ESOP Trust in India: Why Public Companies Use Them

What is an ESOP Trust?

An ESOP Trust is a trust set up by a company to hold shares that are part of the ESOP pool. These shares are managed by appointed trustees and held in the trust until they are allocated to employees based on the plan’s vesting and exercise terms.

In simple terms, the trust acts as an intermediary between the company and its employees. Rather than issuing shares directly to individuals, the company places them in the trust. 

Once employees meet the vesting requirements and decide to exercise their options, the trust handles the transfer or sale of those shares.

Direct route vs ESOP Trust route: What’s the difference?

When companies in India implement an ESOP scheme, they generally choose between two approaches for administering and distributing stock options:

1. Direct route (company-managed route)

In the direct route, the company grants stock options to employees under its ESOP scheme without involving a trust.

Upon exercise, shares are either issued as fresh allotments (primary shares) or transferred from existing shareholders (secondary shares). All administration, documentation, and compliance are managed internally by the company.

This approach is commonly used by early-stage private companies with smaller ESOP pools.

2. ESOP Trust route

In the ESOP trust route, the company sets up an independent legal entity to hold shares on behalf of employees. This trust acts as a vehicle to manage ESOP grants, exercises, and buybacks of primary (newly issued) and secondary (existing) shares.

The company funds the trust in one of two ways:

• By issuing new shares (primary shares) to the trust
• Or by lending money to the trust so it can buy existing shares (secondary shares) from the open market (for listed companies)

Public companies and late stage private companies often prefer this route.

When do companies use an ESOP Trust?

One of the primary reasons for using an ESOP Trust is to acquire shares, either from the company, existing shareholders, or, in the case of listed companies, from the public market, for the purpose of distributing them to employees. 

This is permitted under Section 67(3)(b) of the Companies Act, which provides an exception to the general prohibition under Section 67(1) on companies purchasing their own shares or providing financial assistance for such purchases. The exception allows a company to fund a trust to acquire shares, provided they are distributed to employees under a properly approved ESOP or similar benefit scheme.

Parties involved in an ESOP Trust structure

In an ESOP Trust structure, several parties are involved to ensure the smooth operation and fairness of the trust. These parties work together to manage the trust's assets, uphold its purpose, and protect the interests of employees benefiting from the stock options.

1. Trustee

The trustee is responsible for managing the trust’s assets and operations. 

They must be independent from the company’s key management and must not hold more than 10% of the company’s paid-up share capital to maintain impartiality in decision-making.

2. Settlor

The company, typically represented by its founders, acts as the settlor. The settlor defines the trust’s objectives and provides the initial funding.

3. Beneficiary

Employees who receive stock options through the trust are the beneficiaries. 

4. Protector

The protector, usually a key management figure, is responsible for overseeing the trust’s operations and ensuring that the beneficiaries' interests are well-represented. The protector plays a critical role in safeguarding employee rights within the trust structure.

How an ESOP Trust functions in India

An ESOP Trust acts as an intermediary between the company and the employees, helping with the purchase, holding, and distribution of shares under the ESOP scheme.

Here’s a breakdown of how an ESOP trust works in India:

1. Formation of the trust

The company creates an ESOP trust under the Indian Trusts Act, 1882, by executing a trust deed and appointing trustees, who are typically company officials or external professionals. Once registered, the trust operates as a separate legal entity.

2. Funding the trust

The ESOP trust can be funded in two ways:

• Loan from the company: The company gives a loan to the trust to buy its own shares (typically from promoters, secondary market, or fresh issue).
• Grants or contributions: Sometimes the company may directly issue shares to the trust at nominal or fair value.

3. Acquisition of shares

The trust uses the funds to purchase shares of the company.

• In private companies: from promoters or investors.
• In public companies: from the open market.
• Or directly from the company via fresh issuance.
  

4. Granting options to employees

The company  grants stock options to employees under an approved ESOP scheme.
The grant defines:

• Employee name and ID
• Number of options
• Vesting schedule
• Vesting Date
• Exercise price
• Exercise Period
• Other terms

‍5. Vesting and exercise

As employees complete vesting conditions, they become eligible to exercise their options.

Upon exercise:

• The trust transfers the shares (previously held) to the employee at the exercise price.
• The exercise price paid by the employee goes to the trust (or back to the company if the trust is repaying a loan).
  

6. Exit or sale

During an IPO, M&A event, or secondary transaction, employees may sell their shares, and the trust can help facilitate the process.

Why do public companies in India use ESOP Trusts?

Some important reasons why public companies in India use ESOP Trusts include:

1. To buy shares from the market

Listed companies can use ESOP trusts to purchase shares from the open market, hold them, and later allocate them to employees. Without an ESOP trust, Section 67 of the Companies Act would prohibit such transactions.

2. To reduce dilution

When a company issues fresh shares for every ESOP exercise, it increases the total share capital and dilutes existing shareholders. 

To prevent this, companies use treasury shares held by the ESOP trust to fulfill ESOP grants without issuing new shares.

3. To comply with SEBI regulations

Under the SEBI (ESOP) Regulations, 2021, ESOP trusts provide a structured and compliant way to manage employee stock option plans, especially when dealing with market purchases.

FAQs

1. What is the difference between an ESOP Trust and a traditional ESOP plan?

A traditional ESOP plan typically involves the company directly issuing stock options to employees via the ‘direct route’. In contrast, an ESOP Trust serves as an intermediary, it holds shares on behalf of employees and manages allocation, exercises, and even buybacks. 

2. Can an ESOP Trust be established for both private and listed companies?

Yes. ESOP Trusts can be set up by both private and listed companies in India. 

However, listed companies must comply with SEBI’s ESOP Regulations, while private companies follow guidelines under the Companies Act, 2013.