Employee Stock Ownership Plan (ESOP)

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.

ESOPs are distinct from traditional stock market investments, where individuals purchase shares from the primary market. They are conditional, with specific rules governing their exercise. Typically, employees gain access to ESOP shares either through share buyback programs or when the company goes public through an Initial Public Offering (IPO). ESOPs fall under the category of employee benefits and serve as a mechanism for wealth creation, particularly for those employees who commit to long-term employment with the company.
In this article, we will explore ESOPs in depth, including what they are, how they function, the benefits they offer to 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.

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

Direct Stock Purchase Plans (DSPPs)

DSPPs allow employees to purchase shares of their company's stock with after-tax income. Some companies even offer a small discount on the stock price. In certain cases, tax-qualified plans might also be offered.

Restricted stock and stock options

Restricted stock grants employees actual shares, either as a gift or at a discount, but with conditions like vesting or performance goals. Stock options, in contrast, give the right to buy shares at a fixed price within a set period—profitable if the stock value increases.

Phantom stock and Stock Appreciation Rights (SARs)

Both phantom stock and SARs offer compensation linked to the company’s stock performance without granting actual shares. Phantom stock provides cash bonuses based on share value, while SARs reward employees with cash or shares reflecting the stock’s appreciation over time.

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.