Aditya Narwekar, Partner — Deals, PwC India
Meghana Goud, Associate Director — Deals, PwC India

Print Document   Email  Save 


Print Document  26 March 2021

Share-based compensation plans have always been and have increasingly become a popular way of rewarding employees, especially among the start-up ecosystem. Share-based compensation (one of the popular variants being Employee Stock Option Plan (ESOP)) provides an opportunity to reward employees for the growth of an enterprise, by incentivising them with an equity stake or a cash pay-out based on an equity stake. In the midst of a pandemic situation where many companies have announced pay-cuts, grant of stock options may work as an efficient tool to motivate employees to make long-term commitments, thereby making them an integral part of the growth narrative of a successful enterprise.


Stock options are generally issued to employees pursuant to a comprehensive plan that details out the mechanism for grant of options, vesting conditions, exercise price and other relevant details. The ESOP plans are approved by the shareholders of the employer company and are also required to comply with the other prescribed conditions of the Companies Act, 2013. Further, ESOP plans formulated by public listed companies must also comply with the Securities and Exchange Board of India (Employee Share Based Payments) Regulations, 2014.


With companies facing increasing challenges at various fronts in this competitive globalised market, corporate restructuring has become a permanent feature of the corporate ecosystem. Corporate restructuring is a complex exercise involving extensive commercial, strategic decision making and an interplay of various laws and regulations. One of the sensitive aspects to confront in such a corporate restructuring transaction is the migration of an effective stock option plan.


A key issue in a merger and acquisition transaction is whether, and to what extent, outstanding options will survive the completion of the transaction and whether and when the vesting of options will be accelerated. Hence, it becomes critical for a properly drafted stock option plan to include clear, unambiguous provisions for the treatment of outstanding awards or shares in connection with these types of transactions.


At the time of merger or acquisition, the options granted to employees by the transferor/ target company may either be vested and exercised, vested and unexercised or unvested entirely. Depending on the nature of the options, the transferee/ acquirer company may choose to structure them. In this article, we have analysed some of the common ways adopted by the acquirer companies to handle the ESOP plan of the transferor/ target companies to ensure fair and equitable treatment to its employees.


1. Cashing out of vested options: In this case, prior to the merger/ acquisition, either the target company or the acquirer cashes out the options held by employees in lieu of the employees exercising the options and being issued shares. This mechanism involves payment based on the fair market value of the shares of the transferor/ target, or the transaction price, with appropriate deductions for the agreed exercise price.


2. Acceleration of unvested options: For unvested options, the transferor/ acquirer company can accelerate the vesting of options, choosing to pay cash or shares, in exchange for the cancellation of outstanding grants. However, as per the applicable Company Law regulation, there shall be a minimum period of one year between the grant of options and vesting of option, and since there are no exceptions, one must be mindful of this requirement before opting for this method.


Generally, ESOP plans provide for accelerated vesting of options in case of occurrence of certain events (such as change in control of the target company, acquisition, or liquidation), in which case the transferor/ target may be able to accelerate vesting of the unvested options. However, in case such clauses are not present in the ESOP plan of the transferor/ target, the plan would need to be amended prior to the merger or acquisition.


Tax implications in the hands of the employee — As per the provisions of section 17(2)(vi) of the Income tax Act, 1961 (the Act), tax implications as 'perquisite' arises only when the shares are allotted or transferred upon exercise of the options. Hence, if the options are surrendered (as in the case of cashing-out), the same will not come within the purview of 'perquisite', and hence may not be chargeable as salary in the hands of the employee. However, the definition of capital asset, defined under section 2(14) of the Act, is wide enough to cover even the options or rights to subscribe to the shares of the company, within its gambit. Accordingly, stock options may also be treated as 'capital assets', and hence, income arising from the surrender of such options may be taxed under the head 'capital gains' in the hands of the employees. Even if the options are considered as a capital asset, the next question is to analyse whether the cost of acquisition of such options is ascertainable/ determinable — in case it is not, the capital gains may not arise.


Cashing out offers various advantages such as no post-closing administration, no stock issuance procedure and no potential stake dilution. It provides a simple way for employees to receive cash for their options without funding the exercise price themselves; for the option holders of the private companies, it provides them with liquidity. Though cashing out is an easier and clean process, the transferor/ target may not be comfortable in opting for the same, as it may require large cash outflow for the company.


3. Assumption of Awards — In this case, the transferee/ acquirer assumes the outstanding options (vested and/ or unvested) granted under the transferor/ target company's ESOP plan including the plan itself, so that the vesting and other terms and conditions of the award will generally continue in effect after the merger/ acquisition, except that shares of transferee/ acquirer company will be issued in lieu of the transferor/ target company's shares. The number of shares, the exercise price per share, etc. will need to be adjusted based on the swap ratio/ acquisition price, to reflect the transaction. The tax implication in this scenario shall be two-fold, i.e., as salary (in the form of perquisite) and capital gains, in the hands of the employee.


4. Substitution of Awards - In this case, the transferee/ acquirer cancels the transferor/ target company's options and issues new options under its own stock option plans. For issuance of the new options to transferor/ target employees, the transferee/ acquirer may either formulate a new plan (to maintain the demarcation and avoid modifications to its existing plan) or modify its existing plan (to maintain uniformity for all the employees, post the merger or acquisition). In this case as well, the number of shares, the exercise price per share, etc. will need to be adjusted to reflect the transaction.


Tax implications in the hands of the employee — In case of a merger, section 47(vii) of the Act provides an exemption only to the shareholders of an amalgamating company; there is no specific exemption for option holders. Hence, the exchange or substitution of the options may give rise to capital gains in the hands of the employee in a merger or acquisition scenario. However, as iterated earlier, though it may be possible that the options qualify as a capital asset, the question mark on the ascertain ability of the cost of acquisition of such options may negate the capital gains implications.




Managing the treatment of stock options in any merger or acquisition transaction requires careful analysis and planning as a variety of approaches are available depending on the type of the outstanding options and the intent of the parties from a commercial and operations perspective.


A variety of factors may impact how the parties intend to treat the target company's ESOPs, such as the extent of cash outflow that the parties can afford, potential dilution, employee retention, consistencies between the compensation culture of the parties, legal compliance, corporate regulations, tax, securities law issues and administrative issues.


Importantly, the terms of the transferor/ target company's plan will need to be reviewed to determine whether the proposed treatment of the options is permitted by the plan if not, such plan may need to be modified.


Additionally, companies must consider drafting the plans in such a manner that it provides maximum flexibility for a company to equitably adjust awards under its plan and permit a company's board of directors in its discretion to determine at the time of a merger or acquisition or any similar transaction.


** The article includes input from Abhishek Dudhwewala — PwC India, Associate - Deals.



Disclaimer: The views expressed in this article are personal. The publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it


Most Viewed