Soaring valuations and constant innovation have made the start-up landscape in India extremely competitive. Not only has this led to an increased demand for executive talent but it has also led to a more active exploration of employee compensation or incentive schemes in order to retain such talent.
While employee stock option plans (ESOP) are the most common form of employee incentive schemes, they raise many adverse issues. First, they inevitably result in the dilution of other shareholders’ holdings, with investors therefore viewing large ESOP pools unfavourably. Second, at present ESOPs cannot be issued to promoters, except in the case of start-ups as defined by the Department for Promotion of Industry and Internal Trade.
Other than in the cases of ESOPs and sweat equity, company law in India does not recognise stock-related methods of compensation such as stock appreciation rights (SAR) and restricted stock units. This is the case even though these methods of compensation are recognised by the Securities and Exchange Board of India (SEBI), the securities market regulator, in the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (regulations). This may be about to change as the Company Law Committee (CLC) issued a report in March 2022 recommending amendments to the Companies Act, 2013 (CA) that include recognising and holding SARs.
SARs are generally given to employees entitling them to benefit from the appreciation in the monetary value of a specified number of shares of the company over a specific period. SARs are defined under the regulations as “a right given to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company”. SARs are unique and differ from other stock-linked incentives in that they may be settled in cash, that is they result in the payment of the cash equivalent of the appreciation in the specified number of shares to their holder, or in shares, that is they result in the issue of shares equivalent to the appreciated value of the specified number of shares to their holder. However, SEBI has, through informal guidance, clarified that the SEBI (Share Based Employee Benefits) Regulations, 2014, which preceded the regulations, only applied to schemes “dealing in or subscribing to or purchasing securities” of the listed company directly or indirectly and did not regulate the issue of cash-settled SARs.
SARs remain largely unregulated in the context of unlisted companies and, where created, are mainly governed by contract. To align regulation in India with global best practice and to increase the operational efficiency of the CA, the report recommended that the CA should be amended to enable the issue of SARs. The CLC did not outline the proposed scope of any enabling provisions. However, the CLC did recommend that the regime under the CA be aligned with the regulations to the limited extent of permitting cash-settled SARs. The CLC also set out the proposal that the offer and issue of SARs settled in shares would require board approval and, in the case of SARs settled in shares, the approval of the shareholders of the company by way of special resolutions. The CLC also recommended that a general approval for the offer and issue of SARs on an annual basis should be allowed in order to obviate the need for multiple approvals of issues of SARs during the year.
The CLC effectively only proposed legal recognition under the CA for the grant of SARs to remove the ambiguity as to their legality. This would limit their effectiveness for listed companies as the CLC did not make any recommendations regarding details such as minimum vesting periods and transferability. However, unlisted companies will continue to retain the flexibility to regulate the terms of SAR schemes contractually
If the proposed amendments are implemented, there may be more frequent issues of SARs by unlisted companies. However, this also depends on what the grantee does in the company, as the taxation of SARs varies according to the grantee’s role and position. Despite this inconsistent tax treatment, the amendment of the CA to provide legal recognition of SARs would be a positive step and would encourage greater investment in start-ups.
Vandana Pai is a partner and the head of the investment funds practice, and Shreya Sreesankar is an associate at Bharucha & Partners.
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