Employee Stock Option Plans or ESOPs were first introduced in 1947 in the US to encourage employee ownership, based on the theory that such companies perform better. The positive effect that ESOPs had on performance was studied and documented by Harvard Business Review in 1987. It showed that 73% of companies that started an ESOP showed improved performance, and the increase in sales growth attributed to ESOP commencement was 3.51%.
Therefore, the theory on which ESOPs were first introduced has proven to be factually correct. However, if ESOPs were transferable, will these benefits still stand?
Can ESOPs be transferred?
Legally speaking, “The option granted to employees shall not be transferable to any other person. The option granted to the employees shall not be pledged, hypothecated, mortgaged, or otherwise encumbered or alienated in any other manner. No person other than the employees to whom the option is granted shall be entitled to exercise the option. In the event of the death of an employee while in employment, all the options granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.”
It is amply clear that ESOPs cannot be transferred at will.
Here are four key reasons why ESOPs are not transferable:
1. No vested interest
The idea of working for ourselves is something that empowers and motivates employees to take ownership of their work and perform better, consequently resulting in improved business performance.
When a company issues an ESOP, one of the primary objectives is to motivate its key employees to focus on the growth of the business, which will, in turn, add monetary value to the company’s stock. This will directly impact the gains that the ESOP holders will obtain.
If ESOPs were transferable, employees would lose this motivating factor that drives them to work hard, which reduces the stability and success of themselves as well as the company. To protect this underlying core value of ESOPs, it is better that they are non-transferable. ESOPs are instruments that rely on the future potential of an organization and drive top-level employees to work towards realizing such potential.
2. Lack of control over shareholding
ESOPs provide the opportunity for an employee to become one of the shareholders of the employing organization. When employees are in ownership and possession of ESOPs, the management personally knows the shareholders and ensures there are no ulterior motives that may adversely impact the business. This is crucial because shareholding comes with voting rights for minor and major managerial decisions, which can greatly influence the performance or even the continuity of the business.
ESOPs may also be used as a tool to preserve the flavor of the existing management. When succession planning is done by honing and training existing employees, the business can run efficiently and effectively compared to handing it over to an outsider.
If ESOPs are transferable, the power to impact how the company is steered goes to various parties and can change hands. This loosens the grip that the top management and owners have on the business. It also gives scope for unwanted external influence, which may interfere with the dreams and plans of the owner(s). The scope for succession planning is also reduced. Hence, it is important that ESOPs are non-transferable in the best interest of the existing shareholders.
3. Chances of Devaluation due to Unethical Practices
In the case of publicly listed companies, non-transferability of shares is important to prevent stock price manipulation. If they are transferable, the shares allotted to an employee can change hands multiple times, losing a little bit of value each time and finally reach a stage where the stock’s market value has significantly gone down.
In the case of startups that are not listed, the shares can still change hands if they are transferable. However, instead of a formal medium like the secondary market, the transactions take place through brokers. These brokers buy and sell ESOP shares, among other financial products, in an informal manner, which makes it difficult to trace and hold them accountable. Those who buy shares in a startup through an unregistered broker might have to sell them to another such broker. Thus the brokers are the ones who have a grip on the market value of the shares of a startup. This is very dangerous as it can lead to severe devaluation and also hurt the brand value of the startup early on. Making ESOPs transferable is a risky business as the exposure to stock price manipulation, undervaluation, and being the victim of unethical business practices increases. Hence it is crucial that ESOPs are non-transferable.
4. Probability of Tax Evasion
For an employee, taxation of ESOPs arises in two events:
- At the time of allotment of shares (when the employee exercises his options after the vesting period), when the difference between market value and exercise value is seen as salary income, and
- When the shares are sold, and the capital gains on such sale of shares is taxed
Now, if the ESOPs were transferable, an individual may transfer it to a non-working spouse, child, or other dependents whose annual income doesn’t exceed the minimum amount necessary to be subjected to tax, in order to avoid or reduce the individual’s own tax liability.
This way, the employees can enjoy the benefits of ESOPs while avoiding the payment of tax. Since ESOPs are structured in a way that is directly beneficial to the employee by creating wealth for them, it is better if they are not transferable. If employees are not motivated to transfer their ESOPs, companies need not spend on encouraging and reemphasising their non-transferability.
Learn more about how the taxation of ESOPs works.
Although ESOPs are not transferable, the nomination is possible. MyStartupEquity can aid in managing ESOP nominations. Click here to download a nomination form, along with grant letters and exercise forms for startups in India.
An ESOP is a powerful compensation mechanism that is highly beneficial to employers and employees alike. However, they are not transferable due to the reasons discussed in this article. To know more about ESOPs and how they are structured, contact MyStartupEquity today!
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