An Employee Stock Ownership Plan (ESOP) is a way for employees to own a part of the company they work for. Instead of just receiving a salary, employees get shares in the company, making them partial owners. Over time, as the company grows, the value of these shares can increase, giving employees a direct benefit from the company’s success.
ESOPs are a great way to keep employees motivated and invested in their work. When employees have a stake in the company, they tend to be more engaged, work harder, and stay with the company longer. For businesses, this means better performance, stronger teamwork, and lower employee turnover.
In this blog, we’ll go over everything you need to know about ESOPs, from how they work to their benefits and tax implications. So, without waiting any longer, let’s dive in!
How Employee Share Ownership Plans (ESOPs) Work
ESOPs allow employees to own a part of the company they work for. This is done through a structured process that ensures fair distribution and management of company shares.
-
Setting Up the ESOP Trust
To start an ESOP, the company creates an ESOP trust. This trust holds shares of the company on behalf of employees. The company contributes shares to this trust, and in some cases, these contributions come with tax benefits. The trust acts as a bridge, making sure the shares are properly managed before they are given to employees.
-
Allocating Shares to Employees
Once the trust is set up, shares are distributed among employees. The company decides how to divide these shares, often based on salary, years of service, or both. This way, employees who have been with the company longer or have contributed more receive a larger share.
-
Earning Ownership Over Time (Vesting)
Employees don’t get full ownership of their allocated shares right away. Instead, they go through a vesting period, meaning they earn rights to the shares over time. Some companies allow employees to own their shares immediately, while others require them to stay with the company for a certain number of years before they can claim full ownership.
-
Who Can Participate?
New employees usually have to complete a minimum period of service before they can be part of the ESOP. This helps ensure that those who stay with the company for the long run benefit from the plan, promoting employee loyalty and stability.
-
Buying Back Shares from Employees
When employees who own shares leave the company, the company must repurchase their shares. If the share value has increased significantly, this can be a major financial responsibility. To manage this, companies need to plan ahead and make sure they have enough funds available for these repurchases.
Who Can Get ESOPs in India?
Wondering who is eligible for ESOPs in India, and how does the process work? Let’s break it down.
-
For Businesses
Not every business can offer ESOPs. In India, companies must meet certain conditions:
- Private and Public Companies can offer ESOPs, but listed companies must follow SEBI regulations, while private companies follow Companies Act guidelines.
- Startups recognised by the DPIIT (Department for Promotion of Industry and Internal Trade) can grant ESOPs to founders and promoters, which is not allowed in other companies.
- Businesses must have a formal ESOP plan that is approved by the board and shareholders before offering shares to employees.
- There are tax and compliance rules that companies need to follow, including valuation and disclosures to employees.
-
For Employees
Not all employees qualify for ESOPs. The eligibility depends on company policies, but here’s what usually applies:
- Full-time employees and directors of the company can get ESOPs. Some companies also extend ESOPs to consultants and advisors.
- Promoters and those holding more than 10% of the company’s equity (in non-startup companies) are not eligible.
- ESOPs come with a vesting period, meaning employees must stay with the company for a set number of years before they can claim the shares.
- Once vested, employees can buy shares at a predetermined price, which is often lower than the market value.
Connection Between EOSPs and Unlisted Shares
If your company offers ESOPs (Employee Stock Ownership Plans), you might be wondering how they relate to unlisted shares. Simply put, ESOPs often come in the form of shares in the company, and if your company is not publicly traded, these shares are considered unlisted.
Since unlisted shares aren’t available on the stock market, selling them isn’t as straightforward as selling regular stocks. If you hold ESOPs in an unlisted company, you may need to wait for specific events, such as a buyback by the company, a private sale to investors, or the company going public through an IPO. Until then, these shares hold potential value but aren’t as easy to trade.
For employees, ESOPs in an unlisted company can be a great way to benefit from the company’s growth. However, understanding the terms of your ESOPs, including vesting periods, tax implications, and liquidity options, is important to make the most of them.
What Happens to ESOPs When the Company is Listed?
If you have ESOPs in an unlisted company, selling your shares can be tricky since there may not be many buyers. The share value is determined by merchant bankers, and when you sell, capital gains tax applies just like it does for debt funds.
If you sell within 36 months of exercising your ESOPs, the profit is taxed as short-term capital gains, which means the tax rate matches your income tax slab. If you hold the shares for more than 36 months, the profit is considered a long-term capital gain and is taxed at 20% with indexation benefits.
But things change once the company gets listed. The stock becomes publicly traded, making it easier for employees to sell their shares whenever they want. The fair market value (FMV) is now determined by market prices rather than a valuation by bankers, giving employees more flexibility.
Before making any decisions, it’s important to understand how ESOPs work, the vesting period before you can exercise them, and the tax rules involved. They can be a great part of your salary package, but knowing when and how to sell can help you make the most of them.
How ESOPs Benefit Employers
Stock options are a way for companies to reward and motivate employees. Since employees gain when the company’s stock price goes up, they have a strong reason to give their best at work. While ESOPs help in keeping employees motivated, retaining talent, and recognising hard work, they offer several other advantages as well.
One major benefit is that ESOPs help companies manage cash flow better. Instead of offering direct cash rewards, companies can use stock options as an alternative, reducing immediate expenses. This is especially useful for businesses that are expanding or scaling up. Offering ESOPs allows them to reward employees without putting too much strain on their finances.
Tax Implications
ESOPs come with benefits, but it’s important to understand how they are taxed. Here’s how the taxation process works:
-
When You Buy the Shares (Exercise Tax)
The first-time tax comes into the picture is when you decide to use your ESOPs to buy company shares. The tax is applied to the difference between the market value of the shares on that day and the price you pay for them. This amount is considered a benefit and is taxed as part of your salary. Companies usually deduct tax at the source (TDS) for this. However, for employees of certain startups, a change in the tax rules in 2020 allows this tax to be deferred until specific events occur, making it easier to manage.
-
When You Sell the Shares (Capital Gains Tax)
Tax also comes into play when you sell the shares. The profit you make is taxed as capital gains. If you sell the shares within a short period, the tax rate is higher. Holding them for a longer time qualifies for lower tax rates. The exact tax depends on how long you keep the shares before selling.
Challenges of Employee Stock Ownership Plans (ESOPs)
While ESOPs offer benefits like employee ownership and potential financial growth, they also come with challenges that companies and employees should be aware of.
-
Risk of Putting All Savings in One Company
Since ESOPs are tied to a single company’s stock, employees’ retirement savings depend on the company’s performance. If the business struggles or fails, employees may lose both their income and the savings they built over time. This lack of diversification can be risky, as seen in past cases where companies collapsed, leaving employees with little to no savings.
-
Limited Benefits for New Employees
ESOPs often reward employees who have been with the company for a long time. Those who joined recently may not have built up much savings in the plan and may also have less say in company decisions. This can make it harder for newer employees to see the benefits of the plan compared to those who have been part of it for many years.
-
Ownership Gets Spread Out Over Time
As more employees become part of the ESOP, the shares are divided among a larger group. This can reduce the ownership percentage and voting power of employees who have been in the plan longer. Over time, this dilution may also impact the financial returns that employees were expecting from their shares.
Closing Thoughts
ESOPs give employees a chance to share in the company’s success while helping businesses build a committed workforce. They offer financial benefits, but understanding how they work, including taxes and risks, is important. For both employees and employers, ESOPs can be a valuable tool when planned and managed well.
