What is ESOP? Full Form, Meaning, Taxation, Shares

In today’s startup and corporate ecosystem, equity-based compensation has become a valuable tool for attracting and retaining top talent. ESOPs (Employee Stock Ownership Plans) not only offer potential upside as a shareholder but also help employees build long-term wealth, provided they understand the vesting terms, tax rules, and liquidity risks.

This guide explores ESOP meaning, their types, taxation, and how to plan around them for financial stability and growth. 

What is ESOP?

The ESOP full form is the Employee Stock Ownership Plan. It is an employee benefit plan where employers offer their employees stock ownership in the company. Instead of immediately offering the stock, they grant them the right to exercise this option at a pre-determined date. 

Depending on the employer, the stock can be offered at a discounted price or at no extra cost. Since they offer partial ownership, an ESOP aligns the employees’ interests with the company’s long-term success. However, they may not be granted to all employees, and the employer has the right to choose the beneficiary employees with certain eligibility criteria. 

How Do ESOPs Work? What is the Vesting Period in ESOP?

To grant ESOP benefits, the employer decides the total number of shares and the ESOP share price at which they shall be allotted to selected employees. The employer also determines a vesting schedule and vesting dates at which the employees can exercise their right to avail of the shares.

Meanwhile, the stocks are transferred to a trust fund for a specific period, also known as the vesting period, which usually lasts a few years. The employee must remain in the company during this period. If they leave before it ends, they lose their right to any unvested ESOP.

On the ESOP vesting date, if the employee decides to take the stocks, they can buy them at the pre-determined price, which is usually lower than the market price. If they leave before the entire vesting period is completed, they typically forfeit any right to unvested ESOPs. For shares that have already vested by their departure date, the employee can exercise their option to buy them at the pre-determined price, as per the terms of their ESOP agreement. The company’s policy, outlined in the ESOP scheme documents, will determine the process and timelines for exercising these vested options and any applicable conditions or obligations for the company to buy back such vested shares, especially in unlisted companies.

Also, ESOP accounting treatment helps recognise the fair value of stock options as an expense over the vesting period in the company’s financial statements.

Types of ESOPs

A company can offer different types of ESOPs to its employees. The most common ones include-

Employee Stock Option Plan (ESOP)

This is the most common type of ESOP. This ESOP stands for employee stock ownership plan. Under this ESOP policy, the company gives employees the option to buy shares at a fixed price after the vesting period ends. 

However, it may be contingent upon achieving certain performance milestones during this period. Once vested, the employees gain full ownership of the stock along with voting rights and entitlement to dividends. 

Also, clear and transparent ESOP accounting provides investors with a true picture of potential dilution and long-term liabilities. 

Employee Stock Purchase Plan (ESPP)

What is ESPP? Under ESPP, employees can buy shares at a discount price, usually lower than the market price. The price of the share is paid through regular payroll deductions for a specific period. These plans often have a defined purchase period and pricing mechanism.

Accurate ESOP valuation helps assess the financial impact of stock-based compensation and supports transparent reporting.

Restricted Stock Units (RSUs)

RSUs are company shares granted to employees as a reward or compensation. They are subject to vesting conditions, but unlike ESOP, employees do not have to buy these shares. The units are vested over time, but the employees receive the actual shares only upon the completion of the vesting period.

Stock Appreciation Rights (SARs)

SARs give employees the right to earn profits from the company’s stock price appreciation without actually purchasing the shares. The gains are paid in cash or stock equal to the appreciation value, making it a risk-free benefit for employees.

ESOP Taxation in India

ESOPs attract dual tax implications. The employee must pay taxes both when exercising their ESOP rights and when selling the shares. 

ESOP Taxation at the Time of Exercise

When employees exercise their ESOPs, the difference between the fair market value (FMV) and the exercise price of the share is liable to income tax. It is treated as a perquisite, and the amount is taxed as salary income as per the tax slab of the employee. 

For example:

A company, X Pvt. Ltd., grants ESOP to its employees with the following details:

Exercise price – ₹50 per share

FMV – ₹125 per share

No. of Shares Exercised – 1,000

Prerequisite = FMV – Exercise price

= ₹125-₹50

= ₹75* 1000 shares

= ₹75,000

Now, this ₹75,000 shall be taxed according to the income tax slab of the employee.

Taxation At The Time Of Sale

When employees sell their ESOP shares, the difference between the FMV on the date of exercise and the selling price is subject to capital gains. In India, the tax on the perquisite value (difference between FMV and exercise price) is generally applicable at the time of exercising the ESOPs. However, for employees of specific ‘eligible startups’ as defined by the Income Tax Act, there’s a provision to defer the payment of TDS on this perquisite value for a specified period or until they leave the company or sell the shares, whichever is earliest. This deferral applies to the TDS payment, not necessarily the tax liability itself accruing at exercise. For most other employees, the perquisite is taxed as part of their salary income in the year of exercise.

When selling shares acquired through ESOPs:

• For Listed Shares: If you sell listed shares within 12 months of exercising your ESOP (date of allotment), the profit is considered Short-Term Capital Gains (STCG) and is typically taxed at 15% (plus applicable cess and surcharge).
• For Unlisted Shares: If you sell unlisted shares within 24 months of exercising your ESOP (date of allotment), the profit is considered Short-Term Capital Gains (STCG) and is added to your total income, taxed at your applicable income tax slab rate.
• For Listed Shares: If you hold listed shares for more than 12 months from the exercise date before selling, the profit is Long-Term Capital Gains (LTCG). LTCG exceeding ₹1 lakh in a financial year is taxed at 10% (plus applicable cess and surcharge), without indexation benefit.
• For Unlisted Shares: If you hold unlisted shares for more than 24 months from the exercise date before selling, the profit is Long-Term Capital Gains (LTCG). LTCG from unlisted shares is taxed at 20% after allowing for indexation benefits (or 10% without indexation if certain conditions are met, though 20% with indexation is more common).

Pros and Cons of ESOP

Issuing ESOPs has its own advantages and drawbacks. Here is an overview:

Advantages of ESOPs for Employees

• ESOPs give employees part ownership in the company they work for, aligning their interests with the company’s growth.
• It gives you an opportunity to earn dividends and cast voting rights in the company.
• Since the share price is discounted, you get it for less than the market price.
• If the company shows significant growth, you can sell the shares upon retirement or when you leave the company at a huge profit.

Limitations of ESOPs

• If the market price of the shares falls in the future, you may end up with a loss. Investors usually evaluate the size of the ESOP pool to understand potential dilution before committing to funding.
• Being able to exercise ESOP right means you may have to stay in the company for several years.
• It is difficult to sell shares of an unlisted company as compared to a listed company.
• Dual tax implications increase the tax burden. 
• TDS on ESOP is applicable at the time of exercise, and the employer is responsible for deducting tax based on the perquisite value of the shares.

What is ESOP Buyback?

ESOP buyback happens when the company decides to buy back the vested shares from its employees at fair market value. It could be part of the original granting condition or contingent on employee exit. In the case of unlisted companies, it helps them to prevent dilution of ownership after an employee leaves the organisation. 

On the other hand, employees get cash for the increased value of vested shares, creating a win-win situation for both.

Difference between ESOP and Other Employee Benefit Plans

Management Stock Option Plan vs. ESOP

MSOPs are similar to ESOPs but are only granted to the company’s top management. The vesting period for MSOPs is also longer and often tied to achieving certain performance metrics to meet the long-term goals of the company. 

While ESOPs can dilute the ownership as they can be given to any employee, MSOP concentrates it on the top management. 

RSU vs ESOP

RSUs are granted to employees for free as a reward and are not required to be purchased. ESOPs, on the other hand, are purchased by employees at a discounted price if they exercise their option to avail it. 

The main difference between ESOP and RSU is that while ESOPs offer employees the potential for higher gains if the stock price rises, RSUs provide guaranteed ownership without upfront costs.

Sweat Equity vs. ESOP

Let’s understand the difference between sweat equity and ESOP. Sweat equity is often given to a company’s founders or employees in exchange for their time, efforts, and skills. It is ownership in the company instead of salary compensation. ESOPs, on the other hand, are given to retain employees and are part of their compensation along with salary. 

While both are forms of equity compensation, one key difference often highlighted is their primary purpose: ESOPs are generally broad-based plans aimed at retention and rewarding a wider set of employees, often with a structured vesting schedule. Sweat equity is typically issued to founders, directors, or key employees for their valuable contributions, know-how, or intellectual property rights. While sweat equity can also be subject to vesting conditions or lock-in periods as per the agreement or company policy to ensure sustained value creation, the terms can be more bespoke than standardised ESOP schemes.

ESOP vs ESPP

What is ESPP? ESPP enables employees to gain shareholding in the company at a discounted price through a payroll deduction. On the other hand, employees get the right to buy shares in ESOP at a pre-determined price, which may not always be less than the market price. ESPPs are more common in listed companies, making it easier to buy and sell company shares. 

Conclusion

ESOPs present a powerful way for employees to build wealth while actively contributing to their company’s success. With proper understanding and planning, employees can leverage ESOPs to secure financial growth and long-term stability. 

However, stock ownership comes with risks, including market fluctuations and tax liabilities. Diversifying investments, staying informed about tax implications, and seeking professional advice can help employees make the most of their ESOP benefits.

If you need help managing your wealth, including ESOPs and other investments, you can talk to our experts at Scripbox for smarter financial planning. 

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