Q&A on SAR, Phantom Shares, ESOPs, and Related Topics for Private Limited Companies and Start-ups

Q1: What is the difference between SAR and Phantom Shares?

Answer:
While Stock Appreciation Rights (SARs) and Phantom Shares are similar in their objective of rewarding individuals without issuing actual equity, they differ in key aspects:

1. Regulatory Framework:

1. • SARs: Governed by specific regulations
   • Phantom Shares: Not governed by specific regulations; they are structured through contractual agreements, making them more common for private companies.

2. Target Audience:

1. • SARs: Primarily issued to employees as part of their compensation package.
   • Phantom Shares: Often issued to consultants, vendors, or external collaborators for their contributions.

3. Valuation:

1. • SARs: Share prices are readily available in listed companies, making valuation straightforward.
   • Phantom Shares: Valuation depends on subjective methods, often requiring external valuations for unlisted companies.

4. Tax Treatment:

1. • SARs: Taxed as salary income when exercised by employees.
   • Phantom Shares: Taxed as business income if issued to consultants or vendors.

Q2: How are RSUs different from ESOPs?

Answer:
Restricted Stock Units (RSUs) and Employee Stock Ownership Plans (ESOPs) share similarities but differ in execution:

• Ownership Transfer:

• • RSUs: Shares are granted directly to employees after a vesting period, with no purchase required.
  • ESOPs: Employees must exercise their options by paying an agreed exercise price to acquire shares.

• Financial Outlay:

• • RSUs: No upfront cost to employees.
  • ESOPs: Employees bear the exercise cost, aligning them with long-term company growth.

• Applicability:
  • RSUs are preferred by larger, listed companies because they offer direct equity ownership tied to the company’s market value, which is already established. In contrast, ESOPs are common in start-ups and private companies as they allow employees to purchase shares at a predetermined price, aligning with the company’s growth potential and future valuation, which is yet to be realized.

Q3: Are merchant banker valuations relevant in today’s scenario for ESOPs?

Answer:
Yes, merchant banker valuations are highly relevant, particularly for unlisted companies. As per Rule 3(8) of the Income Tax Rules, 1962:

• Valuation Requirement:
  For unlisted companies, the Fair Market Value (FMV) of shares must be determined by a SEBI-registered merchant banker on the specified date (usually within 180 days of exercise).
• Purpose:

• • FMV is used to calculate the taxable perquisite value of ESOPs at the time of exercise.
  • Ensures transparency and compliance with tax authorities.

Q4: Are Phantom Shares subject to any regulations? How are they legitimized?

Answer:
Phantom Shares are not governed by specific regulations, unlike ESOPs or SARs. Instead, they derive legitimacy through:

1. Contractual Agreements:
   Structured under the Indian Contract Act, 1872, with clearly defined terms agreed upon by the parties involved.
2. Trust in the Issuer:
   Typically offered by growth-stage companies with a credible reputation, Phantom Shares incentivize stakeholders such as consultants or vendors by linking their rewards to the company’s performance.

Q5: How should a start-up create an ESOP pool from promoter shareholding before bringing in investors?

Answer:
Start-ups planning to allocate ESOPs before investor funding should follow these steps:

1. Approval by Shareholders:
   The ESOP scheme must be approved by existing shareholders to allocate shares from the promoter’s pool.
2. Flexible Clauses for Future Investors:
   Include a clause in the ESOP scheme that allows for adjustments to align with future investor terms. For example:

1. • If the ESOP pool needs resizing post-investment, the scheme should enable proportional adjustments.

3. Example:

1. • ABC Pvt. Ltd., a promoter-driven company, creates an ESOP pool with the clause: “The scheme is subject to future amendments based on investor agreements.”

Q6: What happens if a company cannot pay back in a Community Stock Option Plan (CSOP)?

Answer:
If a company fails to pay under a CSOP, it breaches the contractual agreement, leading to:

1. Predefined Remedies:

1. • The contract must specify alternative options, such as cash compensation or deferment of payments.

2. Practical Approach:

1. • In the startup world, this is treated like an investor’s risk. If the company idea or model fails, stakeholders (including CSOP recipients) may not receive pay-outs.

Q7: When an MSOP or CSOP holder exits, do agreements need to be altered?

Answer:
No, MSOP and CSOP agreements are predefined during issuance and do not require alterations unless renegotiated. Exit terms, buybacks, or transfers are typically outlined in the initial contract.

Q8: Do ESOP holders have rights to dividends and bonuses like regular shareholders?

Answer:
Yes, once employees exercise their ESOPs and become shareholders, they are entitled to:

• Dividends: Share in the company’s profits.
• Bonus Shares: Additional shares issued by the company.

This ensures ESOP holders enjoy the same benefits as regular equity shareholders.

Conclusion

Understanding SARs, Phantom Shares, ESOPs, and RSUs is crucial for private limited companies and start-ups. Each tool serves a distinct purpose, allowing organizations to reward employees, consultants, and partners effectively. Whether it’s through equity-based incentives like ESOPs or cash-based rewards like SARs, these instruments must be tailored to align with business goals, growth stages, and regulatory compliance.

For start-ups, carefully designed ESOP pools with merchant banker valuations and transparent agreements ensure smooth operations and future investor compatibility. As businesses grow, leveraging tools like CSOPs and Phantom Shares fosters stronger relationships with employees and collaborators.