understanding esop & its importance

(Employee Stock Ownership Plan)

ESOP

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ESOP & IT’s IMPORTANCEA reward for their performance.

A motivation for employees to keep increasing their performances.

A plan under which right to exercise shares of a company are given to its employees at a fixed

predetermined price over a period of time.

ESOP

Benefit for Startups to aligns the interest of the employee(s) with the interest of the founders of the company.

Improves the financial and operational performance of the company.

ESOP provide a tax shield for the company.

It is a better incentive plan for employees.

Under ESOP, the price of shares available to employees is lower than its market price.

Importance of ESOP are:


ESOP is:

GenesisEvolved in US in 1950.

A lawyer and investment banker ‐ Louise Kelso in USA, was of the opinion that the

capitalist system would be stronger if all workers, not just a few shareholders, could

acquire and ownership interest in companies where they are employed. He

advocated granting of company stocks through a plan to the employees called

ESOP.

Later, the statutory framework for ESOP was introduced in US under the Employee

Retirement Income Security Act (ERISA) of 1974.

In India, Infosys Technologies Ltd. was the first company to issue ESOP in 1994.


Purpose of ESOP

• To attract, reward, motivate and retain employees.

• To enable employees to acquire beneficial ownership in their company

without having to invest.

• To improve the overall performance of the company.

• To enhance job satisfaction of the employee due to ownership incentive.

• To help in wealth creation for employees.

“The performance of the company is the outcome of its employees’ efforts. The more they are encouraged to work efficiently, better the position achieved by the company in the market.”


ESOP‐ The Non‐Cash Retention SolutionESOP are rights given to employees to exercise shares of the

company. The ESOP compensation expense is a non‐cash expense.

ESOP, therefore, helps companies recruit and retain employees by

offering ownership benefits.


Whom To Issue ESOPThe ESOP can be issued to:

A permanent employee.

A director of the company who neither directly or indirectly

holds more than 10% of the outstanding equity shares of the

company.


The implementation of ESOP is done either by:

Direct Route

Trust Route

Implementation Process of ESOP:


Stages of issuing ESOP to employees

Exercise

Vesting

Formulation of Incentive Plan

Grant

Employee redeems his right and / or acquiresshares.

Employee becomes entitle to redeem his right.

Employee gets a right to receive shares orequivalent value of shares at a future date.

Management plans and formulates a strategy tocompensate employees.1

2

3

4

ESOP


Rules 12(1), 12(2) and 12(4) read with Section 62(1)(b) of the Act require:

i. Approval of the ESOP Scheme by the members of the Company by way of a special

resolution;

ii. The explanatory statement shall disclose prescribed details namely total number of

ESOP to be granted, appraisal process, requirements of vesting, exercise price or pricing

formula, exercise period, lock‐in period, method of accounting, etc;

iii. There shall be separate resolutions in case of :‐ (a) grant of ESOP to employees of the

Subsidiary or Holding Company; or (b) in case of grant of ESOP to identified employees,

during any one year, equal to or exceeding 1% of the issued capital (excluding

outstanding warrants and conversions) of the company at the time of grant of option.

Procedural requirements to issue


Generally the following criterion are taken into consideration:

Performance

Length of Service

Criticality of Employees

Criteria To Issue ESOP


The exit can happen either by an Initial public offering (IPO) or a

strategic sale or a buy back guarantee from the company or

existing promoters.

Flipkart has sold a marginal stake worth between Rs 180 crore to

Rs 240 crore ($28‐36 million) from its employee stock option

(ESOP) Trust Fund and have monetised the wealthy for their

employees as first of such transaction aimed at retaining talent.

Exit Routes in ESOP


ESOP can’t be issued to the person if he is a promoter or a director

holding more than 10 per cent stake. But Sweat Equity is an option for

him.

According to S. 2(88) of the Companies Act, 2013, Sweat Equity Shares

mean equity shares issued by the company to its directors and / or

employees at a discount or for consideration other than cash for

providing know how or making available the rights in the nature of

intellectual property rights or value additions.

Sweat Equity: An ESOP with Slight Differences


SWEAT EQUITY V/S ESOPSWEAT EQUITY ESOP

Sweat Equity Shares are issued as consideration for creation ortransfer of IPR.

ESOP are given in the nature of Incentive and retention plan.

These shares can be issued at discounted price or free for know‐how and services to the company against non‐cash consideration.

The issue price is normally less than the market value of theshares against cash consideration.

These Shares have compulsory Lock‐In Period of 3 years The company shall have the freedom to specify the lock‐in periodfor the shares issued pursuant to exercise of option.

The company shall not issue sweat equity shares for more than15% of the existing paid‐up equity share capital in a year or sharesof the issue value of 5 crore, whichever is higher.The issuance of sweat equity shares in the Company shall notexceed twenty five percent, of the paid up equity capital of theCompany at any time.

There is no such restriction in case of ESOP


Two stages of taxability in the hands of the employee as follows:

•At Exercise: The first stage is when the options are exercised by the employee. The

benefit, which is the difference between the fair market value (FMV) of the shares

on the date of which the option is exercised and the amount at which the options

were granted to the employee, is treated as perquisite as per Income Tax Act, 1961.

•At Sale: The second stage is when the shares are sold or transferred by the

employee in which case the difference between the sale consideration and the

FMV of the share would be treated as capital gains and will be to capital gains tax in

the hands of Employee.

Tax Implication of ESOP for Employees


The case of Huawei Investment & Holding Co. Ltd (Huawei) and Zhongxing Telecom

Equipment (ZTE)

•Huawei implements an ESOP in 1990 to resolve its marketing and expansion problems.

Huawei made available 15% of its stocks to employees. ZTE did not adopt broad‐based

employee ownership. Moreover, only senior managers can hold ZTE shares, while

common employees could not hold ZTE shares

•Huawei restructured their ESOP model by shifting its focus from financing the company

to incentivizing employee productivity in 1997.

•To meet the requirements of Shenzhen Internal Employee Stock Ownership regulations,

Huawei introduced virtual stock options in 2001 and began to phase out their old ESOP

model.

Do’s and Don'ts with Case Studies


Huawei and ZTE’s productivity (unit: million RMB)

Analysis of Productivity of Huawei and ZTE

Huawei(ESOP)

Sales Total Assets Total Asset Turnover

ZTE(non‐ESOP)

Sales Total Assets Total Asset Turnover

2006 65,636 58,501 1.12 2006 23,031 25,916 0.89

2007 93,792 81,059 1.16 2007 34,777 39,173 0.89

2008 125,217 118,240 1.06 2008 44,293 50,865 0.87,

2009 149,059 139,653 1.07 2009 60,272 68,342 0.88

2010 185,176 160,841 1.15 2010 70,263 84,152 0.83

Average 123,769 111,659 1.11 Average 46,527 53,690 0.87


Huawei and ZTE’s productivity growth (unit: million RMB)

Huawei(ESOP)

Employees Sales Adjusted productivity

growth

ZTE(non‐ESOP)

Employees Sales Total Asset Turnover

2006 62,235 65,636 1 2006 39,266 23,031 1

2007 83,609 93,792 1.05 2007 48,261 34,777 1.05

2008 87,501 125,217 1.34 2008 61,350 44,293 1.05

2009 95,106 149,059 1.45 2009 70,345 60,272 1.33

2010 111,290 185,176 1.56 2010 85,232 70,263 1.24

2006‐2010 +78% +179% +56% 2006‐2010 +117% +161% +24%


After analyzing the business attributes of Huawei and ZTE, it is to be

concluded that Huawei has a significant advantage because of its ESOP.

All of Huawei’s shares are owned by its employees while in ZTE, only

senior managers can hold some shares of ZTE. As Huawei’s CEO, Ren

Zhengfei, said ― Huawei belongs to its employees. If Huawei becomes

bigger and creates more profit, employees will acquire benefits more

from its ESOP and they will get huge motivation to work hard to enhance

productivity.

Outcome of the Analysis


Some of the myths of an ESOP are as follows:

•The owner has to give up control of the business and hand it over to the employees

considered under ESOP.

•Interference of employee owner in the management of the company.

•Employees can immediately exercise their option after the issuance of shares under

ESOP.

•Everyone is treated equally while considering for ESOP grant.

All of these statements are NOT true. ESOP works as a productive and strategic tool to

involve and retain employees for collective growth of the organization.

Myths of ESOP in Employees’ MindMyths


ESOP: A good tool for Startups:Startups use ESOP to hire good talent, as they cannot afford to pay very high salaries. Indian startups such as Flipkart, Snapdeal and

Housing.com, are such examples and now they are increasingly offering ESOP as part of their packages, to attract talent.

Benefits of ESOP for Startups:•Retainer ship instrument‐ ESOP can be treated as a retainer ship instrument for startups as there is a lock in period for exercising the right

to purchase the shares. Thus, a business can retain its employees. If an employee opts for this option then he has to serve the lock in period

to become eligible to exercise it.

•Ownership feeling for employees‐ Employees get shares of the company in which they are working and, thereby, it realizes them of an

ownership feeling. In this way, they are motivated to work for the best of the company.

•Option in lieu of salary‐ Businesses that needs funds and are not in a position to spend hefty amounts can offer this option to their

employees in lieu of salary and motivate them to work for the betterment of the company.

ESOP: A Smart Option for Startups


Three Promoters of Startup with an idea

Company Incorporated by these promoters

That After

Three‐ Four YearsCompany will grow

immenselyCompany wants to hire

Employees but do not have funds then this ESOP concept would work


Boss

Company

Boss gives the right to purchase shares of the company at a discounted price

Employee got this right and purchase shares and feel the sense of ownership in the company

Employee


While established companies use this option as a retention

tool for their top assets/brains; startups use it as a tool to hire

talent, as they cannot afford to pay very high salaries. What

makes an ESOP attractive, other than the value or potential

value of the shares or units, is the idea of ownership it imparts

to the employee holding it.

Conclusion


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understanding esop & its importance

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