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OF SECURITIES
Sources of buy-back:
A company can buy-backs its shares or other specified securities out of its:
1. free reserves (those reserves that are free for distribution as dividend and shall include balance to the
credit of security premium account but shall not include share application money)
2. securities premium, or
If the company has bought back the shares from the free reserve, then it must transfer a sum equal to
the nominal value of shares bought back to the “Capital Redemption Reserve Account”. Further, the
specified securities have been defined to include employees’ stock option (ESOP) or other securities as
may be notified by the Central Government from time to time.
2. It should pass a special resolution in the companies’ Annual General Body meeting
3. The maximum amount of buy-back of shares should not exceed 25% of the paid-up capital and free
reserves in any financial year
4. The debt-equity ratio should not be more than a ratio of 2:1 after the buy-back
6. The buy-back should be completed within 12 months from the date of passing the special resolution
7. The company should file a solvency declaration with the Registrar and SEBI which must be signed by at
least two directors of the company
8. After the buy-back is completed, the company should not issue further shares of the same kind as
bought back for a period of 6 months
Advantages of buy-back:
The following are some of the advantages of buy-back:
1. When a company finds that it cannot employ its capital profitably, they may get rid of it by resorting to
buy-back, and re-structure its capital structure
2. The value of shares of the company can be enhanced by utilizing free reserves for buy-back instead of
paying a dividend. This will also help the company improve its earnings per share
3. The company can avoid paying dividend tax by utilizing the surplus cash for buying back its shares
4. It can be used as a weapon to avoid hostile take-over of the company by an undesirable acquirer
Nominal Value of shares issued, excluding premium on such issue, if any. In case the new shares are
partly paid up, then only the paid-up nominal capital amount should be considered.
Nominal value of shares to be bought back – Profits available for Capital Redemption Reserve
Illustration:
XYZ Private Limited bought back 1 lakh equity shares of Rs 10 each at Rs 50 per share. The payment of
the above was made out of the company’s bank balance. The company also has a securities premium to
the extent of Rs 40 lacs. In this case, the following journal entries should be passed:
Basically, it is an option or a right that is being offered by a company to its employees to purchase its
shares at a pre-determined price at a given point in time in the future. Hence, ESOP does not create any
obligation on the employees to purchase the shares of the company at the pre-decided price.
2. Motivate its employees to contribute to the growth and profitability of the company
Useful definitions:
Option: It is a right but not an obligation to purchase the shares of the company on the fulfillment of the
condition mentioned in the ESOP plan at the pre-decided price at the time of grant of options
Vesting: It refers to the entitlement of the options to an employee. The employee has to wait till the time
until he can exercise the option. The waiting time is specified to the employee at the time of granting the
option.
Exercise: It refers to the activity of converting the options granted to the employee into the shares. At
the time of exercise of the option, the employee is required to pay the price that was agreed upon.
Date of Allotment: The effective date of exercise is the date on which the company allots the share to
the employee.
1. The issue of ESOP needs to be approved by passing a special resolution. However, the private
companies exempted from this and are only required to pass an ordinary resolution.
2. The following disclosure to be made in an explanatory statement to the notice for calling the general
meeting:
a. Total no. of stock options to be granted
b. Identification of employees entitled to participate in the scheme
c. Appraisal Process
d. The requirement of vesting and period of vesting
e. Maximum period within which the options shall be vested
f. Exercise price or formula for arriving at the same
g. Exercise period and process of exercise
h. Lock-in period, if any
i. Maximum no. of options to be granted per employee and in aggregate
j. Method of valuation of options
k. Conditions on which options may have lapsed
l. The time period for the exercise of options in case of termination/resignation of the employee
m. Statement of compliance with the applicable accounting standards
3. It shall be upon the company to determine the exercise price in conformity with the applicable
accounting standards
5. The terms of the scheme may vary the terms of the scheme not yet exercised by the employees by
passing special resolution provided such variation is not prejudicial to the interest of option holders.
Further, the notice of the passing of special resolution about such variation shall disclose the complete
variation, its rationale, and details of beneficial employees.
6. There should be a minimum period of 1 year between the grant of option and vesting of the option.
However, in the case of a merger, the said period shall be adjusted against the period during which the
options were held by the employees in the merging company. Further, the company may provide for a
lock-in period for shares issued according to the schemes of ESOP. The employee who is granted the ESOP
shall not have any right of dividend, right to vote or any other shareholder right until the issue of shares
on exercise of such options.
7. The advance amount paid by employees at the time of grant of options can be forfeited if the option is
not exercised within the exercise period. However, it can be refunded if options are not vested due to the
non-fulfillment of conditions of vesting of options.
10. The company is required to maintain a Register of ESOP in SH-6 at its registered office and shall be
authenticated by the company secretary of the company or any other officer authorized in this behalf
11. In case the company is listed then it is required to comply with SEBI Regulations on ESOP.
Under the Intrinsic Value method, the excess of the market price of the share under
ESOP over the exercise price of the option shall be considered. For example, when a company grants an
ESOP (current market price being Rs 200) to its employees, which can be exercised only after 2 years at
Rs 120, then the intrinsic value shall be Rs 80 (i.e. Rs 200 – Rs 120). However, if the current market price
of the shares is Rs 100, then the intrinsic value shall be zero because the exercise price is more than the
current market price. Hence, in this case, the option cannot be exercised and instead will lapse.
In the case of a Fair Value method, the price shall be computed using the option pricing model like the
Black Scholes Merton (BSM) or a Binomial Model. This method considers a number of factors that make it
more appropriate to consider while valuing an option price. The following are the factors that a valuation
model considers:
b. Life of the option: At the time of estimating the expected life of stock options granted to a group of
employees, the enterprise may base it on an appropriately weighted average expected life for the entire
employee group or on appropriately weighted average lives for subgroups of employees within the group,
based on more detailed data about employees’ exercise behavior
d. Expected volatility - Listed Companies should consider the historical volatility of its own shares whereas
unlisted companies are recommended to consider volatility as zero. As an alternative unlisted company
can consider the volatility of other similar listed company
e. Dividend yield - The Companies shall estimate the future dividend yield rate. It may use the historical
dividend yield to estimate its expected future dividend yield
f. Risk-free interest rate for the life of the option – This is the implied yield currently available on zero-
coupon government securities or bonds.
Illustration:
At the beginning of year 1, a company grants 200 options to each of its 1,000 employees. The contractual
life (comprising the vesting period and the exercise period) of options granted is 6 years. The other
relevant terms of the grant are as below:
Solution:
Year 1:
No. of options expected to vest = 200 x 1,000 x 0.97 x 0.97 x 0.97 = 1,82,535 options
2. At the balance sheet date, the enterprise still expects actual forfeitures to average 3% per year over
the 3-year vesting period, hence, no change is required in the estimates made at the grant date. The
enterprise shall, therefore, recognizes one-third of the amount estimated at (1) above (i.e., 27,38,019/3)
towards the employee services received by recording the following entry:
2. The enterprise recognizes the amount determined at (1) above (i.e., 7,48,495) towards the employee
services received by passing the following entry:
1. The enterprise recognizes the amount determined at (1) above towards the employee services received
by recording the following entry:
Thus, a company can avoid the cash compensations as a reward and save on immediate cash outflow by
issuing ESOP to its employees. This is technique is more beneficial for a company starting its business
operations on a bigger scale or expanding its business, as awarding its employees with ESOPs would work
out to be the most feasible option than giving them cash rewards. However, the companies should avoid
ESOP in case it requires a huge amount of additional capital for carrying on its operation.