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An ESOP or an employee stock ownership plan is a strategic employee benefits plan. It is designed to reward employees with an ownership interest in the company. In other words, it is a profit-sharing plan devised by the company to align the interest of its employees with that of its shareholders. 

Simply you can understand ESOP as a corporate finance strategy that a company uses for the benefit of its employees. Firstly, a trust fund is set up by the company. Then the company contributes new shares of its stock or borrows cash to buy its existing shares. Next, the company’s employees and other participants receive several tax benefits from ESOPs.

ESOPs are used by companies of all sizes, from startups to blue-chip ones. They aid succession planning by allowing company employees the opportunity to buy its stocks.

What is an ESOP?

An ESOP (Employee Stock Ownership Plan) is an employee benefit plan. Employees can enjoy an ownership interest or stake in the organization through them. 

Companies may issue Employee stock ownership in three ways, i.e. as direct stocks, profit-sharing plans, or bonuses. Under the scheme, an employer allocates a certain percentage of the company’s stock shares to their eligible employees at no upfront cost. These are issued at the sole discretion of the employer. The parameters may be based on the employee’s pay scale, designation, terms of service, or other allocation parameters. 

However, these options can be purchased at a specified price before the exercise date. Employers abide by the rules and regulations laid out in The Companies Act, 2013. Companies must follow these rules when granting Employee stock ownership plans to their employees.

The shares which the company allocates are held in a trust unit set up for the purpose. The trust serves as an avenue for the safety and growth of the stocks until the employee exits the company or retires. After the exit of an employee, the shares are bought back by the company for further distribution to other employees.

ESOPs give employees ownership in the company and such companies are known as employee-owned corporations. However, unlike worker cooperatives, companies do not distribute the capital evenly in ESOP.  Therefore, senior employees are allocated more shares than newly hired employees. As a result, they enjoy less voting power during shareholder meetings.

It is important to understand the following terms related to ESOP’s:

Option:

It means a stock option granted under the Employee Stock Options Plan. It comprises a right but not an obligation granted to an employee under the Plan. Under which the employee can apply for and be allotted Shares of the Company at the Exercise Price during or within the Exercise Period.

Grant of Options:

It is the issue of the right by the company to its employees to buy its shares.

Vesting:

Vesting is earning the right by the shareholder to exercise the options.

Exercise:

It is the act of an application made by the Employee to the Company for the issue of Shares against the Options vested in him, upon payment of the Exercise Price. Exercise can take place only after the specified Vesting Period.

Eligible Employee: 

An employee who qualifies for the issue of Employee Stock Options under the ESOP scheme. An employee should fulfill the minimum criteria of service duration, pay scale, or any other conditions as decided in the appraisal process.

Vesting Schedule:

The vesting schedule provides all details of the vesting of options granted under the ESOP Plan. It states the vesting period and the percentage of the total options granted that can be exercised upon completion of the vesting period.

Exercise Price:

The price paid to convert the options into shares.

Market price:

It is the closing price of a share on a given date on the stock exchange on which the shares of the company are listed.

Vesting Period:

It is the period that an employee has to wait to earn the right to exercise his options.

Exercise Period:

The period after the vesting period, an employee has to exercise his/her options within this period.

Intrinsic value:

It pertains to the excess of the market price of shares as part of ESOS (employee stock option scheme) over the exercise price of the option. It includes the upfront payments if any.

Amortization:

An accounting procedure according to which the cost or value of an asset gradually reduces through periodic charges against income.     

Share Price:

It is the market price of the stock on a given date.

How Does ESOP Work?

A company grants ESOPs to its employees for buying a specified number of shares at a defined price. The employee can buy the shares after the option period (a certain number of years) known as the vesting period. Before an employee can exercise his option, he must undergo a pre-defined vesting period. In other words, the employee has to work for the organization until he can exercise a part of the entire stock options allotted to him or her.

To create an Employee Stock Ownership Plan, firstly the company must create trust. The company contributes its new shares or cash to buy the existing stock to this trust. These contributions are tax-deductible up to specified limits. Next, the company may issue these shares to all eligible employee accounts. The allocation is generally done on the basis of years of service, or in proportion to compensation. Sometimes the employer may even take both criteria under consideration when calculating the allocation percentage. New employees can usually avail the benefits of the plan and start receiving allocations after completing at least one year of service or probation period.

Exercising ESOP

The shares in an ESOP must vest before employees are entitled to receive them. Vesting refers to increasing the rights of employees on their shares. Their rights may increase as they accumulate seniority in the organization.

When employees who have been allocated ESOPs leave a company, they are eligible to receive their stock. Private companies usually buy back the departing employee’s shares at fair market value. They are bound to do so within 60 days of the employee’s departure. An annual stock valuation is mandatory to determine the price of the shares. In case some long-standing employees are exiting the company and the prices of shares held by them have accumulated substantially. Then the company needs to arrange enough money to pay for all the share repurchases.

We can understand this simply as an attempt to ensure certain employees never leave the organization. Consider if a company plans to give an employee ESOP and he decides to quit his job with the company in a few months. In such a case the company is at loss, therefore the company puts ESOPS in a vesting period. This means the company issues ESOPs to the employee over a period of time. By doing this they ensure the employees do not misuse the benefits of ESOPs. In India generally, the vesting period is 4 years. The company does not hand over the ESOPs it wants to issue to an employee at once. Instead, they distribute it over these 4 years.

Another perspective on ESOP distribution states that a company does not want its employees to work only to avail ESOP. So these companies may replace yearly vesting with quarterly. Thus ESOPs are distributed to eligible employees every three months. 

ESOP as a HR Tool

Beyond financial planning, this serves as a strategic HR tool for companies. They are able to address the following issues through ESOP:

  1. Reduce attrition rate: Since employees can exercise the ESOPs only after completion of their vesting period, they do not leave the company. Employees try to stick with the company at least until the time they can exercise their ESOPs.
  2. Motivation to improve performance: Since the value of the ESOPs depends on the company’s value of shares in the longer-term, it motivates employees to keep it going up. The valuation of company shares depends on the work of its employees, so they work hard to keep the share prices up.

Why Do Companies Issue ESOP?

Organizations issue Employee stock ownership plans as a tool for attracting and retaining high-quality employees. They usually distribute the stocks under the plan in a phased manner. For instance, the company may grant the stocks at the close of the financial year, therefore it acts as an incentive for the employees. The employees are thus bound to remain with the organization throughout the year for receiving the grant. 

Companies offer ESOPs with a long-term objective. They are able to retain their employees for a longer-term by making them the stakeholders of their company. This is applicable for most IT companies as they have alarming attrition rates. Similarly, Startups offer ESOPs to attract high-performing talent. As most of these firms are cash-strapped they are unable to lure experienced talent through handsome salaries. They use the plan to offer competitive compensation packages to quickly fill up key positions. Offering a stake in their organization, they ensure the dedication of the employees towards the growth of the company. To sum it up, an employee stock ownership plan offers a sense of ownership to the employees in the company. They start performing for the benefit of stakeholders as they are one among them.

Firstly, Employee stock ownership plans benefit employees and the company buys shares of a departing owner. Secondly, employee stock option plans can be also used to borrow cash at a lower after-tax cost. The trust can borrow cash, which can be used to buy company shares or shares of existing owners. A company can issue new or treasury shares and deduct their value from taxable income.

Find Income tax payable using: Income Tax Calculator

Advantages of ESOP for Employees

Stock options are a reward for employee loyalty. They have proven to be great incentives for the continuous association of the employees with the organization. The ongoing benefits motivate employees to work harder. 

Following are the key benefits of ESOP for employees:

  • Employees get the benefit of acquiring company shares at nominal rates. 
  • Upon selling the ESOPs (after the vesting period), they make a grand profit. 
  • They enjoy a proportion of the company’s profits along with the founders of the company.
  • Employees do not have to bear any upfront costs.

Tax on ESOP for Employees

Companies usually keep the stocks in trust for safety and growth. Employee stock ownership plans are taxable as perquisites. This means employees are liable to pay tax when they exercise their options. Taxes are applicable in the following cases:

  • While exercising- The amount of difference between the exercise price and Fair Market Value (FMV) as on the date of exercise is taxable.
  • While selling- Capital Gains Tax is also applicable in case the employee sells his shares at a price higher than the FMV on the exercise date. The capital gain tax is applicable as per the period of holding i.e. STCG or LTCG. The period of holding is calculated from the date of exercise up to the date of sale. 

Equity shares listed on a recognized stock exchange are liable for capital gain taxes. If the holding period is more than 12 months i.e. 1 year it is considered long-term. They are liable to LTCG (long-term capital gains) tax. In case the holding period is less than 12 months, it is then considered as short term. These are liable to STCG (short-term capital gains) tax. The taxes are levied as per prevailing tax rules.

Why Start-Ups Are Keen on Offering ESOP?

The benefits of ESOPs are not limited to the workforce, instead, the pastures are greener for employers. Start-ups are keen on the idea as it gives them an edge to attract well-experienced employees. The scheme offers ownership interest to the workforce and increases their participation in the company. As the company grows, the value of its shares rises and the concept of future gains instills ownership in employees. Start-ups leverage this concept of ownership to motivate their workforce to work towards building the company.

Employee motivation, retention, and reward are the key objectives of ESOP. Employers also enjoy some noteworthy advantages too. Start-ups are low on cash and it helps them avoid monetary compensations as a reward, thus reducing immediate cash outflow. ESOPs are more feasible reward options for startups looking at expansion as employees perceive them to be of higher value.

Why Start-Ups Buyback ESOP from Employees?

Start-ups have recently been on an employee stock ownership program buyback spree. The intention was to acknowledge employee efforts during the pandemic. Instead of handing over cash rewards, companies gave their workforce a wealth creation opportunity. Buyback of vested shares by the start-ups strengthens the employee’s confidence in the company. Consequently, it motivates them to perform better as the company rewards their efforts.

How to Manage Your Funds Post Buyback?

Managing funds received from an ESOP buyback may be overwhelming for employees. A large amount of liquidity calls for smart investment decisions and professional wealth management

The following tips will help you take control of your finances:

  1. Firstly, take stock of your financial needs and take control of your financial future.
  2. Secondly, plan your long-term and short-term goals.
  3. Thirdly, focus on investments rather than expenses.
  4. Fourthly, calculate your risk-taking ability and diversify your investments accordingly.
  5. Fifthly, consider your retirement requirements too.
  6. Lastly, calculate your tax obligations.

While some of the above steps are easy to follow, you will need professional help for other important ones. Opt for experienced professionals who can help you get the best returns from your ESOP buyback funds. 

How Does Scripbox Wealth Management Help in Planning?

Scripbox offers professional wealth management services where you can get hassle-free assistance round the clock. Our end-to-end fund management services are built to relieve you from the pressure to invest right. Our experts make all investment suggestions and tax calculations after carefully understanding your financial needs. Though the investment decisions are based on your requirements, they share all product details with you for your better understanding. They also advise you throughout the investment duration while offering an option to review your investments periodically over the Scripbox App.

Following are the main features of Scripbox Wealth Management services:

1. One view of all your wealth: All your investments including those in mutual funds, Indian and US stocks, FDs, and Real Estate are available on a single platform. Beyond monitoring all your wealth from one place, you get insights on how to make the best of it.

2. Wealth management for your entire family: The platform allows you to view and manage your entire family’s wealth. Our intuitive dashboard makes information of all related investors available in just a click.
3. More investment options: We have launched an all-new Invest tab to offer you more options. You can either choose the Scripbox Guided Path or opt for financial products of your choice. The Scripbox Guided Path feature recommends the right asset allocation and financial products suited for your needs. It also automatically rebalances your portfolio.

Contact our expert wealth management advisors today to efficiently invest your funds received after an ESOP buyback and get better returns. 

Key Takeaway

ESOPs are not the only forms of employee ownership instruments. Other financial instruments such as stock options, restricted stocks, phantom stocks, and stock appreciation rights are also available. However, ESOPs are the most preferred among these as they are beneficial for both companies and their workforce. Employers and employees with a long-term objective prefer ESOPs over others as it aligns employee and stakeholders objectives. Thereby, ESOPs contribute to the growth of both the individual and the company.