Introduction: ESOP and Sweat Equity as a means to incentivise employees
Companies, in their business structures, possess certain distinct features like offering stock options or sweat equity to their employees. These methods serve as novel ways to incentivise and retain employees as they are easier to administer in the case of a company and employees exhibit greater acceptability of such incentives in a company than in other business structures.
The start-ups which are in the early stages of their businesses lack the ability to pay competitive and high salaries to their employees which established businesses or large corporations can afford to pay, although the former requires good share of human capital because of them facing resource constraints, and unstable cash flow. Start-ups and other established companies often require motivated employees who can over-perform and exceed their expectations. Therefore, with an aim to retain and incentivise employees, companies come up with rewarding performance bonuses, revenue shares, stock options or a stake in the company.
A revenue or profit-sharing model can either be negotiated or specified in an employment consultancy agreement between employer and employee. . However, mechanisms like ESOPs, stock purchase schemes and sweat equity schemes are extensively regulated.
Employee Stock Option Plans (ESOPs)
ESOP is an option which is given to whole-time directors, officers or employees of a company which gives them the right to purchase or subscribe to the securities offered by the company at a predetermined price on a future date. Stock options have developed and become popular as a very well-known method used by the companies, especially in the technology sector, to incentivise and reward the employees to enhance their performance.
Example: Infosys Technologies Ltd., the first company to issue ESOP in India, issued 1,22,200 shares in pursuance of an ESOP scheme in 1994. It discontinued the scheme in 2004 due to several major problems. Recently, in July 2016, Infosys relaunched its employee stock option programme after a gap of 13 years.
Scheme helps both the employer and the employee
As has already been discussed, ESOP is used to incentivise employee to perform better. The structure of ESOP requires the employee to stay over a certain period of time to reap the benefits. This mechanism works in a way that it creates an interest of the employee framework in particular; in the success of the company. The better the company performs; the greater will be the value of his ESOPs. The employees usually work at a lesser salary compared to market rates, especially when they are involved in start-ups; the ESOP scheme encourages employees to share the risk involved in the businesses in the early stage of their development which rewards the former handsomely in the long run.
ESOP scheme helps in risk sharing
When an employee exercises the option to buy shares under the ESOP scheme; he is required to pay a pre-determined price for the shares to the company. The market value of the shares should exceed the price that is paid by the employee for making profits. Therefore, if the company does not perform well and the market value of the shares is less than the price that has been paid by the employee; the ESOP scheme is of no use then.
Grant of stock options in listed companies is governed by the SEBI (Share Based Employees Benefits Regulations, 2014 from October 28, 2014). Earlier the SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) guidelines, 1999 used to govern the grant of stocks in listed companies.
In case of private unlisted companies; there were no specific rules which were used to govern ESOP by private companies and unlisted public companies. The amendment brought to the Companies Act in 2014 exhibited a provision that controls the issuance of employee stock options by private and unlisted public companies.
Sweat Equity Shares
Why?: A way to incentivise employees who contribute know-how or technical expertise particularly in the nature of intellectual property.
Legislative Framework: The issue of sweat equity shares to the employees is governed by section 79-A of the Companies Act, 1956 or Section 54 of the Companies Act, 2013.
Nature: They are issued by the company to the employees or directors (including promoters) for a discount or non-cash consideration.
It is important for us to understand the distinction between ESOPs and Sweat Equity Shares; the objectives of both of which is to act as a means to retain employees.
While sweaty equity shares are issued as a consideration for creation or transfer of IPRs to the company, ESOPs are issued as incentive or retention plan to the employees.
2) Whom are they issued to?
The Sweat equity shares are issued to all kinds of employees who are associated with the Company; however the ESOPs are issued to all class of employees except the promoters or anyone belonging to the promoter group.
3) Lock-in period
While Sweat equity shares have a lock in period of three years which signifies that the sweat equity shares cannot be cashed out before the expiry of three years, ESOP does not have a lock-in period in specific. But the company shall have the freedom to specify the lock-in period for the shares issued pursuant to exercise of option.
4) Issued against:
While sweat equity shares can be issued for non-cash consideration, ESOPs are issued at a pre-determined price with a right of conversion.
5) To what extent?
Only 15% of the existing paid-up equity share capital in a year or shares of the value of 5 crore whichever is higher can be issued as sweat equity shares by the company, however there is no such restriction in case of ESOPs.
 Section 2(15A) of the Companies Act ; SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 (SEBI Guidelines).
 Rule 12 of Companies (Share Capital and Debentures) Rules, 2014