Key points
- An ESOP requires a shareholders' special resolution under Section 62(1)(b) and must comply with Rule 12 of the Share Capital and Debentures Rules, 2014.
- Promoters and directors holding more than 10% cannot receive options, except in DPIIT-recognised start-ups for ten years from incorporation.
- Tax is charged as a perquisite on exercise and as capital gains on sale; eligible start-ups can defer the perquisite tax under Section 192(1C).
Setting up the plan
The board approves a plan document setting the pool, eligibility, vesting schedule, exercise price and period, and treatment on termination, resignation, death and change of control. Shareholders approve it by special resolution, filed in MGT-14. There must be a minimum one-year gap between grant and vesting. Grants are made by letter; a register of options in Form SH-6 is maintained.
Who can receive options
Permanent employees and directors (other than independent directors) of the company, its subsidiaries and holding company. Promoters and directors holding over 10% of the equity are excluded, but DPIIT-recognised start-ups may grant to them within ten years of incorporation.
Taxation
On exercise, the difference between the fair market value (determined by a merchant banker for unlisted shares) and the exercise price is taxed as salary and the company must withhold TDS. On sale, the gain over the exercise-date FMV is a capital gain. Eligible start-ups under Section 80-IAC may defer the perquisite tax to the earliest of five years, sale, or leaving the company.
Common mistakes
Granting options before the plan is approved; promising a percentage of the company rather than a number of options; forgetting to provide for acceleration or cash-out on acquisition; and letting the pool sit as unissued shares without a trust or clear mechanism, which confuses cap tables in due diligence.
Frequently asked questions
Can options be granted to consultants or advisors?
Not under an ESOP, which is limited to employees and directors. Advisors are usually given sweat equity shares (Section 54) or shares against services with proper valuation.
What happens to unvested options when an employee resigns?
They lapse, unless the plan says otherwise. Vested options must be exercised within the period the plan allows, often 90 days, or they lapse too.
Related practice area: Start-up Advisory
This article is for general information and does not constitute legal advice. Laws, rules and limitation periods change and depend on the facts; please take advice on your own situation before acting. Reading this article does not create a lawyer-client relationship with Akhtars Legalitarian.