An employee stock ownership plan (ESOP) is a type of employee benefit plan under which the employees of a company are generally given the right to acquire the shares of the company, for which they are working, at a predetermined price. Under such a scheme, the employees are granted some rights, called as stock options, to get the shares of the company for free or at a concessional rate, at a predetermined price as compared to the potential market rate. In some cases, the foreign holding/subsidiary company also grants such options to the employees of the Indian subsidiary/ holding company. However, neither a ‘promoter’, nor a director holding more than 10 per cent of the equity shares of the company is entitled to take part in this scheme.
Under the ESOP schemes, the stock option is free when it is given to an employee. Once an ESOP scheme is approved, a Letter of Grant should be issued to the employee informing him how many options are being granted to him, what the vesting period would be and determination of the exercise price.
The right to exercise the option may get vested in the employee in the next future date/s. The dates on which the employee becomes entitled to exercise the right to acquire the shares is called as “vesting date.” The rights may vest (i.e. the right to convert the stock options into equity) fully or partially over the vesting period. For example, an employee is given 1000 options on 31st March, 2016 which can be exercised in phases like 20% on completion of one year, 30% on completion of second year and the balance on completion of the third year from the date of such grant. So in the instant case, the vesting dates for 200 options is 1st April, 2017, for 300 shares it is 31st March 2018 and for balance 500 shares it is 31st March 2019. The plan may stipulate same or different grant price or exercise price for such vesting and is generally substantially lower than the prevailing market price of the shares in case the shares are listed.
Since the employee is given just an option without any obligation attached to it, it is not mandatory for the employee to exercise the option. The employee may decide to exercise the option or may decide to let the option lapse in case the prevailing price of the shares is lower than the exercise price. It is not necessary for an employee to exercise the option once it vests with him. However, once the employee exercises the option, he has to pay for the shares at the price predetermined and thus causing cash outflow. It is also important to understand that in case an employee resigns, any unvested options (i.e. those that have not yet vested) will lapse.