Employee Stock Ownership Plans (ESOP): Definition, Working Principle, and Benefits
Employee Stock Ownership Plans (ESOPs) are an excellent tool for companies to improve the productivity of their employees. It also helps reduce the attrition rate of an organisation and aligns the interests of employees with that of shareholders. As such, employees are incentivised to contribute to the employer’s success as they can get financial rewards.
ESOPs offer a fair share of benefits to both employers and employees. Read this article to find out everything about ESOPs and how it benefits both parties.
What are ESOPs?
ESOPs are employee benefits that give employees the right to acquire ownership stakes in their employer company. Under ESOPs, employees are offered stocks at a low cost with no upfront fees.
You can also define an ESOP as a profit-sharing plan where a company shares its earned profit with employees. Again, employers have sole discretion to decide who will receive these shares. Employees can exercise these options after a specific time, known as the vesting period, depending on the ESOP’s terms and conditions.
Earlier, only senior employees could enjoy this benefit plan. However, many companies and start-ups are now offering ESOPs to their best-performing staff.
Zomato, Paytm, Myntra, Flipkart, J Thomas and Larson & Tubro are some companies in India that offer ESOPs to their employees.
How Do ESOPs Work?
ESOPs allow employees ownership in their organisation through stocks. Under this plan, an employer allows employees a certain number of stock options at a fixed price.
Employers allot ESOPs to employees at a discount rate which is lesser than its market price. The employee cannot exercise these options for a specific period which is referred to as the vesting period. After the vesting period ends, employees can exercise their rights on these vested stocks and buy their allotted shares at a discounted price, known as the exercise price.
Until the vesting period ends, these shares remain in a trust fund set up by the company, where it continues to grow. Employers decide the number of shares offered to employees, the allotted price and who gets to own these shares.
To exercise their rights over ESOPs, an employee needs to stay in the organisation for the entire vesting period. If they leave before this vesting period ends, the employee will lose the rights over the vested stock options.
What Are the Different Types of ESOPs?
There are five different types of ESOPs. Let’s take a detailed look at the types of ESOPs a company offers:
- Employee Stock Option Schemes (ESOS)
Under an Employee Stock Option Scheme, employees receive options as a right, not an obligation. As a result, employees can buy company shares at a price lower than their market prices.
ESOS is subject to a vesting schedule, which means an employee has to serve for the entire vesting period. However, after the vesting period ends, employees can claim their right to these stock options at predetermined prices.
In simple words, an ESOS does not oblige an employee to invest in a company’s shares.
- Restricted Stock Units (RSU)
An RSU is a type of stock option plan wherein a company awards employees some shares on fulfilment of specific conditions. An employee can enjoy a claim on the awarded shares only by fulfilling those conditions.
However, if they do not meet those conditions, the company will retain the awarded shares. Unlike other ESOPs, RSU is not subject to vesting. Therefore, an employee becomes the owner of these shares as soon as they receive them.
- Employee Stock Purchase Plan (ESPP)
Under this plan, employees can purchase shares at a price lower than their Fair Market Value (FMV). The terms of ESPP, like the vesting period and share price, are pre-determined. A certain amount is deducted from the employee’s salary as a contribution towards the plan.
- Stock Appreciation Rights (SAR)
These are not exactly ESOPs, yet companies use SAR as a type of ESOP. Unlike the other types, companies offer cash payments to their employees in the case of SARs. These cash payments are based on the company’s stock appreciation over a specific period. Companies also promise to provide employees equity without downside risk for SARs.
- Phantom stocks
These are long-term deferred employee benefits under which an employee will receive shares without their actual transfer. Companies record exercise prices of these stocks in books. However, the employer does not have to pay these amounts.
Finally, after the vesting period ends, a company pays its employee the total amount these phantom shares would have earned. Therefore, even without possessing shares materially, employees can earn profits on a theoretical purchase.
Why do companies offer ESOPs to Employees?
Now that we understand the meaning of ESOPs, we must know why companies offer ESOPs. Here are some of the reasons why companies would want to offer these benefits.
- To retain their best employees for a longer period
Companies and start-ups use ESOPs to retain their best brains. These companies offer stock options to their employees with a certain vesting schedule. Employees who leave before the vesting period cannot be owners of these shares. Therefore, organisations use such incentives to retain their workforce.
- Incentive as an appreciation for employee
Companies offer Employee Stock Ownership Plans to their best employees as an award for excellent performance. Employees can either encash them after the vesting period or sell them at fair market value for higher returns.
ESOPs are crucial in motivating employees to keep up their good work.
- ESOPs act as a better competitive package
When companies cannot lure in talents with handsome salary packages, ESOPs do the job for them. These companies can choose to offer their ownership alongside existing salaries and other facilities. Thus, ESOPs make the hiring process easy and assist in filling key positions without having to incur additional expenses.
- ESOPs help align personal objectives with the company’s objective
Earning a stake in the company’s ownership makes an employee feel part of the bigger family. This motivates them to work better for the employer’s progress. This aligns their personal goals with the company’s objectives and motivates employees to help the company attain success.
What Are the Benefits of ESOPs for Employees?
Alongside the benefits for employers, Employee Stock Option Plans are also beneficial for employees in a certain way. Here are a few points that detail the benefits of ESOPs for employees:
- ESOPs provide employees with a right to the company’s shares. Therefore they can enjoy ownership in the company they are working in.
- With ESOPs, employees can purchase company shares at a discount price than their fair market value.
- Employees can further sell these stocks at a higher rate and earn good profits from them.
- ESOPs work as an incentive to boost employee morale and improve their work efficiency.
- ESOPs also act as an additional source of income in the form of dividends and incentives.
What Are the Problems Associated with ESOPs?
Although ESOP comes with a good share of benefits, they also come with some problems. Here are a few problems or drawbacks with ESOP implementation for any business:
- Companies managing ESOP have to pay more legal and administrative fees than their counterparts. Therefore, ESOP may not be as cost-convenient as it seems at first glance.
- Organisations need to have professional staff to handle all operations related to ESOP. Else, they could be penalised for violation of regulations or risk issues.
- Companies that require additional funds should avoid ESOP as it leaves fewer shares to offer to the public.
- If the value of a company’s shares does not increase, ESOP will not attract employees as a profit-sharing plan.
- If the cash flow towards ESOP is too high, it can limit a business’s scope to reinvest its profits for a longer period.
What Are the Tax Implications of ESOPs in India?
The Income Tax Act 1961 provides the following two stages of taxation for Employee Stock Ownership Plans.
- Taxation while purchasing shares
Employees can buy shares after their vesting period is over at a price lower than the FMV of those shares, i.e., at the exercise price. The difference between the FMV and the exercise price is the employee’s profit. This is treated as a perquisite or a part of an employee’s salary income and taxed according to their applicable tax slab rate.
- Taxation at the time of selling or transfer of shares
The difference between the FMV and the selling price of the shares is considered capital gains at the time of transfer or sale of shares.
For capital gains from selling listed shares after 12 months of purchase, long-term capital gains (LTCG) tax is applicable at a 10% rate on gains above ₹ 1 lakh. On the other hand, if you sell these listed shares within 12 months of purchase, the short-term capital gains (STCG) will be taxed at a 15% rate.
In case of the sale of unlisted shares after 24 months of purchase, LTCG tax is applicable at a 20% rate. On the other hand, if you sell these unlisted shares within 24 months of purchase, the STCG will be taxed at the slab rate applicable to you.
To conclude, every employee must understand ESOPs, their working, features and taxability when choosing an employer. These can help make your package more attractive. Similarly, employers must be careful while handling stock options and remember the dos and don’ts before offering ESOPs in salary packages.
Frequently Asked Questions
What happens to ESOP after an employee quits?
If an employee quits before retirement age, they can withdraw their vested portion of shares to their regular account. They can also choose to encash them and take this money in equal instalments over some years.
What happens to shares when an employee is fired?
When a company fires its employees before the vesting period is over, employees lose all their rights from their vested shares.
What is the vesting period in ESOP?
The holding period of stock options within which employees cannot purchase or sell them to a fair market is the vesting period. Therefore, an employee must work for the organisation for the entire vesting period to rightfully own these stock options.