Employee Stock Option Schemes are one of the most widely used tools by companies to attract, retain, and motivate talent. In the modern corporate world, organizations rely not only on traditional compensation packages but also on incentives linked to ownership. Allowing employees to participate in the growth of the company builds a sense of loyalty and alignment of interest. The framework for granting such rights is defined under the Companies Act, 2013, along with the relevant rules. Understanding who can and cannot participate in these schemes is essential for compliance and for maintaining fairness in corporate governance.
Understanding the Concept of Employee Stock Option Scheme
An employee stock option scheme, often referred to as ESOS, is essentially a structured program under which a company grants stock options to its employees, directors, or officers. These options represent a right, not an obligation, to purchase shares of the company at a pre-determined price at a future date. Unlike immediate share allotment, this scheme usually involves a vesting period after which the employee becomes eligible to exercise the option.
The underlying idea is to provide employees with an incentive that grows in value as the company performs better. If the company prospers, its share price rises, and employees benefit by acquiring shares at a price lower than the market value. Thus, the interests of employees and shareholders become aligned.
The concept has been recognized and codified under Section 2(37) of the Companies Act, 2013. According to this provision, an employee stock option means the option given to directors, officers, or employees of a company, including its holding company or subsidiary, which entitles them to purchase or subscribe to the company’s shares at a future date at a pre-determined price.
Statutory Provisions Governing Eligibility
The eligibility criteria for participating in an employee stock option scheme are derived mainly from Section 62(1)(b) of the Companies Act, 2013, read with the Companies (Share Capital and Debentures) Rules, 2014. These provisions outline who qualifies to receive stock options and who is expressly disqualified.
A company cannot issue stock options to just anyone on its payroll. The legislature has carefully crafted boundaries to prevent misuse of such schemes, particularly by promoters or controlling shareholders. The provisions also ensure that the scheme primarily benefits employees in the truest sense, rather than those who already wield significant ownership power in the company.
Eligible Participants under ESOS
The Companies Act identifies three categories of participants who are eligible to take part in an employee stock option scheme.
Permanent employees of the company
Any permanent employee of the company, whether working in India or abroad, can be included in an ESOS. A permanent employee refers to someone who has a confirmed position in the company and is not on a temporary or contractual basis. The location of employment does not matter; both domestic and overseas employees are covered. This inclusion ensures that companies with global operations can extend similar benefits to their workforce irrespective of geographical boundaries.
Directors of the company
Directors are also eligible, including whole-time directors and part-time directors. The only exclusion here is independent directors, who cannot be part of such schemes. This is consistent with the principle that independent directors are expected to maintain neutrality and independence in governance and should not have financial incentives linked to ownership in the company. Whole-time directors, on the other hand, being actively engaged in the management, are eligible since they contribute directly to the company’s operations and growth.
Employees of holding and subsidiary companies
An employee of the holding company or a subsidiary company, whether situated in India or abroad, is also eligible to be part of the ESOS. This provision is significant in the context of large corporate groups and multinational enterprises. It allows the parent company to align the interests of employees across its subsidiaries and create a cohesive sense of shared growth.
Ineligible Participants under ESOS
While the scheme is inclusive, the Companies Act specifically prohibits certain categories of persons from participating. The rationale is to prevent conflict of interest, misuse, and concentration of ownership.
Promoters and members of the promoter group
Employees who are classified as promoters, or who belong to the promoter group of the company, cannot participate in an ESOS. Promoters are individuals who have played a key role in the formation of the company or who hold substantial influence over its affairs. Since they already enjoy significant control and often substantial shareholding, granting them further options could undermine the purpose of employee ownership schemes. The idea is to avoid using ESOS as a backdoor method for promoters to increase their stake in the company.
Directors holding more than ten percent of equity shares
Another important restriction applies to directors who hold, directly or indirectly, more than ten percent of the outstanding equity shares of the company. This disqualification also applies if such holding is through relatives or through a corporate entity. The purpose is again to ensure that individuals who already hold significant stakes do not benefit disproportionately from schemes intended for broader employee welfare.
Common Misconception about Eligibility
It is often assumed that every employee of a company is automatically eligible to participate in an employee stock option scheme. This is not accurate. The eligibility is confined to permanent employees, directors (excluding independent directors), and employees of holding and subsidiary companies, with explicit exclusions for promoters and directors holding over ten percent shares. Thus, the scheme is not a blanket entitlement for all employees.
Practical Application of Eligibility Rules
In practical terms, companies design their ESOS policies keeping in mind these statutory requirements. Human resources departments, legal advisors, and boards of directors collaborate to identify eligible employees. The scheme is then placed before the shareholders for approval through a special resolution in a general meeting. Only after approval can the options be granted.
The eligibility framework also requires careful monitoring over time. For example, an employee who becomes a promoter due to a later acquisition of shares would automatically become ineligible for further grants under the scheme. Similarly, a director who crosses the ten percent threshold at a future date would no longer qualify. These dynamics make it essential for companies to regularly review compliance with the eligibility conditions.
Significance of Eligibility Criteria for Companies
The eligibility provisions are not mere legal formalities. They reflect deeper principles of corporate governance and fairness. By ensuring that promoters and heavily invested directors are excluded, the law ensures that employee stock option schemes serve their true purpose: motivating employees who do not already have significant ownership rights. This avoids misuse of ESOS as a mechanism to consolidate promoter control.
For companies, compliance with eligibility requirements also protects them from legal disputes and regulatory action. Non-compliance could render the scheme invalid and may even attract penalties. Shareholders rely on the assurance that stock option schemes are designed within the boundaries of law.
Impact on Employees
From an employee’s perspective, eligibility rules define who can look forward to long-term benefits from stock options. For permanent employees, the scheme provides a sense of belonging to the company’s future. For directors who are actively engaged in management, it offers an incentive to focus on long-term performance. For employees of holding and subsidiary companies, it builds a shared vision across the corporate group.
On the other hand, independent directors, promoters, and major shareholders are deliberately kept outside the framework. While they contribute in different ways to the company, their role and existing benefits make it inappropriate for them to be part of such schemes.
Case Illustrations of Eligibility
To better understand the scope of eligibility, consider a few illustrations.
- A permanent software engineer employed by a company’s branch in the United States is eligible under ESOS, even though they are based outside India.
- A whole-time director managing daily operations can participate in ESOS, while an independent director who attends only board meetings cannot.
- An employee of the company’s subsidiary in Singapore is eligible to be granted stock options by the Indian parent company.
- A promoter who founded the company and holds 20 percent of its equity shares cannot participate, even if he continues to work full-time in the company.
- A director who initially held five percent shares is eligible, but if his stake later increases to twelve percent, he becomes ineligible for further options.
These examples illustrate how the law balances inclusivity with safeguards against misuse.
Shareholders’ Role in Approving ESOS
Eligibility is only one part of the framework. Even when employees fall within the eligible categories, the scheme cannot be implemented unless it is approved by shareholders. Section 62(1)(b) requires that an ESOS be approved by a special resolution in the general meeting of the company. This ensures transparency and accountability. Shareholders, being the true owners of the company, must agree to potential dilution of equity before the scheme is put into effect.
The resolution must disclose all necessary details about the scheme, including eligibility criteria, pricing, vesting, and lock-in conditions. This disclosure allows shareholders to make an informed decision and prevents hidden benefits from being granted to insiders.
Compliance and Record-Keeping
Maintaining compliance with eligibility requirements also involves proper record-keeping. Companies are expected to maintain registers that include details of options granted, options vested, and shares issued upon exercise. These registers are subject to inspection by shareholders and regulators. Transparency in records provides confidence that the scheme is being implemented in accordance with the law.
Moreover, listed companies are subject to additional requirements under the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations. These rules reinforce the eligibility conditions and add further layers of governance to protect investors.
Difference Between ESOS and ESPS
Employee stock benefit schemes have emerged as powerful tools for attracting and retaining talent in the corporate sector. They are not only about monetary benefits but also about creating a sense of ownership among employees.
Two of the most commonly used models are the Employee Stock Option Scheme (ESOS) and the Employee Stock Purchase Scheme (ESPS). At first glance, they may appear similar since both involve granting shares or rights to employees, but there are important differences in structure, implementation, and regulatory treatment. Understanding these differences is essential for companies, employees, and investors.
Conceptual Overview of ESOS and ESPS
The employee stock option scheme revolves around the idea of granting employees the right to purchase shares at a future date. Under this model, employees are given options that become exercisable after a vesting period. The price is pre-determined at the time of grant, and employees can exercise the options after meeting the vesting conditions.
The employee stock purchase scheme, in contrast, is based on the idea of allowing employees to purchase shares immediately, often at a discounted price. The shares are allotted either directly by the company or through a trust mechanism. Unlike ESOS, there is no vesting period in ESPS, and employees become shareholders as soon as the shares are purchased and allotted.
Although both schemes fall under the umbrella of employee share-based benefits, they are distinct in operation and purpose.
Legal Foundation
Both schemes are recognized under the Companies Act, 2013, as well as under the rules made thereunder. While ESOS is covered specifically by Section 2(37) and Section 62(1)(b), ESPS is provided for under the same statutory framework but defined differently. Regulatory provisions also apply in the case of listed companies through the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, which lay down additional governance requirements.
The law deliberately differentiates between the two schemes because of the different economic implications. While ESOS defers actual ownership until exercise, ESPS creates immediate ownership upon allotment. This difference influences aspects such as dilution of shareholding, accounting treatment, and lock-in requirements.
Structural Differences
Timing of ownership
In ESOS, employees do not become shareholders at the time of grant. They only hold a contractual right to acquire shares in the future. Actual ownership arises when the employee exercises the option after the vesting period. This means employees under ESOS enjoy a future benefit rather than immediate ownership.
In ESPS, employees become shareholders right away. Once they purchase shares, whether at market price or at a discount, ownership is transferred immediately. Thus, ESPS results in instant dilution of equity, unlike ESOS, which delays dilution until options are exercised.
Vesting requirements
The most significant distinction is the vesting requirement. ESOS mandates a minimum one-year vesting period before options can be exercised. This provision ensures that employees stay with the company for a certain duration before enjoying the benefit. Vesting also serves as a retention mechanism.
ESPS, on the other hand, has no vesting requirement. Employees purchase and own the shares instantly. The only restriction is the statutory lock-in period that applies after allotment.
Lock-in conditions
Under ESOS, the company may specify a lock-in period for shares issued after employees exercise their options. This lock-in period is discretionary and varies from scheme to scheme. The flexibility allows companies to design policies that align with their retention strategies.
For ESPS, the law prescribes a mandatory lock-in of one year from the date of allotment of shares. This statutory lock-in ensures that employees do not immediately sell the discounted shares in the market, which could defeat the purpose of the scheme.
Pricing mechanism
In ESOS, the exercise price is determined at the time of grant. Employees have the choice to exercise the options at this pre-determined price, which may be lower than the prevailing market price at the time of exercise. The benefit lies in the difference between the exercise price and the market price.
In ESPS, employees purchase shares at the time of allotment, usually at a discount to the market price. The benefit is realized instantly in the form of discounted acquisition. Unlike ESOS, there is no element of optionality or future exercise.
Procedural and Governance Aspects
Approval requirements
Both ESOS and ESPS require shareholder approval by way of a special resolution at a general meeting. However, the nature of the resolution differs. In ESOS, the scheme is approved in advance, outlining eligibility, vesting, pricing, and lock-in. In ESPS, the resolution typically relates to offering shares under a public issue or otherwise, including secondary acquisitions through a trust.
Role of public issue
One of the striking differences is that ESOS cannot form part of a public issue. The options are granted internally and do not involve public subscription. ESPS, however, can be structured as part of a public issue, allowing employees to participate along with other investors but with preferential terms. This makes ESPS suitable for large listed companies conducting public offerings.
Accounting treatment
The accounting treatment for ESOS and ESPS is also different. In ESOS, the expense recognized by the company is based on the fair value of options granted, which is amortized over the vesting period. This reflects the deferred nature of the benefit.
In ESPS, the discount provided on shares is recognized as an immediate expense since the benefit is realized at the time of allotment. This difference affects the financial statements of the company and requires careful compliance with accounting standards.
Practical Implications for Companies
Companies often choose between ESOS and ESPS based on their strategic objectives.
- ESOS is more effective for long-term retention. The vesting period ties employees to the organization and incentivizes them to contribute to long-term growth. It is also useful for startups and high-growth companies where immediate cash rewards may not be feasible, but the promise of future equity is attractive.
- ESPS is better suited for companies aiming to create instant ownership and participation among employees. Since shares are purchased immediately, employees gain shareholder rights without delay. This can enhance participation in governance and build a stronger ownership culture.
Companies must also consider the implications for dilution of shareholding, accounting, and compliance while selecting the scheme.
Employee Perspective
From an employee’s perspective, the choice between ESOS and ESPS depends on their expectations and financial goals.
Employees under ESOS must wait for the vesting period to complete. They may benefit significantly if the share price rises over time, but they also bear the risk that the price may stagnate or decline, making the options less attractive. The scheme rewards loyalty and patience, as employees who stay longer benefit more.
In ESPS, employees get an immediate reward in the form of discounted shares. The benefit is instant, but since shares are locked in for one year, employees must hold them for a minimum period before realizing liquidity. This scheme suits those who prefer direct ownership without waiting for vesting.
Comparative Analysis of Key Features
A side-by-side look at ESOS and ESPS reveals the nuanced differences.
- ESOS grants a right to purchase shares in the future, while ESPS allows immediate purchase.
- ESOS involves a vesting period, while ESPS has none.
- ESOS provides flexibility on lock-in, while ESPS mandates a one-year lock-in.
- ESOS pricing is fixed at the time of grant, while ESPS pricing involves an immediate discount.
- ESOS cannot be part of a public issue, while ESPS can.
These distinctions, though technical, shape the strategic value of each scheme.
Regulatory Safeguards
The regulatory framework ensures that both schemes serve their intended purpose without being misused. For ESOS, the minimum one-year vesting period prevents companies from granting options that are exercisable instantly, which could otherwise resemble discounted share allotment. For ESPS, the one-year lock-in prevents employees from selling shares immediately for profit.
Both schemes require detailed disclosures to shareholders, including eligibility, pricing, vesting, and lock-in details. This transparency ensures that shareholders can assess the impact of the schemes on their ownership and on the company’s financial position.
Global Practices and Adaptation in India
Globally, companies have used stock option schemes for decades to incentivize employees. In the United States and Europe, stock options are particularly popular among technology companies and startups. ESOS models dominate in such contexts because they align employees with long-term value creation.
In India, both ESOS and ESPS have gained popularity, particularly after the liberalization of corporate laws and capital markets. Large listed companies often use ESPS to quickly extend ownership to thousands of employees, while startups rely heavily on ESOS to attract talent in the absence of large cash reserves.
The Indian regulatory framework has evolved to balance flexibility with safeguards. For example, mandatory shareholder approval ensures that promoters cannot misuse these schemes. Similarly, lock-in and vesting conditions protect against short-term opportunism.
Strategic Use Cases
A deeper look into practical use cases shows how companies deploy these schemes differently.
- A high-growth startup may prefer ESOS because it wants to retain employees for at least three to four years until it reaches the stage of a public listing. The options serve as golden handcuffs, encouraging employees to stay.
- A large listed company with a stable profit base may adopt ESPS to immediately increase employee participation in shareholding. The one-year lock-in aligns with corporate governance practices while giving employees immediate ownership.
- A multinational enterprise may run both schemes simultaneously, offering ESOS to senior executives for long-term retention and ESPS to a wider base of employees to spread ownership culture.
Importance of Stock-Based Schemes in Corporate Strategy
Organizations increasingly recognize that employees are not just workforce participants but also stakeholders in long-term growth. When employees are given a stake in ownership, their decisions and behavior align more closely with organizational goals.
Stock-based schemes help companies in several ways. They serve as a motivational tool by linking financial rewards to company performance. They act as a retention mechanism by tying benefits to continued employment. They also position companies as attractive employers in competitive markets where cash salaries alone may not be enough to secure talent. By adopting ESOS or ESPS, companies create an environment of shared ownership where employees see themselves as contributors to the success of the enterprise.
Advantages of ESOS for Companies
One of the most significant advantages of ESOS is its role in employee retention. Since the options vest over time, employees are encouraged to stay with the company to enjoy the benefits. This prevents attrition of key talent, especially in industries where specialized skills are in demand.
ESOS also aligns employee performance with shareholder expectations. Employees benefit when the share price increases, which happens only if the company performs well in the market. This creates a direct link between employee contributions and company valuation.
Another advantage is the ability to conserve cash. Startups and growth-stage companies often face liquidity constraints. Instead of high salaries, they can offer ESOS, which is attractive to employees who believe in the long-term potential of the organization.
Advantages of ESPS for Companies
ESPS has a different set of advantages. Since shares are allotted upfront, companies can quickly build a culture of ownership. Employees become shareholders immediately and participate in voting, dividends, and other rights.
ESPS can be used to broaden employee participation. While ESOS is often targeted at senior executives and specialized talent, ESPS can be offered widely across the organization. This creates inclusiveness and ensures that a larger group of employees is engaged with the company’s success.
For listed companies, ESPS also complements public offerings. When shares are issued through a public issue, employees can be given preferential access under ESPS, strengthening the relationship between the company and its workforce.
Disadvantages and Risks of ESOS
While ESOS provides long-term benefits, it comes with its challenges. A key drawback is the uncertainty around share price performance. If the market price falls below the exercise price, the options lose their value. Employees may feel demotivated if they perceive the options as worthless.
Another issue is the complexity of administration. Companies need robust systems to track grants, vesting schedules, and exercises. Mistakes or delays in communication can lead to disputes and employee dissatisfaction. There is also a dilution effect for existing shareholders when options are exercised. Though the dilution is delayed compared to ESPS, it can still affect shareholder value in the long run.
Disadvantages and Risks of ESPS
ESPS too has certain limitations. Since employees purchase shares upfront, they need to invest their own money. Not all employees may be willing or financially capable of doing so, which can limit participation.
The mandatory one-year lock-in period means employees cannot immediately liquidate their holdings. While this protects against short-term speculation, it also reduces flexibility for employees who may face financial needs. From the company’s perspective, ESPS results in immediate dilution of equity because shares are issued upfront. This can impact existing shareholders more quickly compared to ESOS.
Compliance and Regulatory Challenges
Both ESOS and ESPS require strict adherence to corporate law and securities regulations. Non-compliance can lead to penalties, shareholder disputes, and reputational risks.
For ESOS, companies must ensure that only eligible employees are included. Promoters, those belonging to the promoter group, and directors holding more than ten percent of equity cannot participate. Detailed disclosures are required in shareholder resolutions and annual reports, including vesting conditions, pricing formulas, and lock-in provisions.
For ESPS, the company must comply with statutory lock-in provisions and make full disclosures about the terms of share allotment. In listed companies, compliance with SEBI regulations is critical, especially regarding pricing and secondary acquisitions by trusts. Companies must also adhere to accounting standards that govern the recognition of share-based payments. Inaccurate accounting can mislead stakeholders about the company’s financial performance.
Global Best Practices and Their Relevance
Globally, stock-based compensation is common in large corporations and technology firms. Companies in the United States have long used stock options as part of executive compensation packages. These models emphasize long-term alignment with shareholder interests by tying rewards to sustained performance.
In Europe, a mix of stock options and purchase schemes is common, with strong regulatory oversight to protect minority shareholders. Asian economies have also adopted similar practices, tailoring them to local corporate governance frameworks.
Indian companies can learn from these global practices by emphasizing transparency, fairness, and alignment. Clear communication with employees about risks and rewards is critical. Companies must also avoid overly complex structures that employees may not fully understand.
Illustrative Examples
Consider a high-growth startup in the technology sector. It offers ESOS to its core team with a vesting period of four years. The employees know that if they stay until the company’s listing, their options could yield significant returns. This creates a strong incentive for them to contribute to the company’s growth journey.
Now consider a large listed company in the manufacturing sector. It offers ESPS to its entire workforce, allowing employees to purchase shares at a discount during a public issue. This broadens ownership and ensures that employees feel directly invested in the company’s success. Both models work, but in different contexts.
Strategic Factors in Choosing Between ESOS and ESPS
When deciding between ESOS and ESPS, companies must consider their goals, resources, and workforce composition.
- If the priority is to retain key talent over the long term, ESOS is more suitable. The vesting requirement ensures continuity.
- If the goal is to create immediate ownership among a large employee base, ESPS is better. It fosters inclusivity and shareholder participation.
- Companies with limited cash flow but high growth potential may prefer ESOS, while companies with stable revenues may find ESPS more feasible.
In many cases, companies adopt a combination of both. Senior executives may be offered ESOS for long-term alignment, while other employees are included in ESPS for immediate participation.
Impact on Corporate Governance
Stock-based schemes also influence corporate governance. Employees who become shareholders through ESPS gain voting rights, which can impact decision-making. While their individual shareholding may be small, collectively they can influence resolutions in shareholder meetings.
In the case of ESOS, employees only gain ownership when they exercise options. This means governance impact is delayed. However, once exercised, employees can become significant shareholders, especially in startups where early employees receive substantial option grants.
Psychological and Cultural Impact
The psychological effect of stock-based schemes should not be underestimated. Employees who feel like owners are more likely to be committed, innovative, and aligned with the company’s mission.
ESOS fosters long-term loyalty because employees anticipate future benefits. They are motivated to contribute consistently, knowing that their efforts will eventually translate into equity value. ESPS fosters immediate engagement because employees become shareholders instantly. They may feel more empowered to voice opinions and participate actively in corporate affairs.
Challenges in Communication and Understanding
One of the common challenges companies face is ensuring that employees understand the schemes. ESOS, in particular, can be complex, involving grant dates, vesting schedules, exercise prices, and taxation at different stages. Without clear communication, employees may undervalue the benefit or misunderstand the risks.
ESPS is easier to explain, but companies must ensure that employees are aware of the one-year lock-in and the potential risks of share price volatility. Transparent communication helps employees make informed decisions and enhances trust in the organization.
Future Trends
The use of stock-based schemes in India is likely to grow as companies compete for talent in an increasingly global market. Startups will continue to rely heavily on ESOS, while established companies will expand the use of ESPS. Hybrid models that combine elements of both may also become more popular.
Technological platforms are also emerging to simplify administration, making it easier for companies to manage grants, vesting, and compliance. As regulations evolve, companies will need to adapt their practices while ensuring fairness and transparency.
Conclusion
Employee stock-based compensation schemes such as the employee stock option scheme and the employee stock purchase scheme have evolved into essential components of modern corporate structures. While their design, eligibility, and implementation differ, the ultimate objective is the same: to align employees’ interests with those of shareholders and to foster long-term growth for the organization.
The employee stock option scheme is particularly effective as a retention and motivation tool. Its vesting requirements ensure that employees remain committed to the company for a defined period, while the potential for wealth creation encourages sustained performance. On the other hand, the employee stock purchase scheme provides immediate ownership, instilling a sense of belonging and inclusivity across the workforce, and encouraging employees to actively participate as shareholders from the outset.
Both schemes come with their advantages and challenges. ESOS offers long-term incentives but requires careful administration and can lose value in unfavorable market conditions. ESPS broadens ownership quickly but involves upfront financial commitments from employees and results in immediate dilution for existing shareholders. Choosing the right scheme depends on a company’s objectives, financial position, workforce composition, and stage of growth.
From a regulatory standpoint, compliance is non-negotiable. Companies must adhere strictly to the provisions of the Companies Act, 2013, along with other applicable securities laws and accounting standards. Transparent communication, accurate disclosures, and well-designed administrative systems are crucial to ensuring smooth implementation and building employee trust.
Globally, stock-based schemes have been a cornerstone of executive and employee compensation, and Indian companies are increasingly adopting similar models. The growing reliance on these schemes indicates a cultural shift in the corporate world, where employees are not only workers but also partners in value creation. With the right balance of strategic planning, compliance, and communication, ESOS and ESPS can serve as powerful tools to drive organizational success while empowering employees to share in that success.