Planning to motivate employees with stock awards? Know how it works

Employee Stock Award (stock awards), is a key compensation reward component introduced by many organisations for their employees. The stock award derives its value from the price of underlying instrument (which are shares of the company). Stock awards have many fold long-term benefits like employee retention, motivation, immediate cash conservation for the employer and a sense of ownership and wealth maximisation for the employee.  

With the COVID-19 pandemic presenting unprecedented business disruption, stock awards could be an effective tool for motivating and retaining key talent while deferring immediate cash outflow.  

While most awards are primarily linked to employee performance and the performance of the company, they can also be linked to tenure of employment, seniority, experience, criticality of the role etc.

Further, as part of the award plan, the employer can consider granting instruments such as equity shares, preference shares, debentures, etc.

Also Read: Dr Reddy's Laboratories allots 14,284 equity shares worth Rs 7.3 crore to employees under ESOP

While designing the plan, it is critical to ensure that the objectives of the company, the projections, and the long-term plans are aligned with the performance metrics of the employees to ensure that there is alignment and clarity. Further, the employer also needs to take cognisance of several regulations that need to be complied with.

The popular stock awards schemes are:  

Employee Stock Option Scheme (ESOS) - This is a scheme under which a company grants an employee stock option directly or through a Trust. Here an option is given to an employee which gives him the right to purchase or subscribe at a future date, the shares offered by the company, directly or indirectly, at a pre-determined price.  

Employee Stock Purchase Scheme (ESPS) - This is a scheme under which a company offers shares to employees at a discounted rate.

Stock Appreciation Right (SAR) - This is an appreciation in the value of shares (i.e. difference between the market price of shares on exercise/vesting of the SAR and base price defined on the grant date) that may be settled in shares or cash.

While drafting a stock award scheme, it is also necessary to look at regulatory framework that needs to be complied with. In India, one needs to abide by the provisions in the Companies Act, SEBI regulation (if the company is listed), Income-tax Act and the Foreign Exchange Management Act (if awards are to overseas employees).  

The Companies Act and the SEBI Regulations provide a broad framework or the design and implementation of the stock option scheme like to whom should the scheme apply to, what approvals are necessary, and how the scheme will be executed.

Also Read: OYO to make every employee a shareholder; offers 'deeply discounted ESOPs'

This is to ensure that the scheme is framed in a manner that is fair and equitable and is not detrimental to the interests of stakeholders, such as employees or shareholders. Illustratively, the promoter and promoter groups are excluded from benefiting from the scheme. An exception to this is the issuance of stock options by eligible start-ups for the first 10 years subject to conditions being met.   

For unlisted companies, as there is no ready market to sell the shares, a trust route provides a good exit mechanism. The SEBI Regulations, which are applicable to listed companies, provide guidelines for executing the scheme through a Trust.

It may be noted that as per SEBI regulations, a trust would be necessary for a listed company that seeks to use secondary acquisition as a settlement of stock options. The SEBI regulations ensure that the trust set-up is used for the objectives of ESOP execution and avoid any abuse.

Along with regulatory considerations, it is also important to note income-tax implications for stock options. Stock options are taxable at two stages. First, the point of taxation is when shares are allotted/transferred to employees under ESOS and second stage of taxation is when the employees sell the shares allotted.   

However, some relaxation (i.e. deferral of taxes due on exercise of shares under ESOS) is available to employees of specified start-ups that meet the required conditions such as those recognised by the Department of Promotion of Industry and Internal Trade (DPIIT).

It may be noted that for determination of fair market value for the purposes of perquisite taxation, for listed shares the price quoted on the recognised stock exchange can be used, while for unlisted shares, a valuation by the merchant banker would be necessary.  

While we have provided a few highlights of what regulations would apply to a stock plan of an Indian company, it is necessary that when the employer designs and executes a plan, all regulatory aspects are looked at to ensure a smooth and effective reward scheme for the employees which is not marred with disputes.  

(Information for the editor for reference purposes only)

(Aarti Raote is Partner with Deloitte India, Jimish Vakharia, is Senior Manager, Reena Poddar, is Manager and Kejal Punamiya, is Tax Senior, with Deloitte Haskins & Sells LLP)