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Structuring employee stock ownership plans (ESOP) in mergers and acquisitions (M&As) is of significant legal and strategic importance for both acquirers and target companies. ESOPs help retain and motivate employees, particularly during corporate transitions and provide opportunities for continued or enhanced equity participation.

Typically, ESOP structuring is crucial during acquisitions of service-based companies, such as IT and IT-enabled service companies. Such businesses are often workforce-intensive and ESOPs deliver a sense of ownership, indispensable for retaining and motivating key talent.

Structuring may take several forms, each with legal and commercial implications. These may be option or share swaps, including integration with existing ESOP plans, or termination of the existing ESOP by the acquiring company.

Under the option or share swap approach, various solutions are available. Employees who hold ESOPs in the target company may receive shares in the acquiring company in accordance with the swap ratio agreed commercially. Alternatively, where a target company that has granted ESOPs is acquired by a company with its own ESOPs, the ESOPs of the target company’s employees are replaced with the ESOPs of the acquiring company.

The swap ratio is determined by preserving, as far as possible, employees’ economic and ancillary benefits immediately before and after the acquisition. The parties consider factors such as the relative valuations of the companies, the terms of the existing ESOPs, differences in vesting schedules and variations in the share price or plan framework. This structuring seeks to ensure continuity of employee equity participation and retirement benefits thereby preserving the employee’s morale and retention during the transaction process.

In certain circumstances, the acquiring company may terminate the ESOP following the acquisition. In such a case, it is common for the target company’s ESOP holders to receive a payout based on the fair market value of their shares on the transaction date. ESOPs policies generally provide that any ESOPs that have been granted but remain unvested are subject to accelerated vesting immediately prior to completion of the transaction. Payouts may be lump sums or disbursed in instalments.

When employees of the target company have exercised their vested stock options and hold equity shares, the acquirer is usually required to purchase them as part of the transaction. That is done at the same time the acquirer buys out the other shareholders.

Structuring ESOPs in M&As raises several practical challenges. These include the determination of fair market value, which may be complex. Valuing unvested options is challenging, and their final value remains uncertain.

Another issue is effective communication with employees which becomes essential to manage expectations and maintain the morale of employees. This is important because of the uncertainty that often accompanies M&As.

A common feature of ESOPs in M&As is the termination or amendment of the target company’s existing ESOP. In such cases, the Companies Act, 2013 and the Foreign Exchange Management Act, 1999 (should any foreign entity be involved), must be complied with. Under rule 12(5) of the Companies (Share Capital and Debentures) Rules, 2014, any amendment of or variation to an ESOP scheme cannot adversely affect the rights or interests of the employees granted options under it. Any variation (except those not prejudicial) must be approved by a special resolution of the shareholders, and the company is required to provide complete details and rationale for any proposed amendment in the notice of the general meeting. This is to ensure that companies cannot make changes reducing the benefits, rights or entitlements of existing ESOP holders.

Structuring ESOPs in M&A transactions is complex and evolving. With legislative and regulatory guidance developing, companies must be vigilant and adaptable, ensuring that all actions are compliant and serve the interests of all stakeholders equitably. Above all, they should seek specialist advice about the particular circumstances of their ESOP.

Rohan Jain is a partner, Kshitij Arora is a counsel and Shruti Jaju is an associate at Shardul Amarchand Mangaldas & Co