Employee Stock Ownership Plans (ESOPs) are employee benefit plans that are increasingly becoming a popular way for companies to reward and retain the best talent. By offering them as compensation, companies allow their employees to become stakeholders, aligning their interests with the organisation’s success.
This shared ownership model boosts motivation, enhances productivity, and strengthens long-term commitment. ESOPs serve as both a powerful employee benefit and a strategic financial tool, fostering a culture of ownership and excellence within the company.
In this blog, we take a deep dive into the ESOP definition, how it works, its vesting process, key benefits, and the tax implications employees should be aware of.
What is ESOP?
An Employee Stock Ownership Plan is a powerful incentive that allows companies to reward employees by offering them a stake in the organisation. It’s an employee compensation plan through which employees can acquire company shares at little to no cost. Employers provide them as it aligns their employees’ interests with the company’s long-term success.
ESOPs typically come with a vesting period, after which employees have the option to exercise their rights to purchase shares at a predetermined price. This ownership opportunity not only enhances employee motivation and engagement but also fosters a sense of commitment and accountability.
Since these are granted at the employer’s discretion, they serve as a strategic tool for talent retention and business growth.
How Does the Employee Stock Ownership Plan Work?
Following is a detailed explanation of how ESOPs work:
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Establishing the ESOP Trust
The company sets up an ESOP trust to hold shares on behalf of employees. It will then contribute stocks to the trust, often with tax advantages.
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Employee Participation
New employees typically become eligible for ESOPs after meeting a minimum service period, promoting retention and commitment.
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Share Allocation
Shares are distributed to employee accounts based on factors like salary and tenure, ensuring a fair reward system.
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Vesting
Employees earn ownership of their allocated shares after a certain period called the vesting schedule, which may be immediate or gradual.
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Share Repurchases
When employees leave or retire, the company usually repurchases their shares, and the employee receives compensation equal to the fair market value of the shares. This allows the company to redistribute the shares.
Functioning of ESOP with Example
Suppose an ABC Corporation offers ESOPs to key employees with a 3-year service requirement. Employees receive shares after one year and have three months to opt in.
- Exercise Price: ₹400
- Market Price at Grant: ₹500
- Expected Price in 3 Years: ₹1,000
Here is a breakdown of taxation on ESOPs:
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At the time of Exercise (After 1 Year) – Taxed as a prerequisite:
Perquisite Value = Market Price – Exercise Price
₹500 – ₹400 = ₹100 (taxed as salary income)
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At the Time of Sale (After 3 Years) – Taxed as capital gains:
Capital Gain = Sale Price – Market Price at Exercise
₹1,000 – ₹500 = ₹500 (taxed as capital gains)
Advantages of ESOP for Employees
Once you know what ESOP is, it is essential for you to understand why they are an attractive option for employees. Here are some of the essential benefits of receiving ESOP shares:
- Wealth Creation: Employees gain equity in the company, benefiting from share price appreciation and long-term financial growth.
- Retirement Security: ESOPs serve as an ideal retirement benefit as their value grows steadily over time. This allows employees to sell their shares upon leaving or retiring, providing financial stability.
- Higher Engagement & Productivity: As part owners, employees are more motivated and committed, leading to increased productivity and lower turnover.
- Stronger Sense of Ownership & Loyalty: These foster a culture of collaboration and accountability, as employees feel personally invested in the company’s success.
What are the Types of ESOPs?
Companies can use various ESOP structures to incentivise employees and fund growth. Here are the most common types:
- Employee Stock Option Scheme (ESOS): Grants employees the right (but not obligation) to buy shares at a predetermined price after a vesting period.
- Employee Stock Purchase Plan (ESPP): Allows employees to buy shares, often at a discount, with terms set by the company. Common in public offerings.
- Restricted Stock Units (RSUs): Employees receive shares upon meeting specific conditions or events and become shareholders of the company. They typically don’t have to pay anything to get these restricted stocks.
- Restricted Stock Awards (RSAs): Grants employee’s shares with restrictions based on a vesting period or performance goals.
- Stock Appreciation Rights (SARs): Employees receive cash or stock equivalent to the increase in share value over time, with no downside risk.
- Phantom Stocks: Simulates stock ownership without actual shares, offering long-term deferred compensation based on company performance.
What are the Tax Implications of ESOPs?
These have two key tax events: when employees purchase shares and when they sell them.
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Tax at the Time of Purchase
- Employees buy shares at a price lower than the Fair Market Value (FMV) on the vesting date.
- The difference (FMV – exercise price) is taxed as a prerequisite at the employee’s income tax slab rate.
- Startups get tax relief for TDS on ESOPs, and it is deferred until the earliest of:
- Five years from the grant date
- Sale of shares
- Employee’s exit from the company
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Tax at the Time of Sale
- Capital gains tax applies to the difference between the selling price and FMV at the time of purchase.
- Listed shares: Profits over ₹1.25 lakh are taxed at 12.5% (long-term, >12 months) or 15% (short-term, <12 months).
- Unlisted shares: The FMV is calculated by a merchant banker on the date of exercising the stock options.
- Foreign ESOPs are taxed similarly in India on perquisite income.
Difference Between ESOP vs Other Forms of Compensation
Following is a detailed comparison of ESOP vs other types of forms of compensation, such as profit sharing and direct equity ownership:
| Aspect | Profit Sharing | ESOP (Employee Stock Ownership Plan) | Direct Equity Ownership |
| Ownership | Distributes cash or retirement contributions based on company profits | Provides employees with ownership stakes in the company | Employees buy shares themselves |
| Vesting | Immediate or based on performance | Typically, a long vesting period before full ownership. | Ownership is immediate upon purchase |
| Payout Structure | Rewards employees in cash or benefits | Provides stock that may appreciate in value | Employees receive stock dividends or capital gains |
| Purpose | Rewards employees for company performance | Promotes long-term employee ownership and engagement | Grants direct ownership with potential financial upside |
| Structure | Employer-sponsored plan | Employer-sponsored plan with structured stock allocation | Employees purchase shares directly |
| Cost to Employees | No cost; based on the company’s discretion | Usually, there is no upfront cost; shares are granted | Requires personal financial investment |
| Control & Voting Rights | Limited control over distributions | Limited or no voting rights on company matters | Direct shareholders have voting rights and more control |
| Tax Benefits | May have some tax advantages for the company | Often includes tax benefits for both employees and the company | Typically, fewer tax advantages compared to ESOPs |
How Going Public Affects Employee Stock Options (ESOPs)?
When a company goes public, it impacts existing Employee Stock Ownership Plans in several ways:
- Share Dilution: An IPO involves issuing new shares to raise capital, which may reduce the ownership percentage of participants. However, if the stock price rises post-IPO, the overall value of their holdings can increase.
- Lock-in Periods: Employees with vested ESOPs may face restrictions on selling shares immediately after the IPO. These lock-in periods help stabilise the stock price and encourage long-term value creation.
- Financial Opportunity: Once the lock-in period ends, employees can sell their shares. If the stock performs well, this can result in substantial financial gains.
What are the Risks Associated with ESOPs?
While ESOPs offer potential financial benefits, they also come with certain risks that employees and companies should consider:
- Market Volatility: These plans only provide value if the company’s stock price increases. If the price stagnates or declines, employees may see little to no financial gain.
- Tax Burden: Employees are taxed on ESOPs at two stages: when they exercise their options (as perquisites under salary tax) and when they sell their shares (as capital gains). If share prices show little growth, taxes may significantly reduce overall profits.
- Salary Trade-Off: Some companies offer ESOPs in place of a competitive salary. During economic downturns, firms can give reduced salaries while compensating with ESOPs, which may not always translate to actual financial gains.
- Liquidity Challenges: These shares are not easily sold. Employees can only cash out through an IPO, external buyout, or company buyback, and none of these are guaranteed, especially in the unpredictable startup space.
- Vesting Period Constraints: ESOPs are earned over time, typically vesting over 1–5 years. If an employee leaves or is terminated before full vesting, they may lose a significant portion of their ESOPs.
- Company Flexibility: ESOP pools impact a company’s financial flexibility, making it harder to raise investment or sell the business, as these obligations add to long-term liabilities.
Final Thoughts
ESOPs are a powerful tool for employee wealth creation and business continuity, providing tax benefits while fostering an ownership-driven culture. However, both employees and companies must carefully evaluate the financial, tax, and liquidity challenges involved. For employees, ESOPs should complement a competitive salary, and for companies, they should align with long-term strategic and financial goals.
