What is an ESOP? Meaning, Benefits & How Do ESOPs Work?

Today, the in-hand salary you receive is not the only mode of payment corporations use. They use various ways to incentivise your work and stay ahead of the competition. One of these modes includes a long-term incentive known as the Employee Stock Option Plan.

If this makes you wonder “what is ESOP?” and “why has it become so important as a compensation package?” Well, to answer these questions, stay tuned till the end.

What Is An ESOP?

Let's understand “what is an employee stock option?" Employee stock option plans are a scheme through which a company grants its employees the right to purchase its shares. The purchase is made at a predetermined price after the completion of the vesting period. This scheme is applicable under Section 2(37) of the Companies Act, 2013.

The scheme was created as a strategic compensation tool given by the company to its employees to retain, attract, and motivate them. This leads to aligning the employees' interests with the company’s long-term growth.

How Do ESOPs Work?

The Companies Act 2013 governs matters related to ESOPs in India. However, for some listed companies, it is governed by SEBI regulations. Here is how it works:

Company Grants Options

First, the company grants a fixed number of stock options to an employee. These options can be bought at a set price, also known as the exercise price.

For example, your company grants you 1000 shares, where each share has an exercise price of ₹100. Here, you have received the right to purchase, but do not yet own the shares.

The Company Sets A Vesting Period

After being granted a certain number of shares, options are not available immediately. Instead, they vest over time. This can be a minimum of 1 year according to the law.

In simple words, 25% of the total granted options vest after completing 1 year of service. Whereas the remaining 75% vest gradually over the next three years.

For example, if an employee is granted 1000 options, according to the rule, 250 can be exercised after 1 year. On the other hand, the next 250 can be exercised after the second year. This continues until full vesting in four years.

Exercising Options

You can now purchase the options at the exercise price. Let's say, for example, if 250 options have vested, where each has an exercise price of ₹100, you have to pay ₹25,000. After doing this, the company will allot 250 shares to you.

Selling Shares

After you exercise the ESOP and receive the shares, you become a shareholder. The next step is dependent on whether the company is listed or private.

In case your company is private, you cannot freely sell your shares. This is because there are no public markets. You have to wait for a buyback by the company or a funding round.

On the other hand, you are allowed to sell your shares on the market after the lock-in period if the company is listed on a stock exchange.

Benefits Of ESOPs For Companies

Now that we know what an employee stock option is, let us discuss some of the advantages of ESOPs for the Companies that are granting the options.

• Employee Retention: ESOPs are associated with vesting schedules, which motivate employees to remain in the company for a longer period of time and thus lower the employee turnover rate.
• Better Productivity: Employees, as shareholders, experience an "ownership mentality," which translates into their enhanced performance and accountability.
• Cost-effective compensation: ESOPs help companies, especially startups, to hire the best employees without necessarily paying them high cash salaries.
• Goal alignment: Employees are motivated to work toward the long-term growth of the company, as their personal gain is directly linked to the company's performance.
• Better company culture: ESOPs promote employee loyalty, collaboration, and a sense of shared purpose.

Benefits Of ESOPs For Employees

The following discusses the benefits of ESOPs for employees:

• Wealth-creation opportunity: ESOPs enable employees to profit if the value of the company’s shares appreciates over time.
• Ownership in the company: Employees are given a sense of ownership, which is an integral part of feeling they belong to the company.
• Long-term financial growth: ESOPs ensure that the employees have the opportunity for long-term financial growth, which is not possible with fixed salaries.
• Participation in company success: If the company is acquired or goes public, the employees can benefit immensely from the appreciation of the company’s stock.

Taxation Of ESOPs

Knowing what an employee stock option is will also help us better understand the taxation proceedings. ESOPs are liable to tax at two points in India:

At The Time Of Exercise

The difference between the Fair Market Value (FMV) and the exercise price is taxable as salary income, and the tax rate will be applicable as per your income tax slab.

Taxable Value = FMV - Exercise Price

At The Time Of Sale

When you sell the shares, capital gains tax is applicable on:

Capital Gain = Selling Price - FMV (on exercise date)

Short-term or Long-term tax liability will be applicable based on the holding period. Moreover, tax rates would also differ in the case of listed and unlisted shares.

Risks And Limitations Of ESOPs

ESOPs are often seen as beneficial for both employees and employers. However, it also comes with certain risks and limitations.

Market Risk

An ESOP becomes worthless when the company's market price falls below its exercise price. In such scenarios, exercising the ESOP does not result in any profit. Thus, defeating its value for the stakeholders (employees).

Liquidity Risk

In case a company’s shares are not listed on the stock market or it is a startup, it becomes difficult for the employees to sell their shares. Thus, in such cases, employees may have to wait for an IPO, an acquisition, or a buyback before they can sell their stock.

Tax Liability

Employees may have to pay taxes at the time of exercising the ESOP, even if they do not sell their stocks immediately. This results in a cash outflow without any actual profit.

Vesting Requirements

If an employee resigns from the company before the vesting period, any unvested stock is forfeited. However, a company may allow vested shares to be exercised within a designated period after resignation, under its policy.

Sources:

Investopedia