Retaining quality talent is impossible unless you compensate them well for their efforts. However, one of the biggest problems most startups face is funding and cash flow and this hampers their ability to retain their good employees. Nevertheless, an easy solution to this problem is to offer stocks through an ESOP trust (Employee Stock Option Plan Trust).
In a 2021 ESOP survey, it was found that 30% of Indian companies have already implemented an ESOP trust and 8% are planning to do so soon. This shows that the concept of ESOP has already found a strong ground in India. Given that 30% of the companies currently have an ESOP system, it’s safe to state that it is definitely a profitable arrangement.
All You Need To Know About ESOP Trusts
What Is an ESOP Trust?
ESOP trusts are private entities formed by a company. They are not to be mistaken for charitable trusts.
These trusts allow the employees to buy company stocks at a rate lower than the current market price. This usually compensates for a certain percentage of the employee’s salary through stocks.
The ESOP trust is not mandatory, and employees are free to refuse. However, it has proved to be beneficial for both the company and employee which has led to its widespread acceptance, especially among startups.
Laws Governing ESOPs & Eligibility Criteria For Employees
The laws governing ESOPs in India are different for listed and unlisted companies. When it comes to unlisted companies, the Companies Act 2013 and the Companies (Share Capital and Debentures) Rules, 2014 govern the ESOP trust.
As for listed companies, the ESOP trust is issued in accordance with the Securities and Exchange Board of India Employee Stock Option Scheme Guidelines.
As a startup, you might have your own specific criteria for employee eligibility based on their years of experience or skills. But according to the Companies (Share Capital and Debentures) Rules, 2014 that governs ESOP trusts, generally, all employees are eligible for the scheme who are:
- Permanent employees of the company
- Employees of the parent company’s subsidiary, or associate company
What Are The Options Available To Set Up An ESOP
Before setting up an ESOP trust, it is important to know what options you have to set it up. There are two routes to set up an ESOP.
- The Direct Route
- The Trust Route
To help you understand the difference between the two routes better, here is a comparative explanation of the two.
This article discusses how ESOP is established and run under the trust route. Although it requires a lot more legal formalities, it does compensate for that by boosting the ROI.
Setting Up an ESOP Trust For Employees: A Step-By-Step Guide
Here is a detailed guide to help you avoid some common mistakes while granting stocks and set up an ESOP trust for your company seamlessly..
1. Formation of a Compensation Committee
The first step is to create a compensation committee. The committee will be constituted of the board of directors with independent directors in the majority. This committee will govern the formation of the ESOP and lay down the rules and guidelines for the same.
2. Listing Eligible Employees
Before you get into the legalities, you need to prepare a list of employees who are eligible for this scheme. The list has to be drawn up taking their experience, expertise, as well as legal guidelines into consideration.
3. Drafting The ESOP Policy
The next step is to draft the policy that will govern the operation of the ESOP trust in accordance with SEBI’s guidelines .
These are a few things that you need to keep in mind while drafting this policy:
- The eligibility criteria of the employees
- The rights of the employees under the scheme
- The rights of the shareholders
- The quantum of the ESOP pool
- Terms & conditions to exit the scheme
- The tax liabilities.
4. Approval By The Board
Once a list of eligible employees is prepared and the ESOP policy is drafted, it is time to get it approved by the board. The board has to approve all the ESOP policies as well as the list of eligible employees. Along with that, a notice to hold a general meeting for the shareholders’ consent also has to be prepared.
5. A General Meeting With Shareholders
A general meeting has to be conducted with the shareholders to get their approval to issue company stocks to the employees. The approval needs to be passed by an ordinary resolution (a resolution passed by a simple majority) . However, the authority to grant the ESOP scheme to the employees remains only with the compensation committee.
6. Registration of The Trust
A trust deed has to be drawn and the ESOP trust has to be registered under The Indian Trust Act, 1882 . Also, a board of trustees will be formed which will be controlled by the company. In addition, the Trust will have to be registered under the Income Tax PAN before it can start operating.
7. Funding The Trust
The trust has to be funded with stocks. For this the company needs to give the trust a loan. The stocks can be provided in any of these three ways:
- The owner of the organization can sell some of his stocks to the trust
- Fresh stocks can be allotted to the trust by the company
- Stocks can be bought from existing shareholders.
8. Issuing The Shares To The Employee
To issue the shares to the employee, the Share Transfer Form (Form 7B) has to be implemented by the trustees and the employee receiving the stocks. Moreover, for the employee to become an official shareholder of the company, the form also needs to be approved during the board meeting. Once the transfer is approved, a shares certificate has to be issued which is followed by updating the Register of Members.
9. Implementation Of The Lock-in Period
The period between the grant of the stocks and when the employee actually receives authority over the stocks is known as the lock-in period. Generally, this period lasts for about a year.
What Is The Exit Mechanism From An ESOP Trust?
Although the trust route for an ESOP is considered more complicated than the direct route, the exit mechanism is comparatively easier in the trust route.
All that the employee has to do is either sell it back to the trust or in the secondary market. Under the Company Act, 2013, the trust can buy back the shares from the secondary market using a loan from the company.
ESOPs are not just rewarding for employees but also for the company. It leads to higher productivity, higher employee retention, and also more profit. Along with this, employers also enjoy massive tax benefits because the loans offered to the trust to buy shares are non-taxable. Tax benefits for start-ups are a blessing since they help you save and re-invest in the company.
Need help creating or rolling out ESOPs? Do you want to streamline ESOP management? Get in touch with our team.