A Comprehensive Guide on Employee Stock Options (ESOs)

12 min read • Published 11 November 2022
Written by Chandhana Padma
A Comprehensive Guide on Employee Stock Options (ESOs)

Many large enterprises offer stock compensation to their employees and executives. This type of equity benefit attracts top talent to work for the company. Companies, especially start-ups, often offer Employee Stock Options (ESOs) to their initial members when they cannot provide them with large salary packages.

What Are Employee Stock Options?

Employee stock option plans are one of the benefits besides employee health insurance that enable retention of  top executives in a company. Many organisations offer such financial equity compensation to employees through regular call options. By virtue of these options   ,  executives and employees from that company can purchase its stocks at a specific price and time.

A call option is a derivative contract that gives  the holder the right to purchase a company’s shares at a specific price.This call option however does not bestow the holder with the obligation to buy the underlying stock.

In an ESO, an organisation and an employee sign an agreement agreeing to a few terms and conditions dictating the terms of option exerciseIn India, most Employee Stock Option (ESOs) allow employees to convert their ESOs into stocks at a predetermined time. The actual transfer of ownership will however be done only after the vesting period. How Do Employee Stock Options Work?

In ESOs, companies allocate specific stocks from their trust funds to employees they want to compensate. Once the employee completes his/her vesting period, he/she can start exercising their Employee Stock Options.

According to SEBI, vesting is a process through which an organisation grants an employee the right to apply for a company’s shares. These are given in the form of stock options, which allow the employee to purchase stocks at a predetermined price.

Such employees also need to work for their employer’s company till their vesting period ends to exercise their ESO. Employees must not leave the organisation before their vesting period to convert their ESO to stocks.

Furthermore, employees should keep the following things in mind if they have agreed to take ESOs as compensation:

  • Total number of shares they will be entitled to purchase
  • The price at which they will be allowed to buy the shares
  • The period after which they can start buying these shares (vesting period)

What Are the Various Types of Employee Stock Options?

There are a number of ESOs available in India that an organisation may offer to its employees. These are:

  • Employee Stock Option Scheme (ESOS)

In India, ESOS is the most common type of employee stock ownership. Under this plan, an organisation will give employees the right to purchase stocks, but it cannot compel them to do so.

In this case, an employee will get this option from the employer after the vesting period if he/she has passed specific performance goals. Furthermore, the employee can only quit after the vesting period ends if he/she wants to be eligible for these stock options.

After the vesting period, employees can exercise their rights and may even end up purchasing the company’s shares at a price lower than the market price (this is when the exercise price is lower than the market price).cIf any employee does not wish to exercise this right, he/she can just let it expire. 

However, if one chooses to exercise such rights, he/she will get full ownership of the stocks which entails rights to receive dividends and voting power.

  • Employee Stock Purchase Plan (ESPP)

An Employee Stock Purchase Plan (ESPP) is an employee stock option where the organisation grants the liberty to purchase these shares at a discounted price. Usually, the discounts are made from the fair market value of the stocks. 

Through ESPP, employees can periodically invest towards the company’s stocks to increase their ownership in the organisation. Furthermore, when the employee makes such investments, they are also entitled to receive associated dividends (if any).

  • Restricted Stock Units (RSU)

Some organisations in India offer RSUs to their employees. In this case, the employees will have the right to convert their RSUs into actual stocks of the company provided they fulfil certain time/performance based conditions. 

This ESO allows the employee or executive to hold onto their share units.  They will however not have voting rights or receive dividends until the vesting period is over. 

  • Restricted Stock Award (RSA)

Restricted Stock Awards and Restricted Stock Units sound very similar but are significantly different. In the case of RSU, a company promises its employees that it will issue them stock units after they fulfil specific criteria.

On the other hand, in RSAs, the company immediately offers stock units to the employees. The organisation will grant these employees voting rights within the organisation and the employees are entitled to receive dividends.  

People use the term restricted in this case because it is accompanied by a vesting period during which employees cannot sell their stocks. 

The organisation can also include specific criteria during the vesting period that the employee has to fulfil. If the employee fails to meet such requirements or leaves the organisation before the vesting period, it will repurchase the awarded stocks from the said employee.

  • Stock Appreciation Rights (SARs)

Many companies want to provide stock options to their employees and executives, but at the same time, they also don’t want to liquidate their ownership. In this case, such companies can instead choose to grant their employees only the rights for stock appreciation using SARs.

In the case of SARs, the employees will have the right to obtain the incremental amount of appreciated stock price. once they have completed the vesting period. However, this, too, will have an expiration date. 

The employee will not receive any stock units, and therefore, he or she will not have the opportunity to make investments. However, the company will offer them cash payments equal to the appreciation in the share’s market price. 

  • Phantom Equity Plan (PEP)

Many people use the terms Phantom Equity Plan and Stock Appreciation Rights interchangeably. However, there are a few differences between the two terms. With PEPs, employees do not get real stocks but get notional stocks that are recorded in the company’s books.

Here, the company will offer employees cash at a predetermined date in the future after they have fulfilled specific requirements. The employee will not have any rights to exercise their PEPs within the organisation. 

What Are the Advantages of Employee Stock Options?

Below are certain advantages of employee stock options:

  • It makes compensation packages extremely attractive. So if a company is trying to hire top talents from another company, it may use ESOs to entice such candidates.
  • ESOs also increase employee retention so that fewer employees leave the organisation. 
  • Employees feel more connected to an organisation when they get a sense of ownership. 
  • Employees will be able to earn dividends,  this will eventually serve as a secondary income stream. 
  • Employee stock options also help in creating job stability for employees. Since there is a vesting period, the employee will have to continue the job until it ends. 

What Are the Disadvantages of Employee Stock Options?

Here are all the disadvantages of employee stock options:

  • Filing taxes can be a complex process for employees who opt for employee stock options as a part of their compensation package.
  • It is challenging to find the true value of ESOs.
  • If an organisation dilutes its equities in future, it will be very costly for its shareholders.
  • Some executives tend to keep receiving higher compensations even if the organisation is underperforming.
  • Some employees will receive more compensation than others from stock option plans. As a result, it may lead to conflict within the team.

Tax Implications of Employee Stock Options 

If an organisation grants an employee ESOs, the options will not be taxable. However, if the employee exercises his or her rights, then the employee stock option plan is taxed in the following way:

  • First stage- Upon exercising the options

The first stage includes the employee using his or her right to purchase company stocks at the exercise price. Once the employee has exercised these options, the difference between the value of the stocks and the employee’s exercise price will be considered as income for the employee.

The employer will deduct tax at source if this employee exercises his/her option the employer  treats this like theemployee’s prerequisite, which is his/her salary income.

prices of stocks a company allots to an employee will be average market price on the day an employee decides to exercise his/her option. this average is calculated using the highest and lowest prices of the shares. However, this only applies to the stocks listed on the stock exchange.

When stocks are not listed on the exchange, the fair market value of the stocks will be considered. This value is derived from the valuation certificate that a merchant banker provides. Furthermore, this valuation certificate should’ve been issued within 180 days from the day on which the employee decides to exercise his or her option.

If a company’s shares are listed in foreign exchange, the organisation will have to get a certificate from a merchant banker. Second stage- When the stocks are sold off

The second stage of ESO taxation is when stocks are sold off. When the employees sell the shares, they will have to pay a capital gains tax. The percentage of tax each employee has to pay will depend on the period till which the employee has held the stock units. The amount of tax an employee must pay for listed and unlisted shares will also differ. 

Long-term capital gains (LTCG) will be considered if an employee holds the listed shares for more than a year. On the other hand, an employee has to hold on to unlisted shares for more than two years for them to avail LTCG tax treatment on investment. 

The platform where employees have traded these stocks will also play a significant role in the amount of tax that they have to pay. For example, if this platform has already paid Security Transaction Tax, it will be different from the taxes one must pay if the individual decides to trade through a broker.

As per Section 112A, when an employee trades the shares through a broker, the employee has to pay 10% taxes if his/her LTCG is over ₹1 Lakh. Meanwhile, under Section 111A, short-term capital gains (STCG) are taxed at a 15% rate.

If an employee does not sell his/her shares via a stock exchange, then an indexation will be applied to the original cost of purchase, and then long-term capital gains will be calculated. These indexed gains will be taxed at 20%, and a surcharge and education cess will also be applied.

If an employee does not add indexation benefits, then he or she will only have to pay a 10% tax. Furthermore, such short-term capital gains will be considered the employee’s income and will thereby be taxed according to their tax slab.

  • Tax Implications of Foreign ESOs

If a company whose shares are listed in an exchange outside India grants ESOs to an Indian resident employee, he or she will have to pay taxes in India on the same. Such employees may even have to pay taxes to the country where they live unless it has a double taxation avoidance agreement with India. 

Shares of a foreign company not listed on Indian stock exchanges are treated as unlisted shares for the purpose of taxation. Indian residents need to report these stocks as foreign assets while filing Income Tax Returns. 

Should Employees Accept ESOs as a Part of Their Remuneration?

On most occasions, employees tend to opt for cash compensation rather than opting for employee stock options because that is the most logical thing to do. finding out the value of such shares in the future is a difficult thing to do. 

The price of some shares may or may not rise significantly in the future. In many cases, employees may not have a choice to opt out of ESOs. In such scenarios, employees should thoroughly study the company, its growth potential and the kind of returns it has garnered historically. Then, they should decide if they want to accept ESOs in their salary package.

Final Word

In India, many companies, especially start-ups, offer employee stock options to attract more talented candidates to join their organisations. If you are opting to take ESOs as a part of your salary, you must read through the terms and conditions of your agreement thoroughly. In addition, you should research the fundamentals of the company to ensure maximum benefits. 

Frequently Asked Questions

What are the benefits of applying for an Employee Stock Purchase Plan (ESPP)?

ESPP plays a pivotal role in retaining employees by allowing them to purchase the employer company’s stocks at discount price. With this, employees can enjoy certain rights that come along with the status of shareholders. Furthermore, ESPP also helps employees build their savings for short-term purposes or retirement plans.

hould an employee rely on the RSU he or she holds in an emergency?

It would not be wise to rely on RSUs for emergencies, as one can liquidate these units only after the vesting period ends. Instead, experts advise individuals to invest their money in funds with high liquidity or keep funds in savings accounts for an emergency.

Will all employees get the same number of stocks if their organisation assigns them RSUs?

No, the number of stock units a company will assign to its employees will depend on their designation and performance. For instance, an employee in a managerial position will receive more shares than another employee in an associate position.

Do stock options expire?

Yes, stock options expire, and the expiration date differs from one plan to another. Individuals who have opted for ESOs as a part of their compensation should keep an eye on its exercise period because if it expires, it will be of no use. 
Some special rules apply to employees who are deceased or are retiring soon. This is why it is essential to go through  the ESO agreement.

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Chandhana Padma

Investment Associate
Chandhana is a budding investment professional with growing expertise in the capital markets. She has completed her Bachelors in Business Administration with a specialisation in Finance from Christ (deemed to be) University,Bangalore. She is also a CFA L2 candidate. She is currently working as an Investment Associate at Wint Wealth.

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