What is ESOP pool?

How an ESOP pool works

The company sets aside a number of shares for employee stock options. From that pool it grants options to individual employees. Each option gives the right to buy one share at a fixed exercise price once it has vested, usually in parts over a few years of service. Options that lapse, for example when an employee leaves before vesting, go back into the pool.

The pool is counted in the fully diluted shareholding from the day it is created, whether or not any options have been granted. Some companies issue new shares to employees when they exercise; others hold shares for the plan through an employee welfare trust.

Before or after the round

When an investor asks for the pool to be created or topped up before the round, on a pre-money basis, the whole cost of the pool falls on the existing shareholders, mainly the founders. If the pool is created after the round, the investor shares that dilution. This is common in Indian venture deals and is a point worth negotiating.

Size the pool against a hiring plan: work out the senior roles you expect to fill before the next round and what each would need. A pool far larger than the plan needs dilutes the founders for nothing.

The rules for an unlisted company

ESOPs are issued under section 62(1)(b) of the Companies Act, 2013 and rule 12 of the Companies (Share Capital and Debentures) Rules, 2014:

• The shareholders approve the scheme by resolution: a special resolution in general, though a private company may use an ordinary resolution.
• Options can vest only after the minimum period the rules set from the date of grant.
• Options cannot be granted to independent directors, promoters or the promoter group, or to a director who, directly or through relatives or companies, holds more than the share of the equity the rules allow.
• A DPIIT-recognised startup may grant options to its promoters and to such directors for a period after incorporation, as long as its turnover stays within the limit in the rules.

These periods and limits are set by the rules and can change, so check the current rule 12 before designing a scheme.

Listed companies follow SEBI's regulations on share-based employee benefits instead.

Tax for employees

Employees are taxed twice, at different times:

1. On exercise: the fair market value of the shares on the exercise date, minus the exercise price paid, is a perquisite taxed as salary. The employer deducts TDS on it through payroll.
2. On sale: the gain over that same fair market value is taxed as a capital gain.

Because an employee of an unlisted company may have no way to sell the shares, an eligible startup can defer the tax on exercise. The tax then falls due shortly after the earliest of: the end of the deferral period the law sets, the sale of the shares, or the employee leaving the company.

In the accounts

Options are an employee cost even though no cash is paid.

• A company following Ind AS applies Ind AS 102: the fair value of the options at the grant date is charged to the profit and loss account over the vesting period, with the matching credit to equity.
• Other companies follow the Guidance Note on Accounting for Share-based Payments, which recommends the same fair value approach and also permits the intrinsic value method.

Either way, the charge is spread over the vesting period based on the number of options expected to vest. Show it separately in management accounts, because it lowers reported profit without affecting cash or unit economics.