Employee Stock Ownership Plan (ESOP)

Get an understanding of ESOPs, what they are, and how they work.
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3 mins
12-May-2025

What is an Employee Stock Ownership Plan (ESOP)?

Employee stock ownership plans, or ESOPs, have gained significant traction in the corporate world. To understand the employee stock ownership plan meaning, it’s important to know that these plans empower employees by giving them ownership stakes in the company, typically in the form of shares of stock. The concept is simple but profound: as the company prospers, so do its employees.

An ESOP is basically a retirement plan that grants employees company stock, enabling them to share in the company's success and aligning their interests with the company's goals.

An Employee Stock Ownership Plan (ESOP) is a retirement benefit plan that gives employees ownership interest in the company they work for. Under this arrangement, the employer contributes shares of the company to a trust fund on behalf of its employees, who then become beneficial owners of those shares over time. ESOPs are designed to align the interests of employees and shareholders by making workers part-owners, which can improve motivation, retention, and productivity.

Unlike traditional retirement plans that invest in a diversified portfolio, ESOPs invest primarily in the employer’s stock. Employees typically receive the value of their shares when they leave the company, retire, or upon the occurrence of other qualifying events. ESOPs are regulated under the Employee Retirement Income Security Act (ERISA) in the U.S. and offer tax benefits to both the employer and the employees. They are often used as succession planning tools or to reward long-term employees.

By participating in an ESOP, employees not only gain a stake in their company’s future but also unlock financial opportunities. However, accessing the value of these shares before a liquidity event, such as an IPO or buyback, can be challenging. That’s where ESOP financing comes in—allowing employees to leverage their vested ESOPs to secure funding without waiting for a company-driven liquidity event. This means employees can own their shares outright and benefit from their value today.

Get funding against your ESOPs and own your shares hassle-free! Apply now

How employee stock ownership plans (ESOPs) work: A detailed explanation

Here is a comprehensive explanation of how ESOPs work:

  1. Establishing the ESOP trust
    When a company decides to create an ESOP, it initiates the process by setting up an ESOP trust. This trust acts as the custodian of the company's shares on behalf of its employees. The company can contribute shares of its stock to the trust. These contributions are typically tax-deductible, up to certain limits, offering a financial incentive for the company to adopt an ESOP.
  2. Share allocation
    Once the ESOP trust is established and funded, the next step is to allocate the shares to individual employee accounts. The allocation can be determined using various formulas, with the most common ones based on factors such as compensation, years of service, or a combination of both. This ensures that employees receive shares that reflect their contributions and tenure within the organisation.
  3. Vesting
    To gain full ownership of the allocated shares, employees must go through a vesting period. Vesting refers to the process of earning rights to the shares over time, typically based on their seniority within the company. The vesting period can be immediate, or it can be a gradual process that spans several years.
  4. Employee participation
    New employees usually become eligible to participate in the ESOP and receive share allocations after completing a minimum service requirement. This encourages employee retention and ensures that those who are genuinely committed to the company's success are the ones who benefit from the ESOP.
  5. Managing share repurchases
    In cases where long-standing employees are leaving the company, and the share price has substantially appreciated, the company must ensure that it has sufficient funds to cover all the share repurchases. Proper financial planning and liquidity management are essential to meet these repurchase obligations.
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Eligibility for ESOPs

Every employee, excluding directors and promoters with over 10% equity holdings, is eligible for an Employee Stock Option Plan (ESOP) if they satisfy any of the following criteria:

  • Full-time or part-time Director of the Company.
  • Current employee of a subsidiary, associate, or holding company, regardless of whether they are based in the UK or overseas.
  • Permanent employee working in an Indian or foreign office of the company.

Benefits of ESOPs for employees

Benefit

Explanation

Stock Ownership

Employees gain ownership in the company, aligning their interests with the success of the organization.

Dividend Income

Employees are entitled to receive dividends, providing them with an additional income stream linked to company profits.

Acquire Stock at a Discount

Employees may purchase company shares at a discounted price or at the fair market value, offering a financial benefit.

Enhancing Productivity

Ownership increases commitment and motivation, encouraging employees to be productive and contribute to company success.

 

Benefits of ESOPs for employers

Benefit

Explanation

Attract and Retain Employees

ESOPs help companies attract and retain talent, especially when salaries alone may not be competitive.

Reduce Attrition

ESOPs can reduce turnover, especially in industries with high attrition rates, by incentivizing long-term employee loyalty.

Long-Term Commitment

Companies offer shares over time, incentivizing employees to stay with the company and align with long-term goals.

 

ESOP vs. stock options: Key differences

ESOPs grant actual ownership of company shares, often at no upfront cost, fostering long-term loyalty. Stock options, on the other hand, offer the right to buy shares at a set price, benefiting employees when the stock value rises.

Other equity compensation plans

Companies may offer alternative equity plans to reward employees and align them with long-term business goals.

Type of plan

What it offers

Key features

Direct Stock Purchase Plans (DSPPs)

Lets employees buy company shares using after-tax income.

Often includes a small discount on the stock price; may be part of a tax-qualified plan.

Restricted stock

Grants employees actual shares, often as part of a reward package.

Comes with conditions like vesting schedules or performance targets before full ownership.

Stock options

Gives employees the right to buy company stock at a fixed price in the future.

Profitable if the stock price rises above the set purchase price during the option period.

Phantom stock

Mimics actual stock ownership without issuing real shares.

Provides cash bonuses based on the value of the company’s stock.

Stock Appreciation Rights (SARs)

Rewards employees for stock value growth without requiring them to buy shares.

Employees receive cash or shares based on the increase in stock price over a set period.

 

Which model is right for your company?

The best employee ownership model for your company depends on various factors, including your financial situation, company culture, and long-term goals. It's essential to consider the tax implications, administrative costs, and potential dilution of ownership when choosing a model.

ESOP taxation and legal considerations

Employee Stock Ownership Plans (ESOPs) have a dual tax impact:

  1. Exercise of ESOPs: When an employee exercises their option to purchase company shares, the difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price is considered a taxable perquisite. This perquisite is taxed at the employee's marginal income tax rate. However, the government has relaxed these rules for start-ups, allowing employees to defer the tax on the perquisite until the earlier of five years from the grant date or the date of sale.
  2. Sale of ESOP Shares: When an employee sells their ESOP shares, the capital gain or loss is calculated based on the difference between the selling price and the FMV on the date of exercise.
    • Short-Term Capital Gains Tax: If the shares are sold within one year of purchase, the profit is taxed as short-term capital gains at a flat rate of 15%.
    • Long-Term Capital Gains Tax: If the shares are held for more than one year, the profit is taxed as long-term capital gains. The current long-term capital gains tax rate for equity shares is 10% on gains exceeding Rs. 1 lakh.

Taxation of Foreign ESOPs in India

If an Indian resident receives ESOP benefits from a foreign company, the perquisite value is taxable in India. The tax implications would be similar to those of domestic ESOPs.

It's important to consult with a tax professional to understand the specific tax implications of your ESOPs, as tax laws can be complex and subject to change.

Tax implications when selling ESOP shares

When employees sell their ESOP shares, they are subject to capital gains tax based on the holding period. If shares are sold within 12 months, short-term capital gains tax applies, while sales after 12 months attract long-term capital gains tax. Additionally, ESOPs are taxed as perquisites at the time of exercise. Below is a table summarizing the tax treatment:

Tax component

Condition

Tax rate

Perquisite Tax

At the time of exercise

As per income tax slab

Short-Term Capital Gains (STCG)

Sold within 12 months

15%

Long-Term Capital Gains (LTCG)

Sold after 12 months

10% (if gains exceed Rs.1 lakh)

 

What happens to ESOPs when a company gets listed?

When a company gets listed on a stock exchange, the dynamics of its ESOP program may undergo changes. There are a few potential scenarios:

  1. Company buyback
    The company may choose to buy back its shares from employees who hold ESOPs. This often provides employees with a straightforward method to realise the value of their ESOP holdings.
  2. Employee Sales
    Employees may decide to sell their ESOP shares on stock exchanges once the company is publicly traded. This allows employees to take advantage of market liquidity and potentially realise gains based on the prevailing stock price.

How to value ESOPs

ESOP valuation can be conducted using two primary approaches:   

  • Intrinsic value method: This method focuses on the immediate, inherent value of the option. It calculates the difference between the current market price of the company's stock and the exercise price of the option. If the market price exceeds the exercise price, the option has intrinsic value. However, this method doesn't consider factors like the time to expiration or the volatility of the stock price, which can significantly impact the option's true value.   
  • Fair value method: This method provides a more accurate valuation by considering various factors that influence the option's value, such as:
    • Current market price of the company's stock: This is a key input, as it directly influences the option's potential profit.
    • Exercise price: The price at which the employee can purchase the stock.
    • Time to expiration: The period during which the employee can exercise the option.
    • Volatility of the stock price: The degree to which the company's stock price fluctuates.   
    • Risk-free interest rate: The rate of return on a risk-free investment, which is used to discount future cash flows.
    • Expected dividends: The anticipated dividends the company may pay during the option's life.

Pros and cons of Employee Stock Ownership Plans (ESOPs)

Employee Stock Ownership Plans (ESOPs) offer employees the opportunity to acquire company shares—often at a discount or as part of their compensation. This ownership can enhance motivation, engagement, and alignment with business goals. Employees may feel a stronger sense of pride and responsibility, contributing more actively to the company’s success. Financially, ESOPs can help build long-term wealth through dividends and capital appreciation.

However, there are challenges. ESOPs can lead to a lack of portfolio diversification, tying both employment and retirement savings to the company’s performance. Newer employees may receive fewer benefits and hold limited influence, while growing participation can dilute ownership and voting power for long-term employees.Top of Form

What happens to ESOPs when a company gets listed?

In the hypothetical scenario in the Indian market, let's consider a software company called "TechSolutions Pvt. Ltd." that decides to implement an ESOP for its employees.

TechSolutions Pvt. Ltd. has been performing exceptionally well in the market, and the management believes that providing ownership opportunities to its employees will further motivate them and align their interests with the company's growth.

Here's how the ESOP might work for TechSolutions Pvt. Ltd.:

  • Offer details: The company announces an ESOP scheme, offering eligible employees the opportunity to purchase company shares at a discounted price. For example, employees may have the option to purchase shares at 20% below the market price.
  • Eligibility criteria: The ESOP scheme may be open to all full-time employees who have completed a certain period of service, such as one year with the company.
  • Vesting period: The company may implement a vesting period during which employees gradually gain ownership rights to the shares. For instance, shares could vest over a period of three years, with one-third of the shares becoming fully owned by the employee each year.
  • Exercise period: Employees are typically given a window of time, known as the exercise period, during which they can purchase the vested shares. This period could be, for example, six months from the date of vesting.
  • Payment options: Employees may have the option to purchase shares either through a cash payment or by opting for an ESOP loan provided by the company.
  • Tax implications: The company would provide information on the tax implications of participating in the ESOP scheme, including any tax obligations upon exercising the options or selling the shares.
  • Benefits: By participating in the ESOP, employees have the opportunity to become shareholders in the company, potentially benefiting from any increase in the company's stock price over time. This can serve as a valuable incentive for employee retention and motivation.

In this example, TechSolutions Pvt. Ltd. effectively implements an ESOP scheme to empower its employees with ownership in the company, fostering a sense of loyalty, alignment, and motivation among its workforce.

How Bajaj Finance Limited can help with ESOP liquidity?

For employees seeking financial support to maximise their ESOP investments, financial institutions, and lenders like Bajaj Finance Limited offer ESOP financing options at competitive rates. These financial products are designed to assist employees in managing the financial aspects of exercising their ESOPs and realising the potential gains. If you are eager to capitalise on ESOPs but have financial concerns, get in touch with us today to explore the available financial aid for your ESOP investments.

Conclusion

Employee stock ownership plans (ESOPs) are not just a corporate buzzword; they are a dynamic way for companies to engage, motivate, and retain their workforce. By offering ownership stakes to employees, ESOPs promote a sense of shared success and financial security. Employees benefit from ownership, dividend income, discounted stock acquisition, job satisfaction, and enhanced productivity. However, it is essential for employees to grasp the associated tax implications, as they can significantly impact the financial outcomes of their ESOP participation.

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Frequently asked questions

Are ESOPs common in India?

ESOPs are increasingly becoming common in Indian companies.

Can I lose money with ESOPs?

Yes, you can lose money with ESOPs. The value of ESOPs is tied to the company's stock price. If the stock price falls, the value of your ESOPs decreases. Additionally, for non-listed companies, ESOP value depends on company valuations. If the company's valuation drops, the value of your ESOPs will decrease proportionally. It is crucial to consider market conditions and potential risks associated with ESOPs.

What is the ESOP scheme?

An Employee Stock Ownership Plan (ESOP) is a corporate benefit plan that gives employees ownership stakes in the company. Companies offer ESOPs to attract and retain top talent, align employee interests with company goals, and boost employee morale. Through ESOPs, employees receive company shares, often at a discounted price or as a performance reward. These shares can be vested over time, allowing employees to gradually own a portion of the company.

Is an ESOP risky?

Yes, ESOPs can be considered risky investments. The value of your ESOPs is directly tied to the company's performance, which can fluctuate significantly. If the company faces financial difficulties or the stock price declines, the value of your shares may decrease. Additionally, ESOPs are often illiquid, meaning you may not be able to sell your shares easily or quickly. It's important to understand these risks before investing in ESOPs and consider diversifying your investments to mitigate potential losses.

What happens to my ESOP if I quit?

If you quit your job, the fate of your ESOPs depends on the vesting period and the company's policies. Vested shares, which you have earned through your tenure, generally remain yours and can be exercised or sold. However, unvested shares, which are still tied to your continued employment, may be forfeited. It's crucial to review your company's ESOP plan document to understand the specific terms and conditions regarding vesting, exercise periods, and potential forfeiture in case of resignation.

What is the vesting period for ESOPs?

The vesting period is the length of time you must work at the company before you fully own your ESOP shares. This period varies depending on the company and the plan, but it's often several years. Check your plan documents or ask HR for the specifics of your company's vesting schedule.

Can you borrow against ESOP?

Yes, you can borrow against your ESOPs by leveraging their vested value as collateral. Many financial institutions offer ESOP financing, allowing employees to unlock liquidity without selling their shares immediately. This provides a flexible way to meet financial needs while retaining ownership in the company.

Access loans up to ₹175 crore against your ESOPs value! Apply now

 

What is the process to exercise my ESOPs?

To exercise ESOPs, you must submit an exercise request, pay the exercise price per option, and complete any required documentation. Once approved, the company allots the shares, which are then credited to your demat account.

Are there any restrictions on selling ESOP shares?

Yes, ESOP shares may have a lock-in period or be subject to company-specific sale policies. In private companies, liquidity may be limited, while in public companies, trading restrictions may apply based on insider trading regulations.

What happens to my ESOPs if the company is acquired or merges?

In case of a merger or acquisition, ESOPs may be vested, canceled, converted to new options, or cashed out—depending on the terms of the agreement. Companies often outline these outcomes in the ESOP policy or acquisition contract.

How is ESOP taxed in India?

ESOPs are taxed twice, first at the time of exercise as a perquisite (part of salary) and again at the time of sale as capital gains. The tax rate depends on the holding period and type of shares.

What is the difference between ESOP and RSU?

ESOPs give employees the option to buy shares at a set price, while RSUs (Restricted Stock Units) are granted outright after vesting. RSUs involve no purchase and are taxed as income when vested.

How long is the ESOP vesting period in India?

As per SEBI guidelines, the minimum ESOP vesting period in India is one year. However, companies often set longer vesting periods (e.g., 3–4 years) with graded or cliff vesting structures.

Can I cash out my ESOP shares?

Yes, once your ESOPs are vested and exercised, you own the shares and can sell them—subject to company policies, lock-in periods, and market conditions if it's a listed company.

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