ESOP: Definition, Benefits, and How it Works

Employers offer ESOP or Employee Stock Ownership Plan to specific employees. It allows employees to own a particular portion of the company. Companies may provide shares with bonuses or profit-sharing agreements under ESOPs at low or no upfront cost.

Employees can encash these shares at the overall market value after a specific period. Shares offered by companies are kept in a trust until the employee retires or quits. This allows the share prices to grow and provide decent returns. Companies offering ESOP must adhere to the regulations of the Companies Act, 2013.

Now that you know ESOP let’s understand how it works.

How Do ESOPs Work?

Shares offered through ESOPs are kept safely in trust by companies for a specific period. This is known as the vesting period. Employees need to work in the company for the said vesting period to exercise their ESOPs. 

It is the sole prerogative of employers to determine the number of shares they want to offer and the allotment price of each share. The vesting period also varies from one company to another company. The date on which the vesting period ends and employees are eligible to avail ownership of stocks is called the vesting date. 

Once an employee completes the vesting period, they can buy stocks online at the allotted price, which is relatively lower than the market value. After this, one can sell ESOP shares to book profits or keep them as a long-term investment option.

On the other hand, if an employee leaves the company or retires before the vesting period, the company must buy back those shares from their employees within 60 days at the overall market value.

Why Do Companies Issue ESOPs?

Companies offer ESOP benefits to their employees as an added incentive to attract talent. This gives employees a sense of belonging in the workplace. It makes them believe that they are not mere workers but they partly own the company.

Another reason companies offer ESOPs is to retain the talent in their organization. IT companies, in general, have a high attrition rate, so to tackle that problem, companies offer ESOPs with a vesting period. This means that employees will have to continue working in the organisation to avail ESOP benefits.

Offering shares in a company to its employees also has psychological benefits. Employees will work for the organisation with complete diligence and motivation. It will improve their productivity and also help the company grow. 

Benefits of ESOP for Employees

Here are some benefits of ESOP for employees:

• Ownership

Individuals or employees will get direct ownership of the company. Also, they will receive shares at a lower price than the market price. Employees will enjoy all benefits of a shareholder. 

• Dividend

Shareholders earn dividend income for shares owned by them. Thus, employees receiving shares as a part of ESOP are entitled to dividend payouts.

• Wealth creation

After completing the vesting period, employees can buy shares at an allotted price. They may use these shares as a long-term investment plan and book profits. This is a good option for wealth creation in the long term. Many examples of company founders and employees becoming millionaires after selling their allotted ESOPs. 

Taxation of ESOPs in India

ESOPs are taxed under two heads as per their end use:

• As a perquisite

Employees exercise ESOPs. They are subject to taxation as a gratuity. The taxable amount is the difference between the market value of stocks on the day of exercise and the price at which an employee buys their ESOP. This is added to an employee’s income and taxed per the slab rate. 

Here is an example of taxation of perquisites in an ESOP:

The amount gets added to the individual’s taxable income for the year and is taxed according to the applicable slab rate. 

The government has relaxed tax implications related to ESOPs for start-ups. Employees holding ESOPs do not have to pay tax under perquisites in the year it was exercised. The government has deferred taxation up these dates (whichever comes earlier):

• End of 5 years from the date of ESOP grant
• The date on which the holder sells their ESOPs
• Date of quitting the company
• Taxation at the time of sale of shares 

• Capital gains

Shares received by employees under the employee Stock ownership plan can be traded on stock exchanges. Any gains from the sale of such shares will come under capital gains. These gains are subject to short-term capital gains tax or long-term capital gains tax as per the holding period.

The holding period is the total time from the exercise date to the selling date. If this duration is less than 12 months, any gains from the sale of these shares are taxable as STCG and taxed at 15%. 

However, if the holding period is more than 12 months, an employee is liable to pay long-term capital gains tax at 10% without indexation benefit. However, LTCG of up to Rs. 1,00,000 are tax-exempt. 

Why are Start-ups Keen to Offer ESOPs?

Start-ups offer these benefits to attract quality talent to their organization. As these companies face a financial crunch and cannot pay a lucrative salary package, they use ESOP to make the pay structure more competitive.  

What Will Happen to ESOP Once a Company is Listed?

In the case of ESOPs of unlisted companies, employees may find it difficult to sell their shares as there may be few buyers for that particular stock. However, when a company is listed on the stock exchange, employees may find quick takers for their shares. 

After listing a company, employees may choose to sell their shares at the listing price and book profits. Moreover, they may also wait and use the shares as a long-term investment option, which will allow them to accumulate wealth over time. 

Final Word

ESOPs – Employee Stock Ownership Planare a very lucrative employee benefit plan that allows them to be a worker and owner of the company in which they are working. However, the vesting period associated with these ESOPs is a minor hindrance as it will bind the employees with the company. Therefore, one must consider the vesting period, taxability, and allotted price and quantity before going for these options. 

Frequently Asked Questions

• What problems do employers face while issuing ESOPs?

The biggest problem of ESOPs for employers is the cost of managing them. Companies offering ESOPs must have advisors and third-party administrators for proper oversight. Once a company has institutionalized ESOPs, it will have to bear legal costs, expenses of trustees, etc.

• What are the things that one must consider while opting for ESOPs?

Employees must consider the vesting period and allotment price of shares before opting for the ESOP. If the allotment price is closer to the fair market value, then it may not be a feasible option to go for ESOPs. 

• What is the minimum lock-in period for ESOPs?

As per the SEBI mandate, the minimum lock-in or vesting period of ESOPs is one year. The higher limit may vary from one company to another. 

• Who is a permanent employee for the issue of ESOPs?

The term permanent employee is not defined in any Act or regulation guidelines. However, any employee who has completed the probation period may be treated as a permanent employee for practical purposes. 

• Who is not eligible for the issue of ESOP?

Promoters or individuals belonging to promoter groups are not eligible for ESOPs. Moreover, any director who holds more than 10% shares directly or indirectly is not suitable for an Employee Stock Ownership Plan.

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