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Comparative Analysis of ESOP, Sweat Equity and Phantom Stocks

By June 17, 2020 One Comment

A. INTRODUCTION:

With the growing job opportunities and the increase in competition, companies have to ensure that there is a minimization of attenuation and attrition of employees. For the purpose of ensuring the same, the companies offer incentives to their employees in the form of stock options and shares to ensure that the employees are well-motivated and retained by the company for a longer time period. The most popular form of incentive provided to the employees is employee stock options. However, few other forms of incentives are also available to the employees such as the offering of sweat equity shares and phantom stocks.

In this article, we will be discussing in detail the comparative analysis of employee stock options, sweat equity shares and phantom stocks.

B. EMPLOYEE STOCK OPTIONS:

An employee stock option is one form of incentive which is provided to an identified group of employees. The main purpose is to motivate the employees through ownership in the company by way of issuing equity shares to them. The directors, employees or officers are given the right to purchase or subscribe to the shares of the company at a price which is pre-determined and at a future date as mentioned in the grant letter. The options are granted to the employees in accordance with the employee stock option scheme and upon the completion of a minimum period of 1 year from the date of grant of options, the employee shall have the right to exercise the options. The date on which the employee becomes entitled to exercise the right to acquire the shares of the company shall be referred to as vesting date. The terms and conditions with regard to the grant and the exercise of options shall be clearly laid down in the employee stock option scheme and in the grant letter which the company shall provide to the employee. Upon the exercise of the options by the employee after the completion of the specific timelines, the company shall issue shares to the employee.

C. SWEAT EQUITY:

Sweat Equity shares are shares issued by the company to the directors or the employees of the company at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions. In accordance with Rule 8 of the Companies (Share Capital and Debenture) Rules, 2014, value addition shall mean actual or anticipated economic benefits derived or to be derived by the company from an expert or a professional for providing knowhow or making available rights in the nature of intellectual property rights, by such person to whom sweat equity is being issued for which the consideration is not paid or included in the normal remuneration payable under the contract of employment, in the case of an employee.

D. PHANTOM STOCKS:

A Phantom Stock Option is one form of stock option plan wherein the underlying value of the shares of the company is provided to the non-employee/employee i.e. the non-employee/employee is provided with a cash entitlement upon the occurrence of certain events and completion of certain timelines. This is a performance-based incentive which is provided to the non-employee/employees for the purpose of effective performance and the retention of the non-employee/employees in the organization. The cash entitlement which becomes payable to the non-employee/employees is linked to the share value. In the event, there is a hike in the price of the shares there is a likelihood for the non-employee/employee to get a higher cash entitlement. There is no dilution of the share capital in phantom stocks as shares are not issued to the non-employee/employees, as the underlying value of the share is provided, which is payable in the form of cash.

There are two kinds of phantom stocks i.e. full value and appreciation only. A full value phantom stock shall entitle the non-employee/employee to receive the value at which the stock is worth at the time of the cash settlement. In the appreciation only method, the non-employee/employee would not be provided with the cash settlement at the current value of the stock but at a value i.e. the difference between the value at which the stock was granted to the non-employee/employee and the current value of the stock. For the purpose of issuance of phantom stock, an agreement shall be entered into between the non-employee/employee and the company. The phantom stocks are granted to the non-employee/employees as per the terms and conditions as laid down in the agreement. The number of units along with the specific timeline is detailed out in the agreement. The starting value of the unit shall be mentioned in the agreement and similar to the non-employee/employee stock options, the vesting schedule, the events of payment such as liquidation event such as infusion of funds, merger, acquisition, change in control, strategic investment in the company etc. or any other mechanism shall be clearly laid down in the agreement.

There is no law which governs the issuance of phantom stocks and the same are usually governed by the agreement entered into between the non-employee/employees and the company. The Companies Act, 2013 does not have any provisions which would govern the phantom stocks.

E. COMPARATIVE ANALYSIS:

 

Sl. No: Parameters: Employee Stock Options: Sweat Equity Shares: Phantom Stocks:
1. Meaning: Section 2 (37) of the Companies Act, 2013:

“Employee stock option means the option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.”

Section 2 (88) of the Companies Act, 2013:

“Sweat equity shares means such equity shares as are issued by a company to its directors or employees at a discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called.”

A stock option plan in which the underlying value of the share is provided to the employee/non-employee in the form of a cash entitlement in accordance with the terms laid down in the agreement entered into between the company and the employee/non-employee.
2. Governed by: Section 62 (1) (b) of Companies Act, 2013 read with Rule 12 of

Companies (Share Capital and Debenture) Rules,  2014.

The listed entities have to comply with Securities and Exchange Board of India Regulations on Employee Stock Options.

Section 54 of Companies Act, 2013 read with Rule 8 of

Companies (Share Capital and Debenture) Rules,  2014.

The listed entities have to comply with Securities and Exchange Board of India Regulations on sweat equity.

Agreement entered into between the employees/non-employee and the company.
3. Issued to whom: a)      A permanent employee of the company who has been working in India or outside India.

 

b)      Director of the company, whether whole-time director or not, excluding an independent director.

c)      An employee as defined in clauses (a) or (b) of a subsidiary, in India or outside India, or of a holding company of the company but does not include- (i) an employee who is a promoter or a person belonging to the promoter group; or (ii) a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than ten per cent of the outstanding equity shares of the company.

Start-ups may issue the employee stock options to its promoters and directors who hold more than 10% for a period of 10 years from the date of their incorporation.

a)      A permanent employee of the company who has been working in India or outside India or

b)      A director of the company, whether a whole-time director or not; or

c)      An employee or a director as defined in sub-clause (a) or (b) above of a subsidiary, in India or outside India, or of a holding company of the company.

 

Non-employees such as promoters, agents, consultants, advisors etc and employees.
3. Share Capital Dilution: The share capital is diluted if the options issued to the employees are vested. The share capital is diluted as the shares are issued to the employees. The share capital is not diluted as the underlying value of the shares is given to the employee/non-employee.
4. Consideration: Employees are required to pay the predetermined price of the shares at the time of exercise in cash.  The consideration can be in cash, IPR or non-cash. Employees/non-employees are not required to pay any price. In turn, the company is required to pay the employee the underlying value of the shares as a cash payment to the employees/non-employees.
5. Valuation: The Company has the freedom to determine the exercise price in conformity with applicable accounting policies. The issue price shall not be less than the intrinsic value of the shares. The sweat equity shares to be issued at a value determined by a registered valuer as the fair price. Valuation of intellectual property rights or of know-how or of value additions or of any non-cash consideration shall be determined by a registered valuer. The shares may be issued at a discounted price or free for know-how. The valuation of stock would be done as per the terms and conditions of the agreement.
6. Resolution: Employee Stock Option Scheme shall be approved by the shareholders of the company by passing a special resolution.

For private companies, the Employee Stock Option Scheme shall be approved by the members through the passing of an ordinary resolution. Approval of shareholders by way of separate resolution shall be passed for the grant of an option to employees of the subsidiary or holding company or for the grant of options to identified employees during one year equal to exceeding one per cent of the issued capital of the company at the time of grant of the option which shall exclude outstanding warrants and conversions.

For the purpose of issuance of the sweat equity shares, a special resolution shall be passed by the company in a general meeting.

The special resolution authorizing the issue of sweat equity shares shall be valid for making the allotment within a period of not more than twelve months from the date of passing of the special resolution.

No resolution is required to be passed. These are issued in accordance with the terms laid down in the agreement.
7. Lock-in and Vesting Period: The minimum vesting period shall be one year from the date of granting of the options after which the options can be exercised by the employees.

The company shall have the freedom to specify the lock-in period for the shares issued.

The sweat equity shares shall be locked-in for a period of 3 years from the date of allotment. As per the timelines laid down in the agreement.
8. Dividend and Voting Rights: Upon the exercise of the option and issue of shares to the employees, the employee shall have the right to receive dividends and shall have the voting rights in the company. The employees shall have the right to vote and receive dividends from the company. The dividend is not payable and there are no voting rights as there is no issuance of shares.
9. Transferability: The options are neither transferable nor can they be hypothecated, pledged, mortgaged or encumbered or alienated in any manner. The sweat equity shares shall not be transferable for a period of 3 years from the date of allotment. It shall be in accordance with the agreement. However, in our practical experience, these cannot be transferred.
10. Maintenance of Registers: The company shall maintain a Register in Form SH-6. The company shall maintain a Register in Form SH-3. There is no requirement for maintenance of any register for the issue of these stocks.
11. Restriction on the limit of increasing paid-up share capital: The company can raise any amount of paid-up share capital by issuance of ESOP’s. Only up to 15% of the existing paid-up equity share capital shall be issued in the form of sweat equity shares in year or shares of the issue value of Rs. 5 crores, whichever is higher, provided that the issuance of the sweat equity shares of the company shall not exceed 25% of the paid-up equity share capital of the company.

A startup may issue sweat equity shares not exceeding 50% of the paid-up capital up to 5 years from the date of its incorporation or registration.

They are issued to any manager or director of the company.

There is no increase in paid-up share capital of the company as no shares are issued.
12. Disclosure in Directors Report: The Board of Directors shall disclose details of Employee Stock Options Scheme in the Directors Report. The Board of Directors shall disclose details of the issue of shares in the Directors Report for the year in which the shares are issued. There is no requirement to disclose the issue of stock in the Board Report.

F. CONCLUSION:

Companies in their initial stages due to uncertainty, illiquidity to pay high salaries and ambiguity of continuous growing, prefer employee stock options and sweat equity to retain employees and sustain their motivation levels. However, employees in the last 2-3 years are inclined towards being compensated in the form of cash incentives and bonuses. In this context, it becomes interesting to find varied thought processes while deciding the benefits both from the employer's and employee's perspective and hence a lot of Indian companies have started issuing phantom stocks. Indian Laws do not allow giving employee stock options to non-employees and promoters and phantom stocks are usually issued as a way to reward promoters whose shares may have diluted due to subsequent funding.

Authors: Prashant Jain, Co-Founder & Partner; Prajakta V. Gokhale, Associate; Kriti Sanghi, Associate; Nisha Jhawar, Associate.

Disclaimer: The content of this article is intended to provide a general guide to the subject matter. For any queries, the authors can be reached at (i) prashant@samistilegal.in (ii) prajakta@rna-cs.com (iii) kritisanghi@samistilegal.in (iv) nisha@rna-cs.co.in

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