Employee Stock Option Plan
Engagement 1: Addressing Challenges and Proposing Solutions for an Indian Unicorn
Our client is a successful Indian company valued at over a billion dollars, with investments from both global and Indian private equity firms. The company had already implemented an Employee Stock Ownership Plan (ESOP) through an ESOP Trust, which involved allocating shares to the trust in advance. They approached us for a comprehensive examination of their ESOP model and to provide solutions for the identified issues. Our task was to present our findings and proposed solutions to the management team, including the board of directors who consisted of both company promoters and representatives of the private equity investors.
During our study, we identified several key challenges that needed to be addressed:
- Counter-productive impact: The existing ESOP structure resulted in mandatory liquidation of shares at the prevailing fair market value when an employee resigned or was terminated. This approach proved to be counter-productive for the company, as it created a discrepancy between outgoing and current employees, leading to a significant increase in attrition rates.
- Tax inefficiency: The current model required employees to exercise their options before offering the shares for a buyback or transfer, resulting in a highly tax-inefficient process. The effective tax cost for employees during liquidation was found to be as high as 42.744% prior to the fiscal year 2023-24.
- Dual taxation exposure: The transfer of shares by the trust, whether due to employee exercises or adjustments in exercise prices, resulted in tax exposure for the trust. This dual taxation added complexity to the ESOP structure.
To address these challenges, we proposed implementing solutions that would rectify the issues and optimize the ESOP model for our client. By making necessary adjustments to the liquidation process, revising tax policies, and introducing a fair distinction between outgoing and retained employees, we aimed to create a more efficient and equitable ESOP structure.
Engagement 2: Navigating Promoter Exit and ESOP Liquidation
As promoters were in the process of negotiating their complete exit from a Private Limited Company, a crucial step before the transaction was the liquidation of Employee Stock Ownership Plans (ESOPs). These ESOPs had been implemented directly, and although they were fully vested, they remained unexercised. The client sought our advice on three specific areas:
- Mechanism for ESOP liquidation without converting options into shares.
- Ensuring tax efficiency for employees, considering that the delta upon exercise would be subject to a higher marginal tax rate of 42.744%.
- Closing the transaction within a tight timeframe of fifteen days.
Several key challenges were highlighted:
Complex compliance and limitations on fund infusion: The existing process required converting ESOPs into equity and subsequently liquidating them through a buyback scheme. However, implementing this mechanism would restrict new shareholders from injecting funds into the company for six months after the buyback’s completion.
Time constraints: The liquidation of ESOPs, along with the entire transaction, needed to be completed within fifteen days. However, implementing a buyback scheme alone would extend the timeline to a minimum of 45 days.
Ensuring tax efficiency: Both employees and the company sought tax efficiency. The company had already claimed ESOP costs for taxation purposes over the vesting period and aimed to optimize tax liabilities further.
To address these challenges, strategic solutions were proposed. These included exploring alternative methods for ESOP liquidation without share conversion, streamlining compliance requirements, and devising tax-efficient strategies for both employees and the company.
The ultimate goal was to facilitate a smooth exit for the promoters from the Private Limited Company while successfully liquidating the ESOPs within the specified timeframe and ensuring optimal tax outcomes for all parties involved
Engagement 3: Creating a Hybrid ESOP Incentive Program
Our client aimed to implement a Long-term Incentive Program that would provide rewards based on market valuation and the company’s profit growth. These rewards would be paid in cash or equity, contingent upon meeting pre-agreed commercial objectives. They sought our advice on how to structure the program effectively.
Several key challenges arose:
Hybrid ESOP instrument: The client needed an instrument that could align with the company’s requirements while fulfilling the objectives of the Employee Stock Ownership Plan (ESOP) from the employees’ perspective.
Tax efficiency: It was crucial to mitigate the notional tax burden associated with the incentive program. This meant minimizing the tax obligations without actual income for the holders of the incentives.
Compliance: The instrument used in the program had to adhere to the Indian tax and regulatory framework.
To address these challenges, our proposed solution was to create a hybrid ESOP instrument that balanced the company’s needs with the employees’ interests. This instrument would provide flexibility in terms of rewards while ensuring tax efficiency and compliance with Indian regulations.
We have overall worked on varied Employee Stock Incentive plan i.e. Equity Linked as well as Equity as an incentive comprising in-detail advisory and implementation.
