price

How does Employee Benefits


ESOP Advantages

•  No upper cap for the benefit from the scheme.

•  Benefits multiply with the progress of the organization.

•  Benefit as an owner who has a share in earnings,without entrepreneurial risks.


Millionaires at Infosys

Options granted in 1995

1 Option at Rs.100/-

100% vesting after 5

yrs.

1:1 Bonus Share Split

1 Option = 4

Shares Total cost

of 4 shares = Rs.100

Market price Rs.

10,000

Benefit per share 10000 – 25 = 9975/-

Benefit from 100 Options Rs.40 lakhs


ESOP Benefits

A  To Company A  Attracting Talent A Retaining Key Employees A Reduction in costs by providing non-cash

compensation A Market pays, not the company


Types of ESOPs

ESOP •  Employee Stock Option Plan

ESPP •  Employee Share Purchase Plan

SAR •  Stock Appreciation Rights

PEP •  Phantom Equity Plan


Applicable Rules & Regulations


Companies Act

•  Need to pass a special resolution in shareholders meeting u/s 81(1A). –  Not applicable for private companies. They can issue options

with the approval of Board of Directors.

•  Company can grant loan to ESOP Trust to buy its own shares

•  Selective buyback of ESOP shares permitted


ESOP Taxation

GD VD ED SD

Vesting Period

Exercise Period

Holding Period for CG

Perquisite Taxation

Capital Gains

Taxation •  On Exercise

Difference between the prevailing price and exercise price taxed as perquisite

•  On sale of shares

Difference between selling price and price as on date of exercise taxable as Capital Gains


ESOP Taxation

•  Taxation of Stock Appreciation Rights –  Capital Gain / Income under the head Salary / Income from other

sources. –  Decision of Special Bench of Appellate Tribunal in Summit

Bhattacharya v. ACIT 16(1) Mumbai [2008] 19 SOT 663 (Mum.)(SB) / 133 TTJ 633


SEBI Guidelines •  Applicability

•  ESOS / ESPS

•  Eligibility

•  Shareholders approval –  Special Resolution –  Separate resolution for grant to Subsidiary / Holding employees or to

identified employees equal to or grater than 1% of issued capital.

•  Pricing and Lock in

•  Accounting for ESOPs •  Disclosures to Option Holders

•  Disclosures in Directors’ Report •  Administration of ESOP

•  Pre IPO ESOPs


Accounting for ESOPs

ESOP A/cing

Intrinsic Value Method

Fair Value Method

Intrinsic value means the difference between

the market price & exercise price

Fair value means value as calculated

using binomial valuation model

ESOP cost = No. of options x Value Aggregate ESOP cost to be amortized over vesting schedule


Accounting Entries

•  On Grant of Options Deferred Employee Compensation Expense A/c

To Employee Stock Option Outstanding A/c

•  At the end of each year (For amortization of ESOP cost) Employee Compensation Expense A/c

To Deferred Employee Compensation Expense A/c

•  At the time of Exercise of Options Bank A/c Employee Stock Option Outstanding A/c

To Share Capital A/c To Share Premium A/c

•  If Options lapse Employee Stock Option Outstanding A/c

To Employee Compensation Expense A/c To Deferred Employee Compensation Expense A/c


Disclosure in Balance Sheet

•  Employee Stock Option Outstanding A/c is disclosed in the Balance Sheet under a separate heading, between “Share Capital” and “Reserves & Surplus”.

•  Deferred Employee Compensation Expense A/c is disclosed in the Balance Sheet as a negative item under a separate heading, between “Share Capital” and “Reserves & Surplus”.


Deductibility of Discount on ESOPs •  Reasoning in favourable pronouncements

–  Loss suffered in course of business would be allowed even in absence of any statutory provision granting such deduction.

–  ESOP is nothing but a bonus paid in form of company stocks. –  ESOP discount is an ascertainable liability which is recognized in the

books of account.

•  Reasoning for unfavourable pronouncements –  In case of ESOP, primary issue revolves around the character of

discount (whether capital or revenue?) –  Share premium is a capital receipt. Forbearance of such capital

receipt is not deductible. –  Employees pay tax on ESOPs is inconsequential in determining the

allowability.


RBI Guidelines

•  Acquisition of foreign securities under ESOP: –  Foreign holding not less than 51%. –  Shares are offered under cashless ESOP and proceeds are

repatriated to India.

•  Permission for purchase of securities under ADR/GDR linked ESOP subject to: –  The company belongs to knowledge based sector. –  Purchase consideration cannot exceed US$ 50,000 in a block of

5 years . –  Scheme has to be in accordance with SEBI guidelines.


RBI Guidelines

•  Issue of shares to non-resident employees: –  Face value not to exceed 5% of the paid up equity capital. –  Scheme has to be in accordance with SEBI guidelines. –  Company to report to RBI details within 30 days from the date of

issue of shares.


Trends in India

•  ESOS is preferred over ESPS.

•  Initially implemented only in ICE sector companies.

•  Recently manufacturing and service industries have also started implementing ESOPs.

•  ESOP is offered over and above the CTC in initial years.

•  Retention and reward for performance are common objectives found in many companies.

•  Options vest in a graded manner based on time.


Trends in India

•  Uniform structure across organization.

•  Most companies prefer direct route rather than Trust route.


Questions

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