Background
Historically, companies have provided employees with share-based incentives by way of employee stock options (“ESOPs”). However, with evolving corporate incentive structures, various new models have emerged, especially driven by start-ups. These incentives models include Stock Appreciation Rights (“SARs”), Restricted Stock Units (RSUs), Performance Stock Units (PSUs), Employee Share Purchase Schemes (“ESPS”), Phantom Stock Units (PSU), Save As You Earn Share Schemes (ShareSave), Non-qualified stock options (NSOs), Management Stock Options (MSOP), etc. Generally, employees look forward to an “exit event” to realize gains from these incentive structures, with an Initial Public Offering (“IPO”) being one of the most common “exit events”.
In this post, we analyze a company’s eligibility to undertake an IPO in situations where any person holds any rights that would entitle them the option to acquire equity shares of the company, or where there are outstanding convertible securities that can be converted into equity shares of the company. The rationale for this strict requirement has been to ensure that the company’s capital structure is ascertainable before initiating the IPO process. This view has been captured in Regulation 5(2) of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”) which states that:
“An issuer shall not be eligible to make an initial public offer if there are any outstanding convertible securities or any other right which would entitle any person with any option to receive equity shares of the issuer”.
Pertinently, the proviso to Regulation 5(2) of the ICDR states that:
“…the provisions of this sub-regulation shall not apply to (a) outstanding options granted to employees, whether currently an employee or not, under an employee stock option scheme in compliance with the Companies Act, 2013, the relevant Guidance Note or accounting standards, if any, issued by the Institute of Chartered Accountants of India or under the Companies Act, 2013, in this regard.”
Understanding the Extant Regulatory Position
A reading of Regulation 5(2) of the ICDR makes it apparent that there is no embargo on a company with outstanding Employee Stock Options granted in compliance with the Companies Act, 2013 (the “Act”) and other applicable laws, from being an eligible issuer and undertaking an IPO.
Under the Act, a company can issue its share capital “to employees under a scheme of employees’ stock option, subject to a special resolution passed by the company and subject to such conditions as may be prescribed”[1] where an “employees’ stock option” is defined as “the option given to the directors, officers or employees of a company or its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price”[2]. Further, any such issuance of ESOPs would also have to comply with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 (“SCD Rules”).
Hence, the company would not be barred from undertaking an IPO under Regulation 5(2) of the ICDR so long as any employees holding rights entitling them with an option to receive equity shares of the company are holding such rights under an ESOP granted to them under Sections 2(37) read with 62(1)(b) of the Act and Rule 12 of the SCD Rules.
Regulatory Threshold: Proposals for harmonization and reform
Under the extant regulatory threshold, only those outstanding options that qualify as options granted under an “employee stock option scheme” would be exempted from the purview of Regulation 5(2) of the ICDR. While “employee stock option schemes” here should be interpreted to include any share-based employee benefit schemes, such as ESOPs, SARs, ESPS), etc., this has not been the position taken by the Securities and Exchange Board of India (“SEBI”). Historically, SEBI has maintained that only ESOPs would be permissible under Regulation 5(2) of the ICDR, since other share-settled employee benefits/ schemes, such as SARs, ESPS, etc., have not been expressly enabled/ regulated under the Act. This was also evidenced by SEBIs position about companies, that earlier had stock appreciation right scheme, and therefore, such companies had to rechristen their SARs to ESOPs.[3]
This view has led to some ambiguities given that the purpose and effect of excluding ESOPs should logically also apply to other share-settled benefits such as SARs as they have a similar effect on the company’s capital structure. Further given that these share-settled benefits are expressly permitted and regulated under the regulations applicable post listing, i.e., the Securities and Exchange Board of India (Share-Based Employee Benefits and Sweat Equity) Regulations, 2021 (“SBEB&SE Regulations”), it is unclear as to why the scope of the exception under Regulation 5(2) of the ICDR is limited only to ESOPs. Further, the SBEB&SE Regulations have also been issued under the authority granted to it under Rule 12 of the SCD Rules, which regulates the “issuance of employee stock options” and if an interpretation is taken that only traditional ESOPs are permitted to be issued under Rule 12, then SEBI’s SBEB&SE Regulations, 2021 could have permitted and regulated only ESOPs, and all other types of benefits, including SARs, ESPSs and other share settled incentives.
On August 24, 2023, SEBI constituted an “Expert Committee for facilitating ease of doing business and harmonization of the provisions of ICDR and LODR Regulations” (the “Expert Committee”). The Expert Committee, chaired by Shri S. K. Mohanty, conducted a review of regulations applicable to listed companies including, inter alia, the SBEB&SE Regulations, [4] The Expert Committee recently submitted its final recommendations to SEBI, which included a proposal for the express inclusion of SARs under the proviso of Regulation 5(2) of the ICDR. In this regard, the Expert Committee opined that “While the capital structure of a company before an initial public offering must be ascertainable, … the SBEB Regulations recognize SARs as a share-based employee benefit. Accordingly, the Expert Committee recommends permitting SARs to remain outstanding until the date of filing the red herring prospectus”[5]. This makes it evident that even the Expert Committee is desirous of harmonizing the share-settled benefits excluded from the purview of Regulation 5(2) of the ICDR and those regulated under the SBEB&SE Regulations.
Conclusion
Given the magnitude of the impact of excluding share-settled schemes other than ESOPs from the purview of the proviso to Regulation 5(2) of the ICDR, it is imperative to adopt a more liberal view where ESOPs are read to include other share-settled benefits that are governed/regulated by the SBEB&SE Regulations[6] and are designed in compliance with the Act. To this end, the Expert Committee recommendations to include SARs under the proviso to Regulation 5(2) of the ICDR and grant them the same treatment as ESOPs is a welcome move. While this is a step in the right direction, we further recommend using this opportunity to amend the ICDR to harmonize the share-settled benefits regulated by the Act and the SBEB&SE Regulations. Doing so would allow continuity for such schemes (both pre and post-listing) and also prevent any ambiguities in the scope of employee stock option schemes exempted under Regulation 5(2) of the ICDR.[7]
[1] Section 62(1)(b) of the Act.
[2] Section 2(37) of the Act.
[3] The red herring prospectus (“RHP”) of both Honasa Consumer Limited and Go Digit General Insurance Limited accessible here and here, are indicative of the fact that both these companies had amended their SAR scheme to ESOP schemes ahead of the IPO to allow their outstanding options from being captured within the ambit of the proviso to Regulation 5(2) of the ICDR.
[4] To read more about the ambiguous scope of the SBEB&SE Regulations, check our blog here – Regulatory framework governing employee benefits by equity listed companies
[5] Paragraph 39.3(ii) of the recommendations of the Expert Committee, accessible here – SEBI | Consultation Paper on Recommendations of the Expert Committee for facilitating ease of doing business and harmonization of the provisions of ICDR and LODR Regulations <a href=’https://www.sebi.gov.in/sebiweb/publiccommentv2/PublicCommentAction.do?doPublicComments=yes’ target=’_blank’ style=’color:#007ffc’> Click here to provide your comments </a>
[6] Regulation 1(3) of the SBEB&SE Regulations stipulates that “The provisions of these regulations shall apply to the following: – (i) employee stock option schemes; (ii) employee stock purchase schemes; (iii) stock appreciation rights schemes; (iv) general employee benefits schemes; (v) retirement benefit schemes; and (vi) sweat equity shares”. Further, Regulation 1(4) of the SBEB&SE Regulations clarifies the regulatory net about equity listed companies that “seeks to issue sweat equity shares or has a scheme:- (i) for the direct or indirect benefit of employees; (ii) involving dealing in or subscribing to or purchasing securities of the company, directly or indirectly; and (iii) satisfying, directly or indirectly, any one of the following conditions: – (a) the scheme is set up by the company or any other company in its group. (b) the scheme is funded or guaranteed by the company or any other company in its group. (c) the scheme is controlled or managed by the company or any other company in its group”.
[7] Please note that while the Act does not expressly enable a company from putting in place any share-settled scheme other than an ESOP scheme, the market practice has been for companies to read “employee stock options” to include any share-settled employee benefits regardless of their nomenclature given the broad scope afforded to an “employee stock option” under Section 2(37) of the Act.