ESOP Under Companies Act, 2013: The Complete Legal Framework for Indian Companies

Key takeaways

• ESOPs under the Companies Act, 2013 are governed by Section 62(1)(b) and Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. Section 62(1)(b) provides the statutory authority; Rule 12 prescribes the procedural conditions.
• Shareholders must approve the ESOP scheme through a special resolution (75% majority) for public companies. Private companies may use an ordinary resolution per the MCA exemption notification.
• Eligible recipients include permanent employees and directors (excluding independent directors). Promoters and directors holding more than 10% equity are excluded, unless the company qualifies under the Startup India exemption.
• The minimum vesting period under Rule 12 is one year from the date of grant (the cliff). Options cannot vest before this period expires.
• Companies must file Form MGT-14 within 30 days of passing the special resolution, and Form PAS-3 with the Registrar of Companies after allotment upon exercise.
• ESOP expense must be recognised in financial statements under Ind AS 102 or the ICAI Guidance Note, based on the fair value of options at the grant date.
• Listed companies must comply with SEBI (SBEB & SE) Regulations, 2021 in addition to the Companies Act framework.

What is an ESOP under the Companies Act, 2013?

An Employee Stock Option Plan (ESOP) is a compensation mechanism that grants employees the right to purchase company shares at a predetermined price, called the exercise price, at a future date. The employee does not receive shares immediately. Instead, the company grants options that vest over a defined period, and the employee can exercise those options once vesting conditions are met.

Under Indian law, the statutory authority for issuing ESOPs comes from the Companies Act, 2013. Specifically, Section 62(1)(b) authorises companies with share capital to issue shares to employees under an ESOP scheme, subject to specific conditions and approvals. The procedural rules that govern how ESOPs must be designed, approved, and administered are set out in Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

The Companies Act framework applies to all Indian companies, both private and public (unlisted). For publicly listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 provide an additional layer of compliance that supplements the Companies Act requirements.

One important distinction: the Companies Act uses the term "Employee Stock Option Scheme" (ESOS), while the industry commonly uses "Employee Stock Option Plan" (ESOP). Both terms refer to the same instrument. This blog uses "ESOP" throughout, consistent with standard industry usage.

Section 62(1)(b) and Rule 12

The legal framework for ESOPs under Indian law rests on two interconnected provisions. Understanding how they relate to each other is important, because each serves a distinct function.

How Section 62(1)(b) of the Companies Act, 2013 authorises ESOPs

Section 62 of the Companies Act, 2013 governs the further issue of share capital. It contains three sub-clauses, each covering a different method of issuing new shares:

• Section 62(1)(a) governs rights issues, where existing shareholders are offered shares in proportion to their current holdings.
• Section 62(1)(b) governs ESOPs, where employees are granted options to purchase shares under a scheme approved by shareholders through a special resolution.
• Section 62(1)(c) governs preferential allotment, where shares are issued to specific persons (who may or may not be existing shareholders) subject to a special resolution and pricing rules.

Section 62(1)(b) is the enabling provision for ESOPs. It permits a company to issue shares to employees, including employees of subsidiary or holding companies, provided the issuance is approved by shareholders through a special resolution. 

Note: A special resolution under the Companies Act, 2013 requires that the votes cast in favour are at least three times the votes cast against by members voting (in person, by proxy, or by electronic means) at a general meeting. Such a resolution must be proposed with at least 21 clear days’ notice, unless a shorter notice is consented to by members holding not less than 95% of the voting power, and the notice must specify the intention to pass it as a special resolution.

For private companies: The Ministry of Corporate Affairs (MCA) issued an exemption notification (G.S.R. 464(E), dated 5 June 2015) that permits private limited companies to pass an ordinary resolution (simple majority, i.e., more than 50% of votes cast) instead of a special resolution for issuing ESOPs under Section 62(1)(b). 

How Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 operationalises ESOPs

Section 62(1)(b) grants the authority to issue ESOPs, but it does not specify the detailed conditions. Those conditions are prescribed by Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.

Rule 12 defines:

• Who is eligible to receive ESOPs and who is excluded
• The minimum vesting period (one year between grant and the first vesting date)
• The disclosures that must be included in the explanatory statement accompanying the shareholders' resolution
• The requirement to maintain a Register of Employee Stock Options in Form SH-6

The relationship between Section 62(1)(b) and Rule 12 is hierarchical: Section 62(1)(b) provides the legal authority, and Rule 12 provides the operational rules. A company cannot issue ESOPs by complying with only one of these provisions. Both must be satisfied.

Who is eligible for ESOPs under the Companies Act, 2013

Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 defines which individuals may receive ESOPs and which individuals are excluded.

Eligible categories

The following persons are eligible to receive ESOPs under the Companies Act framework:

• Permanent employees of the company, whether based in India or abroad
• Directors of the company, including whole-time directors and part-time directors (but excluding independent directors)
• Permanent employees or directors of a subsidiary or holding company, in India or abroad

Who is not eligible for ESOPs?

The following persons cannot receive ESOPs:

• Promoters and members of the promoter group. The term "promoter" is defined in Section 2(69) of the Companies Act as a person who has been named as such in a prospectus or identified by the company in the annual return, or a person who has control over the affairs of the company directly or indirectly. The exclusion exists because ESOPs are designed to incentivise employees, and promoters already hold significant equity and control.
• Directors who hold more than 10% of the company's total outstanding equity shares, whether directly, through a corporate entity, or through a relative. The 10% threshold prevents ESOPs from being used to concentrate ownership further among large individual shareholders.
• Independent directors. Independent directors are excluded to preserve their independence from management. If independent directors held stock options, their economic incentive would align with management, undermining the oversight function they are appointed to perform.

The startup exemption

Startups recognised under the Startup India Initiative by the Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from the promoter and director exclusion rules for a period of ten years from the date of incorporation. This means a DPIIT-recognised startup can grant ESOPs to promoters and directors holding more than 10% equity, provided the company's annual turnover has not exceeded ₹100 crore (approximately $12 million) in any financial year since incorporation.

How to issue ESOPs under the Companies Act, 2013

The process of issuing ESOPs involves multiple sequential steps, each with a specific legal or procedural requirement. The sequence below applies to unlisted companies (both private and public). Listed companies must follow additional SEBI requirements, covered in the next section.

Step 1: Verify the Articles of Association (AoA) and authorised share capital

Before designing an ESOP scheme, verify two prerequisites:

• The company's Articles of Association must permit the issuance of shares to employees under an ESOP scheme. If the AoA is silent on this, the company must first amend the AoA through a special resolution at a general meeting.
• The company's authorised share capital (the maximum number of shares the company is permitted to issue, as stated in its Memorandum of Association) must be sufficient to cover the ESOP pool plus existing issued capital. If the authorised capital is insufficient, the company must increase it by amending the Memorandum of Association, which requires a special resolution and payment of stamp duty and filing fees.

Step 2: Draft the ESOP scheme

The company must prepare a formal ESOP scheme document that covers the terms outlined in Rule 12. This document serves as the governing instrument for the ESOP and includes the eligibility criteria, vesting schedule, exercise price, exercise window, lapse conditions, and administration procedures.

The scheme document is distinct from individual grant letters. The scheme establishes the framework; grant letters formalise individual awards to specific employees under that framework.

Step 3: Obtain board approval

The board of directors must approve the ESOP scheme at a duly convened board meeting. The board resolution should record the approval of the scheme document, authorise the convening of a general meeting for shareholder approval, and designate one or more persons to administer the scheme.

Step 4: Obtain shareholder approval

The ESOP scheme must be approved by shareholders at a general meeting. The approval mechanism depends on the company type:

• Public companies (unlisted): A special resolution is required under Section 62(1)(b). A special resolution passes when the votes cast in favour are at least three times the votes cast against by members voting at a general meeting.
• Private companies: An ordinary resolution (simple majority, i.e., more than 50% of votes cast) is sufficient, per the MCA exemption notification. However, amending the AoA still requires a special resolution even for private companies.

The notice of the general meeting must be sent at least 21 clear days before the meeting date and must include the explanatory statement containing all disclosures required under Rule 12.

Separate shareholder approval is also required if the company proposes to grant options to employees of a subsidiary or holding company, or to any identified employee whose grant in a single year equals or exceeds 1% of the company's issued capital (excluding outstanding warrants and conversions) at the time of the grant.

Step 5: File MGT-14 with the Registrar of Companies

If a special resolution is passed (which is required for public companies and may be voluntarily adopted by private companies), the company must file Form MGT-14 with the Registrar of Companies (RoC) within 30 days of passing the resolution.

Step 6: Grant options and maintain the register

Once the scheme is approved, the company can begin granting options to eligible employees. Each grant must be documented through a grant letter signed by both the company and the employee.

The company must maintain a Register of Employee Stock Options in Form SH-6, as prescribed under the Companies (Share Capital and Debentures) Rules. This register records the details of every grant, including the number of options, the grant date, vesting schedule, exercise price, and the status of each grant (vested, exercised, lapsed, or forfeited).

Step 7: Vesting and exercise

Options vest according to the schedule defined in the scheme document. Rule 12 requires a minimum period of one year between the date of grant and the first vesting date (the cliff period). After the cliff, vesting may occur monthly, quarterly, or annually, depending on the scheme design.

Once options vest, employees may exercise them during the exercise window by paying the exercise price. At this point, the company allots shares to the employee.

Step 8: File PAS-3 (Return of allotment)

After allotting shares upon exercise, the company must file Form PAS-3 (Return of Allotment) with the RoC. PAS-3 records the details of the newly issued shares, including the number of shares, the allottees, the consideration received, and the class of shares. Failure to file PAS-3 can result in penalties.

ESOPs in listed companies

For publicly listed companies, the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 apply in addition to the Companies Act. These regulations provide a more detailed compliance framework covering scheme administration, pricing, disclosures, and the role of the compensation committee.

Key differences from the Companies Act framework for unlisted companies include:

1. Compensation committee requirement. Listed companies must constitute a compensation committee (a sub-committee of the board) to administer the ESOP scheme. The committee oversees grant decisions, monitors compliance, and certifies that the scheme is implemented in accordance with the approved terms.
2. Additional disclosure requirements. Listed companies must make periodic disclosures to the stock exchange, including details of options granted, vested, exercised, and lapsed during each reporting period. These disclosures are included in the board's annual report and filed with the exchange.
3. Trust-based administration. Listed companies may choose to administer ESOPs through an ESOP trust. If a trust is used, the trust may acquire shares either from the company directly (through fresh issuance) or from the secondary market.

Accounting treatment: Ind AS 102 and ESOP expense recognition

Issuing ESOPs creates a compensation expense that must be recognised in the company's financial statements. This is not optional. The accounting standards require the company to measure the fair value of the options on the grant date and recognise that value as an expense over the vesting period.

Companies following Indian Accounting Standards (Ind AS) apply Ind AS 102 (Share-Based Payments). Companies following Indian GAAP apply the ICAI Guidance Note on Accounting for Share-Based Payments.

Under Ind AS 102, the fair value of each option is estimated on the grant date using an option pricing model (typically Black-Scholes or Binomial). The total fair value of the options granted is then spread as an expense across the vesting period. If the vesting schedule is graded (e.g., 25% per year over four years), each tranche is treated as a separate grant with its own expense recognition timeline.

For founders, the practical implication is that ESOP grants affect the company's profit and loss statement. A large ESOP pool with a low exercise price will result in a higher compensation expense. Finance teams should account for this when preparing quarterly and annual financial statements, particularly ahead of audits and fundraising rounds.

FAQs

1. What is ESOP under the Companies Act, 2013?

Under Section 62(1)(b) of the Companies Act, 2013, an ESOP is a scheme through which a company grants its employees the option to purchase shares at a predetermined price, subject to shareholder approval and prescribed conditions.

2. What is Section 27 of the Companies Act 2013?

Section 27 of the Companies Act, 2013 deals with the variation in the terms of a contract or objects in a prospectus. It applies when a company has raised money from the public through a prospectus and subsequently seeks to change the terms of the contract or the objects for which the funds were raised. This section requires the company to pass a special resolution and obtain approval from SEBI (for listed companies) before making any such variation. 

3. What is Section 47 of the Companies Act 2013?

Section 47 of the Companies Act, 2013 governs voting rights attached to shares. It establishes that every member of a company with share capital has voting rights in proportion to their paid-up share capital. 

4. What is Section 62 of the Companies Act 2013?

Section 62 of the Companies Act, 2013 governs the further issue of share capital by a company. It contains three sub-clauses covering different modes of share issuance. Section 62(1)(a) covers rights issues, where shares are offered to existing shareholders proportionally. Section 62(1)(b) covers the issuance of shares to employees under an ESOP scheme, subject to shareholder approval. Section 62(1)(c) covers preferential allotment, where shares are issued to specific individuals or entities.