Granting employee stock options to promoters

By Vandana Pai and Gayatri Ramesh, Bharucha & Partners

Companies cannot grant employee stock options (ESOPs) to promoters under Indian law. This restriction is set out in rule 12 of the Companies (Issue of Share Capital and Debenture) Rules, 2014 (rules) and Regulation 2(1)(i) of the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (regulations), which apply to listed companies. Promoters are expressly excluded from the definition of employees and the granting of ESOPs to promoters is therefore prohibited.

This prohibition does not apply to startups registered with the Department for Promotion of Industry and Internal Trade. This exemption followed the 2016 report of the Companies Law Committee (committee), which recommended that startups be permitted to grant ESOPs to promoters as they may be working as employees or whole-time directors. The granting of ESOPs would allow start-ups to compensate them adequately without impacting cash-flows.

Granting employee stock options to promoters
Vandana Pai
Partner and Head of the Investment Funds Practice
Bharucha & Partners

While alternate stock-linked compensation structures such as sweat equity and performance-linked incentive plans are available for whole-time directors who are also promoters, these structures are not as transparent and are subject to regulatory and tax impediments.

For example, although companies can compensate promoters using sweat equity, this is not as attractive as ESOPs as, among others, sweat equity is subject to a three-year lock-in, while the lock-in is only one year for ESOPs. Sweat equity shares must be issued at the fair value determined by a registered valuer, while, for ESOPs, the company can determine the exercise price according to its accounting policies. The issue of sweat equity shares cannot exceed the higher of 15 per cent of the existing paid-up equity share capital in a year or an issue value of INR50 million (USD627,000); there is no such limit on the issue of ESOPs.

The global practice in this respect is as follows:

Germany. There is generally no restriction on which employees are eligible to exercise such options under an employee share option plan, the equivalent of ESOPs. However, share options must not be granted to the supervisory board of the company or to external consultants who are not employees of the company.

Singapore. Public companies require the approval of the independent shareholders before granting ESOPs under a share option plan to individuals holding 15 per cent or more of the voting rights, or to an employee, where the granting would increase the employee’s holding to 5 per cent of the total number of options available. There are no such restrictions for private companies.

US. Promoters are not expressly prohibited from participating in employee stock purchase plans. However, ESOPs cannot be granted to highly compensated employees (HCEs). HCEs are employees who, at any time during the year or preceding year, have owned 5 per cent or more of the company, have received compensation in excess of USD80,000 (the amount being adjusted yearly) in the preceding year or were in the top-paid group of employees in the previous year.

While the committee was correct in its view that the granting of ESOPs to promoters would help compensate promoters without impacting the company’s finances, this argument applies equally to late-stage companies led by promoters who are professionals in full-time employment. Often, private equity investors, promoters and the company spend a considerable amount of time and money exploring alternate legal and tax-efficient instruments that will compensate promoters adequately. Granting ESOPs to promoters would simplify matters considerably while ensuring that the promoters remain invested in the growth of the company without adversely impacting the company’s cash flow and private equity investors’ return on investment.

Instead of an absolute prohibition on issuing ESOPs to promoters, the government may consider permitting the grant of ESOPs to promoters who also serve as whole-time employees or directors with certain conditions, such as, prior approval of unrelated shareholders and the terms being pari passu with those offered to other employees.

The government could give effect to this proposal by amending the definition of employees under the rules and regulations to include promoters, subject to the caveats proposed above.

Vandana Pai is a partner and head of the investment funds practice and Gayatri Ramesh is an associate at Bharucha & Partners.

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