What is Employee Stock Ownership Plan (ESOP) – Benefits and Working

What is ESOP? 

ESOP (full form – Employee Stock Ownership Plan) is a type of employee benefit plan that gives employees an ownership stake in the organisation. The company sets aside a certain number of shares for its employees that is held with a trust. The shares are then allocated to individual employee accounts, based on the eligibility criteria set by the company. However, one important point to note is that ESOP shares are slightly different from equity shares because they are tied to a vesting period and a specific set of conditions. Employees can only encash these shares after serving a specified number of years in the company, at a predetermined price.

How Do ESOPs Work?

1. Shareholder Approval is Sought

Before a company launches an ESOP employee benefit plan, it must disclose it at its shareholders’ meet and seek their approval.

2. The Formula for Allocation of ESOPs is Decided

The company must decide how to allocate ESOPs to eligible employees. In general, the number of shares allocated is directly proportional to the number of years of service of the employee, their pay package, or a combination of the two.

3. The Company Establishes a Trust

The trust is known as an Employee Stock Ownership Trust (ESOT), which holds the shares the company has allocated to its employee stock ownership plan. Either the company can allocate new shares of its own stock or cash to buy existing shares.

4. Stocks are Allocated to Employees and a Grant Date is Decided

Stocks are transferred to individual employee accounts. The company then decides a grant date, which is basically the date on which the company and the employee enters into an agreement, giving the employee the right to own these shares at a predetermined price at a later date (and upon fulfilling certain conditions).

5. Employees May Also Have the Option to Make Voluntary Contributions

Based on the agreement and the price arrangement decided between the employer and the employee, an employee may even have the right to make voluntary contributions to their ESOP account. Shares are purchased with money deducted from their salary. 

6. Vesting Period is Set

The vesting period is the minimum time an employee must work for the company before they can take ownership of their ESOP shares allocated to their account.

7. Distribution of Shares

After an employee leaves the company, retires, or is eligible for a distributable event, shares allocated to their ESOP account are distributed to the employee, usually in the form of cash or company stock.

Note that in some cases an ESOP arrangement may also have a “Leaver” clause. If a departing employee decides to exercise this right, they are allowed to sell their ESOP shares back to the company at a fair market value.

Why are ESOPs Offered to Employees?

An employee stock ownership plan is generally launched to increase employee ownership interest in the company. It is often used as a tool to incentivise employees and retain top talent. ESOPs can also create a sense of ownership among employees and make them more aligned and sensitive to company goals and interests. ESOPs are generally seen as a win-win for both parties.

Benefits of ESOPs for Employees

More than acting as a source of reward for their accomplishments, ESOP is beneficial for employees in the following ways:

1. Greater Monetary Incentives for Employees

Once employees acquire a stake in the company at a discounted rate, they can sell these shares. They not only acquire ownership within their organisation, but they can also make massive profits through their ESOP shares.

2. Greater Employee Involvement

With an ownership stake, employees feel more involved and engaged. They also feel more confident about the company’s future prospects, since they feel they have a front-row seat to the company’s plans for the future and the direction it wants to take.

3. Passive Income

Most companies offer dividend payouts to their stakeholders. Thus, as employees own a stake in the company under ESOP, they can earn additional income through dividends.

4. Tax Benefits for Employees

One of the biggest benefits for employees is that the contributions to their ESOP accounts are tax-free. Tax is only levied when a company exits or retires from the company, and the distribution of shares takes place. Any gains that the shares have accumulated over time will attract a capital gains tax only at the time of the employee’s exit from the organisation.  

Benefits of ESOP for Employers

1. Employee Retention

ESOPs can act as an effective tool to attract and retain top talent for the company’s long-term growth. It incentivises staying within the organisation till the end of the vesting period, which is generally four years in India. Thus, by making them stakeholders, employers can ensure that they remain committed to the company’s interest in the long haul.

2. Improves Productivity

An employee who becomes a stakeholder stands to gain more when the company makes profits. By giving them a sense of ownership, employers can boost their workers’ productivity and generate higher revenue. 

3. Better Remuneration Mechanism

ESOP could be an effective employee benefit scheme for attracting and retaining high-quality employees, especially in the early stage of a company’s growth when they cannot afford to offer fat pay packages to their employees. However, with ESOPs, top talent can be attracted as they get ownership in the company and an opportunity to build something big!

ESOP Eligibility

According to Rule 12 of Companies (Share Capital and Debentures) Rules, 2014, ESOPs can be issued to:

• A permanent employee of a company working in or outside India
• A director of a company that includes full-time or part-time directors but is not an independent director
• A permanent director of India or a subsidiary outside India, or a holding company or affiliate. 

The company may not issue ESOPs to the following employees:

• A promoter or promoters of the company
• A director who holds 10% or more of a company’s issued shares, directly or indirectly, by himself, through a corporation, or through his relatives

However, the above conditions do not apply to companies for the first 10 years from the date of their incorporation.

Also Read

What is Employee Stock Ownership Plan (ESOP) – Benefits and Working

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Tax Implications of ESOPs

There are certain variables that one must keep in mind while calculating the tax implications of an ESOP. These include exercise date, fair market value, exercise price, taxable value, number of shares allotted, and total taxable perquisite.

Moreover, ESOPs can get taxed as per the Income Tax Act of 1961 in two ways:

1. When an employee exercises their right to buy their ESOP shares
2. When the employee sells ESOP shares after buying them

1. When Employees Buy Shares

After the vesting period, an employee can exercise their right to buy their ESOP shares at a rate lower than the predetermined Fair Market Value (FMV) of these shares. The difference between the exercise price of a share and its fair market value becomes a profit for the employee (known as employee perquisite), which gets taxed at the rate of the employee’s income tax slab.

Let us understand this better with an example:

Understanding the Calculation with an Example

Now, here is an important point to note. The government has relaxed the taxation rules on ESOPs for startups.

Employees, who exercise their right to encash ESOPs, need not pay tax on the ESOP perquisite immediately. In fact, the tax deduction at source (TDS) will be postponed to a later date. However, the date will be the earliest among the following:

• The employee’s date of exit from the company
• The date on which the ESOPs are sold
• Completion of 5 years from the ESOP grant date

2. When the Employee Sells Shares

If an employee who owns some ESOP shares decides to sell the shares, the difference between the fair market value (FMV) of these shares and the actual value of the shares on the date of selling, will be taxed.

The proceeds from the sale i.e. the capital gains will be subject to capital gains tax, depending on whether the shares were sold within 1 year of buying them (short-term capital gains tax) or after 1 year (long-term capital gains tax).

Short-term capital gains tax (STCG) is levied at a rate of 15% p.a., while long-term capital gains tax (LTCG) is imposed at a rate of 10% p.a., provided the capital gains from the sale exceed ₹1 Lakh.

Let us understand this better with two examples:

Understanding the Impact of STCG on the Sell of ESOP Shares

Understanding the Impact of LTCG on the Sell of ESOP Shares

Points to Note

1. Since the capital gains in this case exceeded ₹1 Lakh, LTCG was applied at 10%. However, for capital gains less than ₹1 Lakh, no LTCG would be applied.
2. On sale of ESOP shares from a foreign company in India, capital gains would be taxed at a similar rate.

What Happens to ESOP When Companies Get Listed?

If a company that issues ESOPs gets listed, it could enjoy more benefits and flexibility while cashing out these shares in the fair market. ESOP schemes in listed companies are called Employee Stock Purchase Schemes (ESPS).

SEBI guidelines allow listed companies to offer shares to their employees as a public issue.  Unlike ESOPs, ESPS allows employees to purchase shares at rates lower than that of the fair market. 

When to Encash ESOPs?

ESOPs can be encashed after retirement, death, or termination of services, provided the vesting schedule is over. The vesting period typically ranges from four to six years, after which an employee can exercise their right to encash.

However, if the vesting period is not over before resignation or termination, an employee will lose the unvested portion of their ESOP. For example, if an employee leaves after 2 years, and the vesting schedule is 25% every year, he or she will lose 50% of the ESOP shares alloted.

The best time to cash out, provided the company is listed, would be when the market is high and you have exited the organisation. For an unlisted company, you may have to wait till the end of the vesting schedule, provided you leave the organisation and the company has a policy of share buyback, at least at the fair market value rate of its shares. 

Disadvantages of Esops

Employee stock ownership plans, despite being a tax-efficient employee benefit program, do have some inherent disadvantages as follows:

For Employees

1. Timing

Timing the exit could be difficult since the value of an ESOP share may be dependent on company performance. If you exit the company when the share price is down or the market is in the grips of a recession, your payout could be much less than what you anticipated.

2. Limited to Fair Value for Unlisted Companies

An employee may not be able to get more than the fair value decided at the time of issue of these shares. This limits their chance to make a bigger profit.

3. Fluctuations

The market value could fluctuate wildly, meaning retirement planning, solely based on ESOP shares owned and vested by you, may be difficult. So, you will have to build a retirement corpus using other investment options, such as mutual funds, etc.

For Employers

1. Limited to Fair Value

By issuing these shares in the secondary market or through strategic investment, a company may be able to get better value. But since ESOP shares are capped at a fair market value, they may not be able to fetch as much value, if an employee decides to buy these shares.

2. May Affect Future Cash Flow

Depending on their terms mentioned in the letter of grant, an employer may be obligated to repurchase the shares issued to an employee as ESOP, at the time of their exit. This could affect the future growth and expansion plans of the company.

3. Increases Administrative and Legal Costs

To maintain a company’s ESOP pool, they need to set up a trust. Most companies outsource the management and administrative duties to third-party vendors, which increases their administrative costs. In addition, to set up and continue an ESOP program, various legal charges have to be paid. In case of violation, a company may need to pay hefty fines as well.

4. Ties Up Company aCsh

To set up an ESOP trust, a company may have to meet and maintain a certain cash reserve. This could limit the company’s future expansion plans, research and development, and reinvestment into the company.

5. Limit Borrowing Opportunities

Banks and traditional lenders often avoid lending money to companies with high debt ratios. ESOPs will appear as a negative equity on the company’s balance sheets and could spike up its debt ratio, thereby limiting its opportunities to raise debt from traditional lenders.

Also Read

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Different Types of ESOPs in India

Employee stock ownership plans offered by companies in India can be categorised as follows:

1. Employee Stock Purchase Plan (ESPP)

This is an arrangement in which an employee is granted company stock usually at a price lower than the actual market value of those shares. The employer decides on the specific date and price at which an employee can buy these shares.

2. Restricted Stock Award (RSA)

In this arrangement, shares are offered at a discounted rate to employees. However, along with company shares, an employee may also receive voting rights and certain other privileges, such as a regular dividend. However, this may depend on fulfilment of certain agreed upon conditions or goals. Non-compliance could mean that the employee may no longer be entitled to receive these shares. Typically, employees receive dividend payouts or bonuses during the vesting period.

3. Restricted Stock Unit (RSU)

This is an arrangement quite similar to an RSA. However, in this an employee doesn’t receive voting rights or dividends during the vesting period. Upon fulfilment of the conditions set by the company, an employee can exercise their right to these shares.

4. Stock Option Scheme (ESOS)

This is an arrangement in which an employee is not obligated to exercise their right to ESOP shares. However, if they choose, they can at a predetermined price, which is usually the fair market value of these shares. The right to exercise may be linked to the employee’s length of service or some other goal.

5. Phantom Equity Plan (PEP)

In this arrangement, an employee receives company shares in principle. On fulfilling the vesting criteria, they may receive cash from the company equivalent to the price appreciation of the shares above the grant price. A PEP resembles a bonus that an employee will be awarded at a future date decided by the company.

6. Stock Appreciation Rights (SAR)

This is quite similar to a PEP. No actual company shares are allotted. An employee only receives shares in theory, which means they cannot liquidate company shares at a time of their choosing. On fulfilment of certain criteria, the employee merely receives cash or real shares equivalent to the price increase of the SAR shares. Since an employee does not have the right to exercise shares, they also do not have to pay an exercise price.

Are ESOPs Good for Employees?

ESOPs are generally considered to be good for employees since it gives them direct leverage and a sense of ownership in the company, which can help boost their productivity. From a financial angle too, these are looked at favourably since employees generally get a bigger payout. However, an employee can really benefit from an employee stock ownership plan if it is set up by a company with a stable management and outlook. 

Final Word

Many Indian companies, especially startups, offer ESOPs to attract and retain employees. It can boost employee productivity and can translate into better company performance, which in turn can create better traction among employees and also growth for the company.

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