What is ESOPs, Phantom Stock and SARs?

Introduction 

Employee stock options (ESOPs), Stock Appreciation Rights (SARs), and Phantom Stocks are three common forms of equity compensation used by companies to attract, retain, and incentivise their employees. ESOPs give employees the right to purchase a company’s stock at a set price, whereas SARs entitle the employee to receive the appreciation in the stock’s value between the grant date and the exercise date in cash or stock. On the other hand, Phantom Stocks are not real stocks, but rather an agreement between the company and the employee that pays out a cash bonus based on the stock’s performance. 

These equity compensation tools have benefits and drawbacks for the company and the employee, and nowadays, these tools have gained much popularity because they are a way for companies to incentivize and retain employees while also aligning their interests with those of the company’s shareholders. These plans allow employees to become partial owners of the company, which can motivate them to work harder and help drive the company’s growth.

On April 13, 2023, WeWork India announced that they are conducting their first ever ‘ESOP surrender program’ to provide employees with the chance to capitalise on their vested stock options (see here). As a gesture of appreciation for the team’s loyalty, hard work, and confidence in the company, eligible staff members will be able to surrender a maximum of 25% of their vested stock options.

This article attempts to provide an overview on these plans while discussing theri legal aspects and the advantages and disadvantages. 

ESOPs

ESOPs are a type of employee benefit plan offered by companies to their employees that allows them to purchase or own shares of the company at a discounted price. The purpose of an ESOP is to promote employee ownership and align the interests of the employees with those of the company. It gives employees an opportunity to invest in the company they work for and share in its success. These are commonly used by both public and private companies as a form of compensation and are subject to legal regulations and guidelines.

In compliance with the Companies Act of 2013 and the Companies (Share Capital and Debentures) Rules of 2014, a company may distribute an ESOP to its employees in order to promote employee ownership of the business. The ESOP allows employees to purchase shares of the company at discounted prices. The Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 must be followed by publicly listed businesses issuing employee stock options. 

ESOPs are defined in Section 2(37) of the Companies Act, 2013 as the right granted to directors, employees, or officers of the company or its holding or subsidiary company to acquire, benefit from, or subscribe to shares of the company at a certain price at a future period. In this way, the ESOP represents a plan where a company seeks to increase its subscribed capital by issuing shares at a fixed rate to its employees.

The Pros & Cons

Pros for Companies:

• Employee retention: ESOPs can be a useful tool to incentivize employees to stay with the company over the long term, as they provide a sense of ownership and a financial stake in the success of the company.
• Tax benefits: Companies can claim a tax deduction for the expenses incurred in issuing shares under an ESOP plan. This deduction is available under Section 37 of the Income Tax Act, 1961, subject to certain conditions.

• When employees exercise their stock options, the company can claim a tax deduction equal to the fair market value of the shares issued to the employees. This deduction is available under Section 112(2) of the Income Tax Act, 1961.

Cons for Companies:

• Dilution of ownership: When employees exercise their options, it can result in a dilution of the ownership of the existing shareholders.
• Administrative costs: Setting up and maintaining an ESOP can be time-consuming and costly, with expenses such as legal fees and valuations.

Pros for Employees

• Ownership: ESOPs give employees a sense of ownership and a financial stake in the success of the company.
• Potential for financial gain: If the company’s stock price rises, employees can benefit by selling their shares or exercising their options.

Cons for Employees:

• Limited diversification: Employees may end up with a significant amount of their wealth tied up in the company’s stock, leading to limited diversification.
• Complexity: ESOPs can be complex, with rules around exercise options, vesting periods, and other details that employees need to be aware of.

Phantom Stocks

Phantom Stocks refer to a form of stock option plan wherein the value of the share is provided to the employee or non-employee in the form of a cash entitlement, as per the terms and conditions specified in the agreement between the company and the individual. There are no specific laws governing the issuance of phantom stocks, and they are typically governed by the terms of the agreement between the non-employee or employee and the company. The Companies Act of 2013 does not provide any provisions regulating the issuance of phantom stocks.

Some key points about phantom plans are:

• Governance: Phantom plans are governed by an agreement between the company and the employees/non-employee.
• Dilution of share capital: The underlying value of the shares is given to the employee/non-employee in the form of a cash payment, thus avoiding dilution of share capital.
• Consideration: Employees/non-employees do not need to pay any price to receive the cash payment, as it is made by the company.
• Resolution: No resolution needs to be passed, as phantom plans are issued based on the terms of the agreement.
• Types of company: Listed companies typically use phantom plans.
• Tax/social security: There are no tax or social security implications on the vesting and granting of the phantom award.

Stock Appreciation Rights (SARs)

SARs are similar to Phantom Stock, with the only difference being that SARs provide the right to the monetary equivalent of the increase in the value of a specified number of shares over a specified period of time, which is normally paid out in cash but can also be paid in shares. SARs serve as an alternative to ESOPs/Purchase Plans/Schemes. The Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 define the SAR scheme under Section 2(1)(ze).

In the case of unlisted companies, the issuance of SARs is unregulated under the Companies Act, 2013. The Act does not prescribe any procedure for the grant or settlement of SARs. The restrictions on ESOPs of unlisted companies under the Companies Act, 2013 do not extend to SARs.

The Act has laid down rules for the issuance of shares to employees under Stock Plans but is silent on the grant and exercise of SARs, including the issuance of equity-settled SARs and Phantom Stock Options or Cash Settled SARs.

However, if private limited companies wish to issue SARs instead of ESOPs, they should follow the basic compliances under the Companies Act, 2013 governing ESOPs by unlisted companies. This includes procuring approval by the board of directors followed by approval of shareholders of the company via a special resolution for the issuance of a SARs scheme and varying the terms of the scheme, provided that such variation is not prejudicial to the interests of the SAR holders.

Below are some important points to consider regarding SARs in unlisted companies:

• Amendment: Previously, Section 194 of the Act restricted unlisted companies from issuing SARs to independent directors or promoters. However, the Companies (Amendment) Act, 2017 omitted this provision.
• No Vesting: Employees can be granted SARs with no mandatory vesting requirement, as there is no statutory regulation mandating a minimum vesting period for SARs in unlisted companies. However, some employees may be granted SARs that are earned in accordance with a vesting schedule.
• No compensation committee: SARs need not necessarily be administered by a compensation committee (as required under SEBI Regulations), and may also be administered directly by the issuing company’s board of directors.
• Section 62(1)(b) of the Act: The Act does not prohibit the issuance of SARs to employees. Section 62(1)(b) deals with the issuance of shares to employees under a scheme of employee stock options, subject to a special resolution by the company and conditions as may be prescribed.

Why do Companies Opt for Phantom Stock Plans and SARs?

Companies use phantom stock and SARs choose these plans for the following reasons:

• To incentivize and retain employees: Phantom stock and SARs can be used as a part of employee compensation to motivate and retain valuable employees.
• To avoid dilution of share capital: Unlike traditional stock options or employee stock purchase plans, phantom stock and SARs do not dilute the share capital of the company.
• To offer a flexible compensation option: Phantom stock and SARs can be customized to fit the needs of the company and its employees, making them a flexible compensation option.
• To align employee and company interests: By linking the value of phantom stock and SARs to the performance of the company, employees are incentivized to work towards the company’s success, aligning their interests with those of the company.
• To offer a simpler alternative to traditional equity compensation plans: Phantom stock and SARs can offer a simpler alternative to traditional equity compensation plans, which may have complex rules and requirements.

Conclusion 

Companies have a variety of options when it comes to incentivizing their employees through equity participation. ESOPs have long been a popular choice, but the emergence of Phantom Stock and SARs has provided companies with additional flexibility in designing their compensation plans. While ESOPs are governed by specific regulations under the Companies Act, 2013, Phantom Stock and SARs are relatively unregulated in India, providing companies with more freedom in designing the terms of these plans. Each of these options has its own advantages and disadvantages, and companies must carefully consider their objectives and the needs of their employees when selecting a particular type of equity compensation plan. Ultimately, the right plan can help companies attract and retain top talent and align the interests of employees with those of the company.