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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK

OF SECURITIES

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF Table of Content
SECURITIES
Buy-Back of Securities: .................................................................................................. 3
Sources of buy-back: .................................................................................................................. 3
Conditions for buy-back of shares: ................................................................................................ 3
Advantages of buy-back: ............................................................................................................. 3
Calculation of Capital Redemption Reserves and Net Proceeds from Fresh Issue: ................................ 3
Illustration: ............................................................................................................................ 4
Employee Stock Options (ESOP): ..................................................................................... 4
Objective of issuing an ESOP: ....................................................................................................... 4
Useful definitions: ....................................................................................................................... 4
Condition for the issue of ESOP: ................................................................................................... 5
Method for Implementing ESOP: ................................................................................................... 6
Accounting treatment and valuation methods: ................................................................................ 9
Illustration: ................................................................................................................................ 9
Solution: ................................................................................................................................ 9

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF Buy-Back
SECURITIES of Securities:
Buy-back of securities is similar to the purchase of own debentures for cancellation or redemption of
preference shares by the company. When a company purchases its own shares, it is called Buy Back of
Shares. A company can buy back its shares from the following:
1. Existing equity shareholders on a proportionate basis
2. Open Market
3. Odd-lot shareholders
4. Employees of the company

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

3. from the proceeds of any shares or other specified securities.

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.

Conditions for buy-back of shares:


1. The company must be authorized by its Articles of Association for the buy-back of shares

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

5. The shares bought back should be fully paid-up

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

Calculation of Capital Redemption Reserves and Net Proceeds from Fresh


Issue:
Capital Redemption Reserve:

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF Nominal value of shares to be bought back – Net proceeds from fresh issue of shares
SECURITIES
Net Proceeds from Fresh Issue:

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.

Fresh Shares to be issued:

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:

Journals Amount (Rs) Amount (Rs)


Share buy-back A/c 50,00,000
To Bank A/c 50,00,000
(being shares bought back)
Equity Share Capital A/c 10,00,000
Securities Premium A/c 40,00,000
To Share buy-back A/c 50,00,000
(Being shares bought back canceled)
Revenue Reserve A/c 10,00,000
To Capital Redemption Reserve A/c 10,00,000
(being capital redemption reserve account created to the extent of the
face value of equity shares bought back)

Employee Stock Options (ESOP):


An incentive mechanism used by the companies to rewards its performing employees as a part of the
salary and ensure the long-term commitment of the employee. Further, giving ESOP to companies also
ensures that the employee would work hard and aim to improve the performance of the company, which
in turn will increase the value of the shares.

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.

Objective of issuing an ESOP:


A company may issue ESOP for two major reasons, namely,

1. Incentive, attract and retain its employees in the company

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

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF Grant: It is the eligibility of a particular employee for a grant of the stock options. The employee can be
SECURITIES
granted ESOP based on his role and performance.

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.

Condition for the issue of ESOP:


ESOP may be allotted to employees by passing a Special Resolution (Ordinary Resolution in case of a
private company) by the company and shall be subject to such conditions as may be prescribed under the
relevant rules. Rule 12 prescribes the conditions for the Issue of ESOP:

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

4. The company will have to pass a separate resolution in case of:


a. Grant of options to employees of the subsidiary or holding company
b. Grant of options to identified employees > or = 1% of the issued capital of the company at the time of
grant of options (excluding outstanding warrants/conversions.)

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.

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF 8. The following other conditions should be fulfilled:
SECURITIES
a. The options granted shall be non-transferrable.
b. The options granted shall not be pledged, hypothecated, mortgaged or otherwise encumbered.
c. Only the employee shall be entitled to exercise the option.
d. In the event of the death of the employee, all the granted option till date shall vest in the legal
heir/nominee of the deceased employee
e. In case of permanent incapacitation, all the options granted to him till the day of such incapacitation
shall vest in him on that date
f. In the case of termination/resignation of the employee, the options which are not vested in him shall
expire. However, vested options may be exercised by the employee as per terms of the scheme

9. The following disclosures shall be made in the Director’s Report:


a. options granted
b. options vested
c. options exercised
d. the total number of shares arising as a result of the exercise of an option
e. options lapsed
f. the exercise price
g. variation of terms of options
h. money realized by exercise of options
i. total number of options in force
j. employee wise details of options granted to:
• key managerial personnel any other employee who receives a grant of options in any one year of
option
• amounting to five percent or more of options granted during that year
• identified employees who were granted an option, during any one year, equal to or exceeding one
percent of the issued capital (excluding outstanding warrants and conversions) of the company at the
time of grant

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.

Method for Implementing ESOP:


There are two ways to implement ESOP, namely, Direct Route and Trust Route.

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF SECURITIES

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF SECURITIES

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF Accounting
SECURITIES treatment and valuation methods:
The company shall recognize an amount for the service received during the vesting period based upon the
best available estimate of the number of shares expected to vest and should revise estimate if necessary.
Further, for the purpose ESOP can be valued using either Intrinsic Value or Fair Value Method.

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:

a. Exercise price, or the price at which option will be exercised

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

c. Current price of shares

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:

• Vesting Period: 3 years


• Exercise Period: 3 years
• Expected Life: 5 years
• Exercise Price: 50
• Market Price: 50
• Expected forfeitures per year 3%
The fair value of options, calculated using an option pricing model, is Rs 15 per option. Actual forfeitures
during year 1 are 5% and at the end of year 1, the enterprise still expects that actual forfeitures would
average 3% per year over the 3-year vesting period. During year 2, however, the management decides
that the rate of forfeitures is likely to continue to increase and the expected forfeiture rate for the entire
award is changed to 6% per year. It is also assumed that 840 employees have completed 3 years vesting
period.

Solution:
Year 1:

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SEBI GRADE A 2020: EMPLOYEES STOCK OPTION AND BUY-BACK
OF 1. At the grant date the enterprise has estimated the fair value of the options expected to vest at the end
SECURITIES
of the vesting period as below:

No. of options expected to vest = 200 x 1,000 x 0.97 x 0.97 x 0.97 = 1,82,535 options

Fair value of options expected to vest = 1,82,535 options x 15 = 27,38,019

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:

Employee compensation expense A/c Dr. 9,12,673

To Stock Options Outstanding A/c 9,12,673

Year 2: Between Grant and Vesting:


1. At the end of the financial year, the management has changed its estimate of the expected forfeiture
rate from 3% to 6% per year. The revised number of options expected to vest is 1,66,117 (2,00,000 x
0.94 x 0.94 x 0.94). Hence, the fair value of revised options expected to vest is 24,91,752 (1,66,117 x
15). Consequent to the change in the expected forfeitures, the expense to be recognized during the year
are determined as below:

Revised total fair value = 24,91,752


Revised cumulative expense at the end of year 2 = (24,91,752 x 2/3) = 16,61,168
Expense already recognized in year 1 = 9,12,673
Expense to be recognized in year 2 = 7,48,495

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:

Employee compensation expense A/c Dr. 7,48,495


To Stock Options Outstanding A/c 7,48,495

Year 3: Upon Vesting:


1. At the end of the financial year, the enterprise would examine its actual forfeitures and make necessary
adjustments, if any, to reflect expense for the number of options that vested. Since 840 employees have
completed three years vesting period, the expense to be recognized during the year shall be determined
as below:

No. of options vested = 840 x 200 = 1,68,000


Fair value of options actually vested (Rs. 1,68,000 x Rs. 15) = Rs. 25,20,000
Expense already recognized Rs 16,61,168
Expense to be recognized in year 3 Rs 8,58,832

1. The enterprise recognizes the amount determined at (1) above towards the employee services received
by recording the following entry:

Employee compensation expense A/c Dr. 8,58,832


To Stock Options Outstanding A/c 8,58,832

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.

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