Employee Stock Ownership Plan (ESOP)- Learn The Fundamentals

Today, there are myriad ways to compensate employees for their hard work and effort. One such method is providing employees with the option of ESOP i.e. Employee Stock Ownership Plan. When it comes to employee compensation and benefits, ESOPs have become increasingly common. Today, companies of all sizes offer ESOP options as a type of compensation for employees. 

Thus, it's ideal that one should understand what is an ESOP, how it works, and what benefits it holds. All this and more is discussed in detail here. 

What is ESOP?

ESOP stands for Employee Stock Ownership Plans. It's an employee benefit where stock ownership is offered to employees.

Employers offer company stock at a discounted price (or no additional cost) to current employees. Employees can encash this stock after a specified period of time at a specified price. An ESOP plan covers all terms and conditions related to the acquisition and sale of ESOPs. 

The primary reason behind offering an ESOP is to reward employees and incentivize them to stay with a company. Simply put, it is an employee benefit plan that encourages employees to work harder for the company, because any monetary success the company enjoys in terms of stock gain will directly benefit the employee as well. It also helps keep stock ownership in the control of stockholders who are employees. 

For employees, these stock options are a way to receive additional compensation for their hard work - beyond the usual salary. Any increase in the stock price will lead to an increase in the compensation for the beneficiary employees. 

In India, multiple companies have offered ESOPs, such as Flipkart, Swiggy, Zomato, etc. 

How Does an ESOP Work?

Before offering ESOPs, employers decide the following things: 

• The number of company shares to be offered
• The price at which the company shares will be offered
• The beneficiary employees. Not all employees are offered an ESOP option. Companies select the list of employees who will receive ESOP options based on a set of criteria (that differs from company to company).
• The duration of the vesting period

After offering ESOPs to employees, the stocks remain in a trust fund for a particular period of time. This is referred to as the vesting period. Employees need to remain with the organization for the entire duration of the vesting period before exercising the stock option. 

If an employee leaves the organization or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.

ESOP Initial Cost 

• In India, the initial cost of ESOP includes legal and accounting fees and administrative costs. Its distribution depends on the company's size and ESOP plan. 
• After an employee acquires shares through ESOP, they have the option to sell the shares right away. However, they can also wait for the stock price to appreciate.
• If employees keep the stocks and the price rises, they may be eligible to receive dividends and capital gains. 
• If employees sell the stock, they receive all proceeds from the sale of the shares, excluding the taxes owed on the gain. 

ESOP Taxation

ESOPs have a tax effect at the time employees purchase the stock and when they sell it. The taxation rules are the same for foreign ESOPs, i.e. ESOPs from a foreign company in India. 

Tax treatment when shares are bought

Once the vesting period is over, employees can purchase shares. As is the case with ESOPs, these shares are available at a price lower than the Fair Market Value (FMV) on that date. The difference between the FMV and the exercise price of the share is a pre-condition or prerequisite for the employee and thus, taxed at the employee's income tax slab rate. The tax amount is included as part of the total income from salary in the tax return and is shown in the employee's FORM 16. 

However, the tax implications of ESOPs are different for new companies. The government offers tax benefits on ESOPs for new startups.

Note: In a start-up, employees don't have to pay tax in the year they exercise the stock option. In startups, TDS can be deferred to any of the following dates, whichever comes earlier: 

• On the completion of five years from the ESOP grant date
• When the employee sells the ESOP
• When the employee leaves the company

Tax treatment when shares are sold

When the employee sells the shares, the difference between the selling price and the FMV on the date the share was exercised is taxable as capital gains.  

ESOP Example

Here's an example to understand how ESOPs work: 

Benefits of ESOPs

For Employees

There are several advantages of ESOPs for employees, namely: 

• Discounted Price: The biggest advantage of ESOP is that employees can buy company shares at a discounted price. This is beneficial, irrespective of when the employee decides to sell the share. 
• Stock Ownership: ESOP is one of the most common versions of employee ownership for a reason. ESOPs allow employees to own part of the company's stock. In some cases, employees also get voting rights or additional benefits with ESOPs. 
• Additional Income: ESOPs are a source of additional income for the employees. Apart from salary and regular benefits (like HRA), employees can also draw income from ESOPs. Employees can sell ESOPs or even wait for the stock price to appreciate and enjoy considerable gains. 

For Employers

Here are the benefits of ESOPs for employers: 

• Employee Retention: The implications of ESOPs for employee retention are manifold. ESOPs encourage employees to work for the company's growth. But they also help retain employees for a longer period of time, especially since employees have to wait for the vesting period to be over before they can exercise their stock options. 
• Rewarding Employee Performance: ESOPs are offered at the company's discretion but not every employee is eligible for it. The list of employees offered ESOPs may depend on tenure. But it also, often, depends on the employee's performance. ESOPs are usually considered a way of rewarding talented employees, and thus, they help boost employee productivity. 
• Limited Cash Outflow: ESOPs help limit the immediate outflow of cash. In certain cases, organizations may offer ESOPs instead of cash bonuses. This is especially beneficial for organizations that may be facing a cash crunch due to expansion plans, and wish to to move from heavy cash compensations. 

Ultimately, ESOPs are additional employee benefits that can help improve a company's performance by retaining talented employees. They're also a valuable tool for recognizing high-quality employees. 

ESOPs After Company Gets Listed

Once a company is listed, employees have more opportunities to cash out ESOPs, and the FMV is decided by market movements. 

In the case of unlisted companies, it's difficult to sell shares brought through ESOPs because there are limited buyers. Moreover, in the case of unlisted companies, capital gains are taxed per debt funds and merchant bankers decide the FMV.

Consequently, shares sold within 36 months of exercising them attract short-term capital gains and shares sold after 36 months attract long-term capital gains. 

Do ESOPs Compensate For Low Salary?

ESOPs can provide additional financial incentives but should not be viewed as a substitute for competitive salaries. In fact, Employee Stock Ownership Plans should be implemented thoughtfully as part of an employee’s overall compensation package rather than as a reactive measure to combat employee turnover or as a substitute for adequate salaries during tough economic periods.

Including ESOPs from the start demonstrates a commitment to sharing the company's growth and success with employees, recognizing their role in the company’s development and the risks they take. There are a few key employee-friendly practices that must be followed here:

1. Low Strike Prices: Setting low strike prices within the ESOP makes it easier for employees to purchase their shares, increasing the likelihood that they will benefit financially from their ownership.
2. Vesting During Liquidity Events: Allowing employees to vest their shares during liquidity events (like an IPO or acquisition) ensures they can realize the financial rewards of their equity, making the ESOP a more attractive and valuable part of their compensation.

This way, companies can create a more appealing and fair compensation structure that rewards employees for their contributions and commitment.

Challenges with ESOPs

Implementing an Employee Stock Ownership Plan (ESOP) presents several challenges, each requiring strategic solutions to navigate effectively.

Complexity

One of the primary difficulties is the complexity of setup and administration. Establishing an ESOP involves intricate legal, financial, and tax considerations. Employers must navigate regulatory requirements, draft detailed plan documents, and ensure compliance with the Employee Retirement Income Security Act (ERISA).

Solution: Engage experienced legal and financial advisors specialising in ESOPs to guide the setup process and ensure ongoing compliance.

Accurate Valuation

Another significant challenge is valuing the company stock accurately. ESOPs require a fair market valuation of the company's shares, which can be complex and subjective. This valuation must be updated regularly to reflect changes in the company's performance and market conditions.

Solution: Hire independent valuation firms with expertise in ESOPs to conduct unbiased and accurate valuations.

Cash Flow Management

Cash flow management can also be a concern. Funding an ESOP often involves significant cash outflows, whether through direct contributions or by leveraging debt to buy back shares from departing owners. This can strain the company's finances, especially if not planned carefully.

Solution: Develop a robust financial plan that includes projections for cash flow, debt service, and potential impacts on the company's liquidity.

Communication and Education

Communication and education are crucial yet challenging aspects. Employees need to understand the benefits and responsibilities associated with owning company stock. Without proper education, employees may not fully appreciate or engage with the ESOP, reducing its effectiveness as a motivational tool.

Solution: Implement comprehensive communication strategies and educational programs to inform employees about how the ESOP works, its benefits, and their roles as employee-owners.

Managing Employee Morale

Maintaining employee engagement and morale can also be tricky. If the company's stock value declines, employees might feel demoralized, affecting productivity and retention.

Solution: Build a strong organizational culture that emphasizes long-term growth and stability. Regularly communicate the company's performance and future prospects to keep employees informed and motivated.

Succession Planning Challenges

Finally, there's the issue of succession planning. As key owners or managers retire and sell their shares to the ESOP, there must be a plan in place to ensure smooth transitions in leadership without disrupting company operations.

Solution: Develop a comprehensive succession plan that identifies potential leaders within the organization and provides them with the necessary training and development opportunities.

By addressing these challenges proactively, employers can effectively leverage ESOPs to enhance employee ownership, motivation, and overall company performance.

Summing Up

In conclusion, ESOPs offer a powerful tool for aligning the interests of employees and shareholders, fostering a sense of ownership and commitment among staff. By providing employees with a stake in the company’s success, ESOPs can enhance motivation, productivity, and retention. Additionally, they offer significant financial and tax benefits to both the employees and the company. When effectively implemented, ESOPs can drive long-term growth and create a thriving, engaged workforce.

Frequently Asked Questions

Q1. What is an ESOP?

The full form of ESOP is EEmployee Stock Ownership Plans. Employee stock option plans or ownership plans are a type of employee benefit wherein employers offer company stock to employees at discounted prices. 

Q2. When can an employee cash out an ESOP?

After the vesting period is over, the employee can cash out an ESOP at any time - either at the time of exercising the stock option or even later. 

However, there may be exceptions to this rule depending on the exact ESOP policy adopted by the company. For example, certain organizations may specify a minimum time period for which employees need to hold the stock beyond the vesting period. 

Q3. What's a vesting period?

A vesting period is the duration of time for which an employee has to stay with the organization before they can exercise the stock options offered under ESOPs. During the vesting period, ESOPs are stored as a trust fund. 

Q4. Are ESOPs good?

Generally, yes. ESOPs provide an additional source of income to the employees and allow employers to retain talented employees and boost the company's performance. 

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