Corporate Law Newsletter – ESOP Pool and ESOP Trust : September 2024
Introduction
The rising popularity of employee ownership calls for a comprehensive understanding of the nuances of the subject. Navigating structures like Employee Stock Option Plans (ESOPs) mandates a thorough understanding of legal compliance and effective employee engagement strategies.
In this newsletter, we attempt to delve deep into two fundamental methods adopted by companies to attract and retain human resource, namely the ESOP Pool and the ESOP Trust, based structures. While both play significant roles in facilitating Employee Stock Option Plans (ESOPs), they each serve distinct purposes and offer unique advantages. Given below, are the key features of both structures:
A. ESOP Pool Route
An ESOP Pool is a virtual reserve of shares within a company’s capital structure that is used to
grant stock options to employees as part of an Employee Stock Option Plan (ESOP). Stated
below is the mechanism followed under the ESOP Pool route:
1. Creation of the ESOP Pool:
- Creation of ESOP Plan: The company is required to create a formal ESOP Plan comprising and outlining the terms and conditions for granting the stock options.
- Resolutions and Filings: The company must pass all the necessary resolutions, secure approvals from relevant stakeholders, such as Board resolution and shareholders resolution and subsequently file the required documents with the Registrar of Companies (RoC).
- Creation of Notional Pool: Subsequently, the company must establish a notional pool of stock options on the company’s share table (such notional pool shall only appear on the company’s share capital table on a fully diluted basis), showcasing and representing the potential number of shares that could prospectively be issued through stock options. The ESOP Pool represents the potential number of shares that could be issued if all outstanding stock options were exercised by the employees.
- Compliance and Consistency in Terms: The ESOP Scheme must be in adherence with the provisions of the Companies Act, 2013 (hereinafter referred to as “Act”) and its rules. The terms at which an ESOP is granted to an employee, must be consistent with the ESOP scheme.
- Authority: The Board may by itself or through a separate remuneration committee created, decide the number of notional shares that are to be reserved towards the ESOP Pool and the terms for implementation of the plan.
2. Granting, Vesting and Exercise of ESOP:
- Grant and Vesting of Options: The company grants employees the ESOPs at a cost pre-decided on by the company through issuance of a grant letter by the Company. The stock options will vest in eligible employee(s) in coherence with the terms of the plan.
- Exercise and Allotment: Upon completion of the vesting period, the grantees may exercise the granted stock options by submitting an exercise letter to the company. Subsequently, the company will issue the shares to the eligible grantee through fresh allotment of shares. The company shall then seek approval of the Board for allotment of shares. Relevant RoC filings such as PAS-3 shall need to be undertaken by the company. It is only at this stage that the paid-up share capital of the company will increase, and the employee will become a shareholder in the company.
3. Governance:
- The Board or the relevant committee constituted by the Board will oversee all decisions pertaining to the ESOP Plan.
4. Suitability:
- Small to medium sized private limited companies generally adopt the ESOP pool route due to ease of compliances and lesser costs.
B. ESOP TRUST ROUTE:
An ESOP Trust (“Trust”) is a legal entity established for the purpose of holding shares reserved under the ESOP Plan for the benefit of the eligible employees.
1. Formation and Registration:
- The Company will be required to establish a private trust under the Indian Trust Act, 1882. This ESOP Trust can hold shares (ESOPs) of the company either through fresh allotment or sale of shares from existing shareholders including the promoters. Given that the Trust is not considered as a separate legal entity in the eyes of law, the shares of the company will be held by trustees on behalf of the company.
2. Limit on number of shares held by the ESOP Trust as prescribed under the Act:
- 5% Cap: The total value of shares acquired by the Trust from the money provided by the company must not exceed 5% of the company’s aggregate paid-up capital and free reserves.
3. Who can be a trustee?
- The Act does not permit the following individuals to be trustees of the ESOP Trust:
- A director of a company;
- Any key managerial personnel (KMP) of the company;
- The promoter (s) of a company;
- Any relatives of such above-mentioned individuals.
- A beneficiary holding 10% or more of the paid-up share capital of the company.
Note: “Company” includes any holding, subsidiary or associate company.
4. Purchase of Shares by the Trust:
- As per Section 67 of the Act read with Rule 16 (1)(a) of Companies (Share Capital and Debentures) Rules, 2014, the Trust may utilize funds acquired as a loan from the company to purchase the shares of the company.
5. What happens upon exercise of granted stock options?
- Upon exercise, the Trust will be required to transfer the shares of the company to the eligible employees in accordance with the Act. The Board of the company will be required to approve the share transfer in the Board meeting.
- Subsequently:
i. The share certificates are transferred from the trustee (on behalf of the Trust) to the eligible employees;
ii. The register of members is updated accordingly. - In the event that options held by an employee lapse (due to circumstances specified in the ESOP Scheme), the Trust will retain these lapsed options and can grant such options to other eligible employees.
6. Repayment of loan:
- The cash received by the ESOP Trust on exercise (by the employee) is used to repay the loan taken by the Trust for purchase of shares from the company.
7. Suitability:
- Large publicly listed companies adopt the ESOP Trust route as the trust route makes it easier to handle the large number of employees to whom ESOPs are granted.
Conclusion
In conclusion, both ESOP Pools and ESOP Trusts offer unique advantages and benefits for companies seeking to implement employee ownership plans. ESOP Pools are simpler to establish and manage, making them more suitable for smaller companies. On the other hand, ESOP Trusts render greater governance and flexibility, making it an ideal choice for larger companies with many employees.
When choosing between these two structures, it is pertinent to consider several factors including the company’s size, financial resources, desired level of control and the needs of its employees.
