In a recent conversation with Uma Shankar, Consulting Partner at ESOP Direct, we discussed the significance of Employee Stock Ownership Plan (ESOP) trusts and their preferred status.
An ESOP trust is an entity established by companies to hold shares for the purpose of the ESOP program and /or to hold shares on behalf of eligible employees participating in the ESOP program. These trusts have become a mandatory requirement in India in case an ESOP program contemplate secondary shares.
Umashankar explains why ESOP trusts are the preferred choice for some companies and provides valuable insights into their lifecycle.
ESOP trusts offer several advantages over alternative methods of share transfer, such as the direct route, including streamlined processes, administrative convenience, better share controllability, and the creation of internal marketplaces.
Understanding the functioning and lifecycle of ESOP trusts is crucial for companies aiming to implement successful ESOP programs.
In India, the Company law restricts companies from dealing in their own shares, except in the case shares are held by an ESOP trust or an employee welfare trust. This exemption has given rise to the concept of ESOP trust within the ESOP framework.
1. Primary shares - for which companies have the option to choose between the direct route or the trust route.
2. Secondary shares - which must be transacted exclusively through the trust route.
When considering the secondary shares, the trust route is obligatory and there is no alternative.
For primary shares, although there are two options available, choosing the trust route offers distinct advantages particularly in following cases:
The direct route typically takes around 30 days (considering the formalities involved) to allot shares to the D-mat account after exercise is done by the employees.
In contrast, the trust route significantly reduces this time, making it a more efficient choice, where trust takes couple of days to transfer the shares to the D-mat account. Trust acts as a savior as employees can get and dispose of shares quickly before a great price fluctuation. This may be highly relevant for listed companies.
Companies with a substantial number of employees face challenges in efficiently exercising and allotting shares daily or even in a reduced frequency like weekly. Establishing a trust in advance and swiftly transferring shares provides administrative convenience to the Company.
Cashless exercise can be carried out through either a trust or an empanelled broker. However, the trust route is often preferred by both companies and employees due to its hassle-free nature compared to the broker route.
Opting for an ESOP trust enables better control over shares in private companies, allowing for effective management and governance by causing the ESOP trust to hold the shares (as a single shareholder) for myriad number of employees who exercise their options.
ESOP trusts facilitate the establishment of an internal marketplace within unlisted companies, offering employees a platform to trade shares.
Overall, the ESOP trust route provides distinct advantages in terms of time efficiency, administrative convenience, controllability, cap table management and internal market creation, making it a favorable choice over the direct route in various scenarios.
Regardless of the company type, whether listed or unlisted, the trust route must be chosen for dealing in secondary shares. When it comes to administrative considerations, there are variations based on the company's status, whether listed, unlisted, public, or private.
Listed companies can use secondary shares up to a maximum of 5% of the equity capital for ESOP purposes. Further, all public companies (listed and unlisted) have a monetary ceiling of loan that can be given by the Company to the ESOP trust to acquire shares up to 5% of paid-up share capital and free reserves. This loan limitation also plays a vital role in determining as to how many shares can be acquired.
On the other hand, private companies have more flexibility and aren't subject to the same limitation, allowing for larger proportions in the trust operations.
Companies (particularly listed companies) face additional restrictions, such as being prohibited from trading in shares or engaging in activities unrelated to their ESOP program.
A trust established by any company irrespective of its status is treated as a private trust and its registration is not mandatory.
The company establishes the ESOP trust as the creator or settler. The trust involves various parties, including the settler, trustees responsible for managing the trust, and the beneficiaries i.e., the eligible employees. It is treated as a private trust and its registration is not mandatory, unlike some legal entities.
The ESOP trust is initially unfunded and needs funding for its operation. Funding can come from internal or external sources.
Internal funding means the company provides the funds, while external sources can include promoters, investors, and banks.
It's important to note that listed companies may receive funding from banks, whereas unlisted companies may not have access to bank funding.
The share transfer to employees takes place at the end of the share acquisition process. This process can involve acquiring shares in the market or subscribing to primary shares. It is essential for the trust to fulfill its exercise commitment and have the necessary shares available before the exercise deadline.
To meet the exercise commitment, the trust needs to maintain an appropriate inventory of shares. The trust should be prepared in advance to ensure it has enough shares to honor the exercise commitments.
Depending on the structure of the plan, there may be a considerable amount of time available before the exercise deadline for the company to acquire the shares. The decision-making process regarding the acquisition of shares is carried out logically, considering various factors and requirements.
In an unlisted context, exercise is generally planned with respect to Liquidity events. Among the available alternatives, cashless exercise is considered the most effective approach.
In cashless exercise, employees authorize the ESOP trust to sell shares on their behalf. Cashless exercise involves either selling the entire shares (Sell All) or a partial sale of shares (Sell to Cover).
In Sell All, entire sale proceeds net of payables like exercise price, taxes, transaction charges are remitted to the employees’ bank account.
In Sell to Cover, only that portion of shares is sold to cover the exercise price, taxes, and transaction charges and rest of the shares are transferred to the D-mat account of the employees.
1. External Broker: This approach involves using an external broker to facilitate the process, which is usually complex and requires too many paper works.
2. ESOP trust: The trust can act as a seller of shares on behalf of the employees. As a recognized entity, the trust handles the acquisition, sale of shares and remittance of money or shares to the employees.
For Employees: ESOP trust is generally tax neutral for the employees. However, it may offer significant tax benefits when an ESOP structure requires the trust to hold the shares for and on behalf of the employees upon exercise. The exercise happens when the valuation is still less at a lesser perk tax. Then, the delta of value growth up to liquidity event/ IPO is generally taxed as capital gains at a lower rate.
For the Trust: The trustees of the ESOP trust are not personally responsible for any tax liabilities. The trust itself is liable for the income of its own. The tax implications for the trust typically involve capital gains taxes. Other forms of income, such as dividend from income-paying companies, may also be subject to taxation.
For the Company: The taxation burden primarily falls on the trust and the employees involved. The company is generally insulated from tax implications in respect of trust transactions particularly when the trust is irrevocable.
In the context of trust governing rules, the regulation of trust differs for listed and unlisted companies.
For Listed Companies: Trust governance for listed companies is overseen by independent trustees (like ESOP Direct) or employees who are not promoters, key managerial personnel, or their relatives.
The trustees hold primary authority in setting the rules and regulations for trust. The Company’s Board or Committee of Directors is responsible for appointing and removing trustees, as well as overseeing audits and other important functions.
For Unlisted Companies: Although there may be fewer specific regulations for trust governance in unlisted companies, they typically follow similar rules as that for listed companies. The same principles of independent trustees or board of directors overseeing the trust and setting governing rules are generally followed.
In conclusion, an ESOP trust offers significant advantages under specific situations, especially for handling secondary shares and providing administrative convenience. The ESOP trust route proves advantageous in terms of time efficiency, control, cap-table management, and the creation of internal marketplaces.
Additionally, the funding and acquisition of shares by the trust play crucial roles in ensuring exercise commitments are met. Tax implications vary for employees, the trust, and the company. Trust governance regulations differ slightly between listed and unlisted companies, but both follow similar principles.
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