Employee Stock Ownership Plan (ESOP)

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

What is an Employee Stock Ownership Plan (ESOP)?

An Employee Stock Ownership Plan, or ESOP, is a unique benefit plan that allows employees to own a part of the company they work for. Instead of just being a team member, you get to be a shareholder too. It aligns your personal growth with the success of the business, giving you both a sense of ownership and a long-term wealth-building opportunity.

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ESOPs are typically structured as retirement plans, where a company contributes its own shares to a trust fund for the benefit of its employees. Over time, as you spend more years with the company, you become eligible to receive a larger portion of these shares. This ownership structure motivates employees to contribute to the company’s success, knowing they directly benefit from it. ESOPs are especially useful for encouraging employee loyalty, increasing motivation, and helping build long-term wealth.

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

Understand how ESOPs are structured, allocated, and vested to empower employees as shareholders in their organisation. Let’s look at the key steps.

1. Establishing the ESOP trust

To start, the company creates an ESOP trust. This trust holds the company’s shares on behalf of employees. These shares can be newly issued, existing ones, or even purchased shares. One advantage for companies? These contributions are often tax-deductible, making ESOPs financially appealing for the employer too.

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2. Share allocation

Shares from the ESOP trust are distributed among eligible employees. The allocation formula varies but often depends on salary, job role, or years with the company. This method ensures fair and proportionate ownership across different levels of the workforce. The more time you spend at the company, the more you benefit.

3. Vesting

Vesting is the process of earning ownership rights to the allocated ESOP shares over time. Companies use vesting schedules (like 3 to 5 years) to encourage employees to stay longer. Only after you're vested can you fully claim the shares allocated to your account. This helps create long-term engagement with the company.

4. Employee participation

Employees usually become eligible for the ESOP after completing a specific tenure, such as one year. This not only rewards loyalty but also filters for those genuinely aligned with the company’s vision. Once eligible, employees are regularly granted shares, which they begin to own over time.

5. Managing share repurchases

When employees retire or leave, companies must buy back their ESOP shares at the current fair market value. This requires financial planning to ensure liquidity. Some companies plan annual budgets specifically to handle these repurchases, especially as ESOP participation grows over time.

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Eligibility for ESOPs

ESOPs are designed to reward employees while maintaining fairness in share distribution. While promoters and directors holding more than 10% equity are typically excluded, others may qualify under the following conditions:

  • You are a full-time or part-time director of the company
  • You work in an Indian or overseas office of the company
  • You are employed by a holding company, subsidiary, or associate entity

This ensures that dedicated employees across locations and functions can participate in the ESOP scheme, building long-term value and engagement.

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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

While ESOPs offer actual company shares over time, stock options provide the right to purchase shares at a fixed price. ESOPs involve no upfront cost and promote retention, whereas stock options are more performance- and price-driven. Stock options are beneficial if the company’s share price grows significantly.

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?

Choosing the right employee ownership model depends on factors like company stage, financial health, tax preferences, and culture. ESOPs are best for companies focused on long-term retention and legacy planning. Other models like stock appreciation rights or phantom stock work better for short-term rewards or when equity dilution is a concern.

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 your company gets listed on the stock exchange, your ESOPs become liquid assets. This gives you more control over how and when to use them. Here's what typically happens:

  • Sell on the stock exchange: Once listed, you can sell your ESOP shares directly in the open market and access the value immediately.
  • Company buyback option: Some companies may offer to repurchase the shares from employees, usually at a fair market price, giving you another route to unlock value.
  • Financial planning opportunity: Going public allows you to plan your finances better whether you want to hold, sell partially, or reinvest the gains.

This transition from private to public makes it easier to realise gains from your ESOP holdings.

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How to value ESOPs

Not sure how much your ESOPs are worth? Knowing their value can help you make smarter financial decisions whether you are planning taxes, applying for ESOP financing, or deciding when to sell. Here are two main methods to estimate their worth:

  • Intrinsic value method: This is the simpler way to value your ESOPs. Just subtract the exercise price (the price at which you can buy the shares) from the current market value. If the market price is higher, that’s your immediate gain. This method works well when you’re close to exercising your options.
  • Fair value method: This is more comprehensive. It looks at additional factors like how much the stock fluctuates (volatility), the remaining time to exercise your options, the prevailing interest rates, and expected dividends. This approach is often used in formal valuations or financial reporting.

While the intrinsic method gives you a quick idea, the fair value method provides a more accurate picture especially if you are making long-term plans or seeking ESOP funds.

Pros and cons of Employee Stock Ownership Plans (ESOPs)

Employee Stock Ownership Plans (ESOPs) offer employees a unique chance to grow with the company, but like any benefit, they come with both advantages and considerations. Here's a simple breakdown:

Pros:

  • Ownership and Wealth Building: You become a part-owner of the company, which helps build long-term financial growth.
  • Dividend Income: ESOPs may pay out dividends, providing an extra income stream on top of your salary.
  • Boosts Motivation and Retention: Employees feel more connected to the company’s goals, boosting morale, productivity, and retention.
  • Retirement Planning: ESOPs can be a valuable addition to your retirement fund, especially as your shares grow in value.
  • Loyalty and Engagement: Knowing you own part of the company increases your sense of responsibility and engagement.

Cons:

  • Lack of Diversification: Since the investment is mostly in one company, your financial security may depend heavily on its performance.
  • Unequal Distribution: New employees or those with short tenures may receive fewer benefits compared to long-term staff.
  • Share Dilution: As more shares are granted to new employees, existing ownership percentages may reduce.
  • Value Fluctuation: ESOP shares are tied to the company’s performance. If the business struggles, so does your share value.
  • Liquidity Constraints: Unless the company is public or offers a buyback, it can be hard to convert ESOPs into cash.

What happens to ESOPs when a company gets listed?

So your company’s going public? That is a big milestone and great news if you hold ESOPs. Here is why:

  • You can finally sell your shares: Once listed, your ESOPs become actual stock that you can trade on the stock exchange. If you've exercised your options and hold the shares, you’re free to sell them at the current market price.
  • More liquidity, less waiting: Listing gives your shares a clear value and an open market. No more waiting on company-led buybacks or private valuations.
  • Valuation is now visible: The stock price on the exchange sets the value of your ESOPs daily, giving you a transparent way to track your wealth.
  • Tax alert: If you sell soon after listing, you may face short-term capital gains tax. Hold them for a year, and you could qualify for long-term capital gains tax at a lower rate.
  • Buybacks may still happen: Some companies continue offering buybacks even after listing, especially to manage share dilution or reward employees.

Going public often means a clearer exit route for employees but planning your sale and understanding the tax impact is key. If you need money sooner, there is another way.

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.

How to access ESOP liquidity?

While many employees wait for an IPO or a company-led buyback to cash in on their ESOPs, there’s another way to unlock their value ESOP financing. With ESOP financing, you can raise funds using your vested ESOPs as collateral without having to wait for a liquidity event or sell your shares. This allows you to meet immediate financial needs while still retaining ownership.

Whether it is for investing, funding a personal goal, or covering expenses, this route gives you access to cash today without giving up your future equity.

Conclusion

Employee Stock Ownership Plans are more than just a financial benefit they are a pathway to true ownership and shared success. By offering a stake in the company, ESOPs motivate employees, reward loyalty, and help build long-term wealth. From understanding what is ESOP, how do ESOP work, to knowing the disadvantages of ESOP, it is clear that these plans carry the potential to transform how employees and companies grow together. However, it is equally important to stay aware of the risks especially if your financial portfolio depends heavily on your company’s future. Diversifying your investments and seeking guidance can help you get the most out of your ESOP plan.

If you are looking to make your ESOPs work for you even before a buyback or listing, ESOP financing could be the perfect bridge. Do not wait for the future leverage your shares today.

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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.

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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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