How an ESOP Works: A Guide for Employees

Learn how Employee Stock Ownership Plan works {ESOPs)- Employers offer their employees the company's stock at a low or no additional cost.
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3 mins read
13-May-2025

Understanding how an ESOP works can be the key to long-term wealth creation for employees. But how does an ESOP work for employees in India, and why is it becoming a core part of compensation packages today? An Employee Stock Ownership Plan (ESOP) is more than just a financial perk—it’s a strategic tool that allows employees to gain ownership in the companies they work for. Commonly offered by startups, tech companies, and high-growth firms, ESOPs give team members the opportunity to acquire company shares, turning them into stakeholders rather than just salary earners.

Why do ESOPs matter? Because they directly link employee performance to company growth, creating a powerful sense of alignment and shared purpose. For employees, this can translate into significant financial gains if the company performs well. For employers, ESOPs serve as a strong incentive mechanism to attract, engage, and retain talent—especially in competitive sectors.

Over time, ESOPs can evolve into a valuable component of an employee’s overall compensation, often with potential to significantly enhance wealth accumulation. From boosting morale and loyalty to offering tax benefits and easing succession planning, ESOPs are increasingly seen as a win-win for both employees and employers. Let’s take a closer look at how ESOPs work and why they could be a game-changer for your financial future.

What is ESOP in CTC (Cost to Company)?

ESOP allows employees to own a stake in the company by purchasing shares at a discounted price or through grants. ESOP in salary packages is often included as part of the CTC, or Cost to Company, offering employees a valuable benefit within their overall compensation.

In a CTC package, ESOPs are considered a non-monetary component, meaning they do not directly add to an employee's cash salary but enhance their total compensation by providing ownership in the company. This ESOP in salary structure is particularly relevant in private companies where shares are not publicly traded and may be used as an incentive to attract and retain talent. The value of ESOPs can fluctuate based on the company's performance and stock market conditions, offering employees the potential for financial growth along with the company's success.

ESOPs usually come with a vesting period, requiring employees to stay with the company for a certain duration to gain full ownership of the shares. This structure in an ESOP in salary setup helps foster employee loyalty and ensures their goals are aligned with the company’s long-term success.

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Benefits of ESOPs for employees

Here are some benefits of ESOPs for employees

Category

Benefit

Description

Financial Benefits

Wealth Accumulation

Employees build equity in the company, allowing them to accumulate wealth as the company’s value grows.

 

Retirement Savings

ESOPs act as a form of retirement benefit. Employees can sell their shares when they retire or leave, providing income for retirement.

Non-Financial Benefits

Increased Engagement

Employee-owners are more likely to be engaged and motivated, as they have a direct stake in the company’s success, improving productivity and reducing turnover.

 

Sense of Ownership and Loyalty

Employees gain a sense of ownership, fostering loyalty and a collaborative work environment, as they feel personally connected to the company's performance.


How does an ESOP work for employees?

  1. Ownership stake: By participating in an ESOP, employees gain a stake in the company's ownership, which can provide them with a sense of ownership and motivation to contribute to the company's success.
  2. Financial benefits: ESOPs can provide employees with financial benefits, such as dividends and capital gains if the value of the company's stock increases over time.
  3. Retirement benefits: ESOPs can serve as a retirement savings plan, allowing employees to accumulate wealth over their tenure with the company.
  4. Tax benefits: Contributions to an ESOP are tax-deductible for the company, and employees are not taxed on the value of the shares until they are distributed or sold.
  5. Liquidity options: Employees may have the option to sell their ESOP shares back to the company or on the open market, providing them with liquidity when needed.
  6. Employee engagement: ESOPs can help improve employee engagement and retention by giving employees a sense of ownership and a stake in the company's success.
  7. Risk mitigation: ESOPs can help mitigate the risk of employees leaving the company by providing them with a financial incentive to stay and contribute to the company's growth.
  8. Company performance: ESOPs can align employee interests with company performance, as employees directly benefit from the company's success.

How does an ESOP work for business owners?

Employee Stock Ownership Plans (ESOPs) are an effective strategy used by companies to attract and retain skilled professionals. By distributing company shares to employees in a staggered manner—often at the close of the financial year—organisations create an incentive for long-term commitment. This approach is especially valuable in high-turnover sectors like IT, as it helps lower attrition while aligning employee interests with the company’s long-term vision. For start-ups, ESOPs are a powerful tool to compete for talent despite limited cash resources. By turning employees into partial owners, businesses cultivate a sense of responsibility and engagement, ultimately boosting performance and driving growth.

How does an ESOP work for stockholders?

An ESOP (Employee Stock Ownership Plan) is a corporate structure that allows employees to own shares in the company. It's a popular strategy for closely-held companies, offering several benefits. ESOPs can provide a ready market for shareholders seeking liquidity, facilitate succession planning, and boost employee morale and productivity. By setting up an ESOP trust and following regulatory guidelines, companies can implement effective ESOPs. SES ESOP Strategies can guide you through the entire process, from design and implementation to valuation and compliance.

How are ESOP shares allocated?

The allocation of ESOP shares follows a structured process. Initially, the company designs the ESOP plan, outlining eligibility criteria, allocation methods, and vesting periods. This plan is then approved by the board of directors and shareholders. The company’s shares are valued to establish the worth of the ESOP shares. Following this, the details of the plan are communicated to eligible employees. Shares are granted based on predefined criteria, but employees must complete the vesting period to gain full ownership. After vesting, employees have the option to buy the shares at a predetermined price during the exercise period, fully integrating them as stakeholders in the business.

How employees redeem or sell ESOP shares

Employees can typically redeem or sell their ESOP shares under specific conditions, often determined by the company's ESOP plan. Common scenarios include:

  • Vesting period: Shares may be subject to a vesting period, meaning they cannot be sold or redeemed until a certain amount of time has passed.
  • Company exit events: In case of a merger, acquisition, or IPO, employees may have the opportunity to sell their shares.
  • Pre-determined exit dates: The ESOP plan may specify certain dates or events when employees can exercise their options or sell their shares.
  • Company-specific rules: Each company's ESOP plan has its own rules and regulations regarding redemption and sale of shares, which employees must adhere to.

It's crucial for employees to understand the specific terms and conditions of their company's ESOP plan to know when and how they can redeem or sell their shares.

Taxation benefits of ESOP for employees

ESOPs offer several taxation benefits for employees. When employees exercise their stock options, they do not have to pay tax at the time of grant or exercise. The tax is deferred until they sell the shares. This deferral can be advantageous as it allows employees to delay their tax liability and potentially benefit from lower tax rates in the future.

Further, if employees hold the shares for more than 12 months after exercise and more than 24 months from the date of grant, the gains are treated as long-term capital gains. Long-term capital gains are taxed at a lower rate than short-term capital gains or regular income tax rates, providing additional tax savings.

Additionally, in some countries, employees may be eligible for certain tax deductions or exemptions on the gains from ESOPs, further enhancing the tax benefits of participating in an ESOP scheme.

Conclusion

In conclusion, Employee Stock Ownership Plans (ESOPs) are a valuable tool for employees to become partial owners of the company they work for. By offering financial benefits, retirement savings, tax advantages, and a sense of ownership, ESOPs can help improve employee engagement, retention, and company performance. Employees should carefully consider the terms and conditions of their ESOPs and consult with a financial advisor to make informed decisions about their participation.

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Frequently asked questions

How does an ESOP make money?
An Employee Stock Ownership Plan (ESOP) makes money for employees through several mechanisms. Firstly, employees receive shares of the company's stock, which can increase in value over time, providing capital gains. Additionally, ESOPs may pay dividends to employees, further increasing their wealth. Employees can realize these gains by selling their shares back to the company or on the open market.
How does an ESOP transaction work?
An ESOP transaction typically involves the company establishing a trust to hold shares on behalf of employees. The company contributes shares or cash to the trust, which then allocates the shares to employees' accounts based on predetermined criteria. Employees can eventually sell their shares back to the company or on the open market, providing them with liquidity.
Do I get my ESOP money if I quit?
Yes, you are typically entitled to your ESOP money if you quit your job. However, the specifics of how you can access this money may vary depending on the rules of your ESOP and the vesting schedule. You may be able to roll over the funds into another retirement account or cash out the shares, subject to any applicable taxes and penalties.
How are ESOPs paid out?

Employees can receive ESOP distributions in either shares or cash. If they choose shares, they have a 60-day window to sell them back to the company. Alternatively, they can sell their shares in the open market, such as through a stock exchange or a private sale. If they opt for cash, they can receive it as a lump sum or in installments over two years.

How does the ESOP really work?

Employers grant ESOPs to selected employees, setting the number of shares, price, and vesting period. During the vesting period, employees must remain with the company to exercise their options. Once vested, they can purchase shares at a discounted price and potentially sell them for a profit. If an employee leaves before vesting, the company must repurchase the ESOP at fair market value.

What is the vesting period in an ESOP?

The vesting period is the duration an employee must stay with the company to earn the right to exercise their ESOPs. Typically, shares vest gradually over a few years, encouraging long-term employee retention.

How does an ESOP appear in my salary or CTC?

ESOPs are shown as a notional component of your CTC under the “long-term incentives” or “equity compensation” section. They don’t offer immediate cash value and are separate from your fixed or variable salary.

Do I have to pay tax on ESOPs?

Yes, ESOPs are taxable. You pay tax twice first as a perquisite when exercising the options, and later as capital gains tax when you sell the shares, based on the difference in value.

What happens to my ESOPs if the company is sold or merged?

In case of a sale or merger, your ESOPs may be converted, accelerated, or cashed out, depending on the agreement terms. Unvested shares may be handled differently, so it's best to review your ESOP policy.

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