Setting Up ESOPs in Indian Startups: Step By Step Guide

Setting up ESOPs in Indian startups can be a strategic idea for business growth but this process of implementing the ESOPs in your business brings multiple legal processes. These steps must be fulfilled within their time limit to avoid any consequences including penalties. Any startup or business structure opting for employee stock ownership plan should understand the steps involved in installation of this process. In this blog, you will get a step by step guide to implement ESOPs for your startup business along with documentation and legal regulations. 

What is ESOP? 

Employee Stock Ownership Plan commonly known as ESOP is a benefit plan for all the employees offered by employers other than a fixed salary in the form of direct stock. This plan is widely accepted by startups as it helps to attract potential employees and conserve cash flow. There are other numerous reasons for startups to adopt ESOP in India. However, to avail the benefit of this plan, employees are required to complete the vesting period within the startups. Usually, the vesting period is of 3-5 years depending on the startup and it helps startups to retain their employees for a longer time period. 

Types of ESOPs Distribution

ESOP distribution can be completed through two different methods including Direct Route and Trust Route. Both the structures carry their own significance and their setup procedure varies from each other. Direct route of distributing ESOP involves only company while Trust route involves the contribution of trust as well to distribute ESOPs. Lets understand steps to setup ESOP for your company/startup through direct route and trust route.  

Steps to Setup ESOPs for Startups in India 

Steps to setup ESOP for Startup through Direct Route: 

Step 01: Draft ESOP Structure: In order to set up ESOP in India through direct route, startups need to draft an ESOP scheme. It must include the total number of grant options, eligibility criteria, right of employees, exercise price and vesting period. 

Step 02: Article of Association: Once the well-structured ESOP scheme is drafted, check AOA of the company whether there is a power to create ESOP or not. In case if AoA is not drafted then amend AoA first to incorporate the clause with respect to ESOPs. 

Step 03: Board Approval: Next startups need to take board approval for the scheme they have drafted. This is one of the major steps to move forward and must be completed in a board meeting. 

Step 04: Shareholder Resolution: Next, startups need to pass a special shareholder resolution which should include an appraisal process for selection, vesting and exercise price details and conditions for lapsing or transfer, etc. 

Step 05: File MGT-14: Next, startups need to file MGT-14 to comply with regulatory authority. This form must be filed to ROC within 30 days of passing the special shareholder resolution.

Step 06: Maintain ESOP Register: Startups need to maintain a SH-6 register including all the information related to granted, vested and exercised options along with the date of issuance and the name of the employee. This register helps to maintain and track all the data within the company.

Step 07: Grants of Option: Now, startups can offer grant letters to their employees clearly mentioning the term & conditions along with grant options. This letter helps to maintain a clear and transparent communication between employer and the employees. 

Step 08: Acceptance & Vesting Period: When the eligible employees accept the grant options, an ESOP agreement must be signed with each eligible employee. All employees who signed the agreement then need to complete their vesting period as decided by the company. 

Step 09: Exercise of Options: After Vesting period, employees can exercise their ESOP grant options whenever they wish as now they are eligible for ESOP. 

Step 10: Sale of Share: In case of retirement or leaving the company, employees can sell their share back to the company. Companies have to buy-back these shares at fair market value.  

Steps to setup ESOP for Startup through Trust Route: 

Step 01: Board Approval & Trust Creation: Company’s Board of Directors must approve the proposal of ESOP Trust creation, Trust deed, trustees and ESOP Scheme. They are required to appoint trustees and authorised a signatory along with arranging a general meeting to seek shareholders approval. 

This step also includes taking major decisions on choosing if the Trust will subscribe to fresh shares or acquire existing ones and finalize the approach for allocation, etc. 

Step 02: Drafting Trust Deed: Prepare the trust deed including its purpose, trustee powers, funding rules, acquisition mechanism, transfer/allotment process, dissolution clauses. Along with these details, confirm the legal structure of your trust. Make sure trustees can not be directors/KMP/promoters/their relatives or any 10%+ holder of share capital.  

Step 03: Stamp Duty: Before executing the Trust deed, pay the stamp duty as per State Stamp Act. Make sure the stamp duty is correct as per the state to avoid penalties. In Karnataka, the stamp duty will be paid via Kaveri 2.0 portal after registering on it.

Step 04: Execution & Registration: The trust deed is signed by the company (Settlor) and Trustees along with two witnesses. The stamped deed must be registered with the Sub-registrar. To register this submit documents including ID proofs, resolution and stamp duty proof. Once the registration process is completed, open a Trust bank account and apply for its PAN. 

Step 05: ESOP Implementation via Trust: Ensure movement of funds must be documented properly. For unlisted companies, comply with Section 62 of the Companies Act, 2013, while for listed companies check SEBI regulations.

Step 06: Share Allocation: ESOP Trust allocate the shares between their employees on the basis of their job role, salary and time spent within the company. This division ensures the fair chance of getting the share and ownership across different levels of workspace. 

Step 07: Vesting Period: Employees of the company must complete the vesting period to enjoy the benefits of ESOPs. The vesting period is usually of 3-5 years and it ensures employees stay longer. 

Step 08: Buy Shares: Employees can purchase shares within the company after successfully completing the vesting period. Shares are usually offered at exercise price which are comparatively lower than the market value. 

Step 09: Exit or Sale: At the time of retirement or leaving the company, employees have the option to sell their shares and the company must buy back the shares at fair market value. The sale of ESOPs shares requires financial planning and helps in ensuring liquidity. However, some companies usually maintain a specific budget annually to repurchase the shares. 

It is the responsibility of the trustees to ensure to remain compliant including annual audits, financials and follow the terms of the Trust Deed.

Documents Required for ESOPs 

In order to set up ESOPs for your startups, there is certain paperwork required. The following is the list of documents required for ESOPs setup: 

• Board & Shareholders Resolution required as a proof of ESOP scheme approval within the startup
• ESOP Plan & Agreement including detailed terms and conditions of stock options required
• Valuation Report is required for fair market value by a certified valuer
• Disclosure Documents for employees rights and restrictions options information
• MGT-14, PAS-3, SH-6, are required for filing with ROC and tax authorities

Legal Regulations for ESOPs 

ESOP or Employee Stock Ownership Plan is regulated under the Companies Act, 2013 and Income Tax Act, 1961 in India. These laws ensure all the stock options are granted, exercised and taxed perfectly. Securities and Exchange Board of India (SEBI) issues other additional regulations which must be followed by the listed companies in India. Let’s understand these legal requirements for ESOPs in detail: 

1. Companies Act, 2013: Companies Act provides the conditions and procedure to issue the shares under ESOPs. Issuance of shares must be approved by the shareholders of the company in a general meeting. Also, the ESOP scheme must be approved by the Company’s Board of Directors.  
2. Income Tax Act, 1961: As per Income Tax Act, 1961, employees are taxed at two stages for ESOPs. When employees exercise the option, the difference between the exercise price and final market value is considered as Income and thus taxed. Another level when the shares are sold by the employee, tax is applicable on capital gains. 
3. SEBI: From a security perspective, listed companies must follow guidelines issued by the Securities and Exchange Board of India. Companies are required to disclose the ESOP details in Annual reports and filings. It helps in maintaining transparency and attracting investors especially for startups. 

Conclusion 

Setting up ESOP for your startup is a crucial step not only from a strategy perspective but also from legal regulatory perspective. The implementation of ESOP in any startup includes drafting of ESOP scheme, taking board & shareholder approval, filing MGT-14, maintaining SH-6 register, providing grants letter, and at last filing of Form PAS-3. These steps are followed by a certain timeline which must be followed in order to avoid penalties. Along with the process, it is important to keep in mind: provisions related to Companies Act, 2013, Income Tax Act, 1961 implication and SEBI Guidelines for a smooth functioning of ESOP in your startup business.