What is Employee Stock Ownership Plan (ESOP)?

ESOP

ESOPs, or Employee Stock Ownership Plans, incentivize employees by offering company stocks, fostering a sense of ownership and responsibility. Employees can redeem these shares after a set period, promoting alignment with company success.

This shared ownership enhances motivation, productivity, and commitment to long-term goals. ESOPs serve as both an employee benefit plan and a corporate finance strategy, empowering workers and fostering a culture of excellence.

What is ESOP?

An employee benefit plan where the employees receive an ownership interest in the company primarily in the form of stock shares is known as an employee stock ownership plan or ESOP shares.

ESOP shares encourage the employees to perform to their optimum capabilities because they know that the company's success will be financially rewarding for the employees too. It also helps employees feel valued for their work and get better rewards. 

ESOPs are a way to push employee compensation beyond basic pay. Companies typically tie plan payments to vesting, which gives employees long-term rights to employer-provided assets. Other versions of employee ownership include direct purchase programs, stock options, restricted stock, phantom stock, and stock appreciation.

The main objective of ESOP shares is to motivate the employees and align their interests with other company stakeholders. From a management perspective, an ESOP provides certain tax benefits and motivates employees to focus on company performance.

Features of ESOP

• ESOPs are typically included in an employee's compensation package without cost to them. They are integrated into the Cost to Company (CTC) structure.
• Two key dates in ESOPs are the Vesting Date, when employees can convert ESOPs into company shares, and the Grant Date, when the ESOP agreement is formalized.
• Employees have the flexibility to exercise their ESOPs fully or partially.
• Employers decide which employees receive ESOPs based on their recruitment strategy.
• ESOPs can be exercised gradually over a specified period.
• The price for purchasing company shares through ESOPs is called the Exercise Price or Grant Price.
• While exercising ESOPs isn't mandatory, employees are typically obligated to do so after the vesting period.

ESOP Eligibility

Every employee, except directors and promoters holding over 10% equity, is eligible for ESOP if they meet any of the following criteria:
• Full-time or part-time Director of the Company.
• Current employee of the Subsidiary, Associate, or Holding, whether based in India or abroad.
• Permanent employee working in an Indian or Foreign office of the company.

How does an ESOP work?

An organization grants an ESOP to an employee to a specified number of company shares at a specified price after the option period (a specified number of years) expires. A predefined vesting period must elapse before the employee can exercise the option. The vesting period implies that the employee must work for the company for a pre-decided minimum term until they can exercise some or all of their stock options. 

The employer decides the number of ESOP shares that any employee gets. During the vesting period, the offered ESOPs lie with a trust fund. Once the vesting period expires, the employee will be entitled to exercise their ESOP. The date on which the vesting period expires is called the vesting date. Employees may exercise an ESOP to purchase company stock at an allotted price below market value. Employees can also sell their ESOP shares to earn profits.

The company has obligations to buy back the ESOP shares at a fair market price within 60 days if the employee leaves the organisation or resigns before the end of the vesting period. 

Advantages of ESOPs

ESOPs provide benefits to both employees and employers. 

Advantages of ESOPs for employees

1. Stock ownership: ESOPs give employees the right to hold a part of the company’s share capital. With ESOPs, they can enjoy the ownership benefits in the company under which they are employed.
2.  Dividend income: Companies distribute a part of their profits as dividends to their shareholders. Since ESOPs allow the employees stock ownership, they can earn additional dividend income.
3. Opportunity to buy shares at a discounted rate: Employees pay a nominal amount to buy the shares while exercising the ESOPs allotted to them. Thus, allowing them to invest at an advantageous rate over others. 

Advantages of ESOPs for employers

1. Employee retention: Employees holding the ESOP must wait till the vesting period before exercising their ESOPs. This measure makes employee retention easier.

2. Increase in productivity: The ownership opportunity in the company captivates the employees to gain from the company’s profits. It can potentially increase employee productivity and consequently benefit the company.

3. Attract talents: ESOPs act as an additional compensation that attracts and retains employees. Often, the ESOP option compensates for low packages in start-ups.

ESOP Up-front Costs and Distributions

Typically, companies do not charge anything to employees for ESOP ownership. The company can hold the offered shares with a trust for security and growth until the employee decides to part ways with the company.

Companies often tie plan distributions to vesting to entitle employees to company assets. They typically earn an increasing percentage of equity for each year of service.

When a fully vested employee retires or resigns, the company "buys back" the vested shares. Depending on the plan, the company pays a lump sum or an equal periodic payment. When a company buys shares and pays employees, the company redistributes or voids the shares. Employees who voluntarily leave the company do not receive shares and are paid in cash only.
 

How to Cash Out of an ESOP?

Vesting does not give employees the right to cash out their ESOP at any time. It is possible only when you resign voluntarily, retire, pass away, or become disabled. A penalty is often involved if you cash out your ESOP share before maturity. The ESOP plan’s guidelines mention the withdrawal specifics.

Tax implication of an ESOPs?

ESOPs are taxable in the two below-mentioned instances.
1. When the employee exercises their rights and buys the company’s shares. When an employee exercises an option, the difference between the fair market value (FMV) at the time of exercise and the exercise price is taxed as a fringe benefit.
2. When the employee sells their shares. A capital gain tax is imposed based on the holding period. The holding period refers to the time between the exercise date and the sale date.

What is an example of ESOP?

ABC Corporation rolled out the ESOP scheme for the key managerial personnel under which the eligible employees shall have to continue the employment agreement for three years. After three years, the employee can leave and sell the shares.

The ESOP scheme is put before the eligible personnel, and they have given three months to decide whether to opt in or not. The exercise price was INR 400, and the market price of the shares was INR 500. The shares will be issued after one year and employees have three months period to decide. The expected market price is INR 1000 after 3 years of the declaration of the scheme.

In this case, ESOPs will be taxed in two ways-

1.    At the time of issue of shares, i.e., after 1 year of declaration and they are to be taxed as perquisite under salary.
Perquisite = Market Price – Exercise Price
●    Perquisite  = INR 500 – INR 400
●    Perquisite  = INR 100

2.    At the time of sale it will be taxed under capital gains, which are calculated as under 
Capital Gain = Expected Market Price – Market Price at the time of Exercising the Option
●    Capital Gain = INR 1000 – INR 500
●    Capital Gain = INR 500
 
 

Conclusion

In conclusion, ESOPs offer several benefits to salaried employees. ESOPs provide an opportunity for wealth creation by increasing equity exposure in one's financial portfolio, allowing for long-term wealth accumulation. Additionally, ESOPs foster a sense of ownership and belongingness with the company, as employees directly contribute to its growth and share in its success.

Furthermore, ESOPs provide flexibility in timing investments, allowing employees to maximize profits by exercising options when market prices exceed the grant price. Overall, ESOPs can be a valuable tool for employees to enhance their financial well-being and align their interests with the company's success.