An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs give the sponsoring company—the selling shareholder—and participants various tax benefits, making them qualified plans, and are often used by employers as a corporate finance strategy to align the interests of their employees with those of their shareholders.
Employee Stock Option Plans (ESOPs) are an innovative way for companies to reward their employees by offering them a stake in the organization. This employee benefit program allows employees to purchase shares of their employer’s company at a discounted price, typically after a certain period of time, called the “vesting period.” Here’s a deep dive into what ESOPs are, their benefits, risks, taxation, and how they operate within Indian companies under the Companies Act, 2013.
What is ESOP?
An ESOP (Employee stock ownership plan) refers to an employee benefit plan which offers employees an ownership interest in the organisation. Employee stock ownership plans are issued as direct stock, profit-sharing plans or bonuses, and the employer has the sole discretion in deciding who could avail of these options. However, employee stock ownership plans are just options that could be purchased at a specified price before the exercise date. There are defined rules and regulations laid out in the Companies Rules that employers need to follow for granting employee stock ownership plans to their employees.
An Employee Stock Option Plan (ESOP) is a scheme that grants employees the right, but not the obligation, to purchase shares of the company they work for, at a predetermined price, after completing a specified period of employment or after meeting performance targets. The purpose of ESOPs is to increase employee commitment and retention by offering them a sense of ownership in the company. By providing employees with stock options, they become invested in the company’s success and are motivated to contribute toward its growth.
How Does an Employee Stock Ownership Plan (ESOP) Work?
An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy shares of the corporate stock. ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes, including a number of large publicly traded corporations. Contrary to what some people say, companies with an ESOP must not discriminate and are required to appoint a trustee to act as the plan fiduciary. Among other things, it is not possible for senior employees to receive more shares or for ESOP participants to have no voting rights.
The ESOP structure typically works in the following steps:
- Granting of Options: Eligible employees are granted options, typically at a price lower than the current market price of the company’s shares. The number of options granted is decided based on factors like seniority, role, or performance.
- Vesting: Employees are required to stay with the company for a certain period (vesting period) before they can exercise the options granted to them.
- Exercising the Options: After the vesting period, employees have the right to purchase the shares at the predetermined exercise price.
- Selling the Shares: Once the shares are bought, employees may hold them or sell them at the prevailing market price. If the shares appreciate in value, employees can realize capital gains.
Key Terms in ESOPs
- Option: The right granted to employees to purchase the company’s stock at a future date for a predetermined price.
- Vesting Period: The period after which employees can exercise their options and purchase the company’s shares. Typically, the vesting period lasts for one year.
- Exercise Period: The time window during which employees can exercise their vested options.
- Exercise Price: The price an employee pays to exercise their stock options. This price is usually lower than the stock’s market value.
- Option Grantee: An employee who has been granted stock options.
- ESOPs for Directors: In case of Directors, especially non-executive Directors, ESOPs are considered a part of their remuneration package, treated as a perquisite under managerial remuneration provisions of the Companies Act, 2013.
Advantages of ESOPs
- Employee Retention
ESOPs are often used to encourage long-term employment. The vesting period ensures that employees stay with the company long enough to fully benefit from their stock options, thus helping retain talent.
- Attracting Talent
Companies use ESOPs as part of their compensation packages to attract top-tier talent, especially in competitive industries.
- Employee Motivation and Productivity
When employees own a part of the company, they are more likely to be motivated to contribute towards its success. Their performance directly impacts the value of their stock options, which in turn motivates them to work harder.
- Wealth Creation for Employees
ESOPs provide a way for employees to accumulate wealth, especially if the company performs well. As the value of the company’s shares increases, so does the value of the stock options granted.
- Sense of Ownership
By owning shares in the company, employees feel a greater sense of ownership and responsibility, which often leads to increased job satisfaction and loyalty.
Risks of ESOPs
While ESOPs provide significant benefits, they also come with some risks:
- Market Risk: If the company’s stock price does not perform well, employees could end up with shares that are worth less than what they paid for them.
- Financial Commitment: In some cases, employees must pay to exercise their options, which could be a financial burden if the company’s performance doesn’t meet expectations.
- Company Performance: If the company struggles or does not meet expectations, employees may face a situation where their ESOPs have no real value.
Taxation of ESOPs in India
ESOPs are subject to dual taxation in India:
- At the time of exercising the options: When an employee exercises their stock options, the difference between the market value of the shares and the exercise price is considered a perquisite and is taxed as income from salary, based on the employee’s income tax slab.
- At the time of selling the shares: If an employee decides to sell the shares acquired through ESOPs, any profit made from the sale (the difference between the sale price and the fair market value at the time of exercise) is taxed as capital gains. If the shares are sold after one year, it is considered long-term capital gain, otherwise, it is short-term capital gain.
Special Tax Provisions for Start-ups
The government offers some relief for start-up companies. Employees of start-ups can defer the tax liability on the perquisite (the difference between the FMV and exercise price) until five years from the date of the ESOP grant or until the employee sells the shares or exits the company.
Who is Eligible to Receive ESOPs?
As per Rule 12(1) of the Companies (Share Capital and Debentures) Rules, 2014, ESOPs may be issued to:
– Permanent employees of the company, whether based in India or abroad.
– Directors of the company, including full-time or part-time directors (excluding independent directors).
– Permanent employees or directors of subsidiary companies, holding companies, or associate companies, irrespective of location.
Who is Ineligible for ESOPs?
A company cannot issue ESOPs to:
– Employees belonging to the promoter group or who are promoters of the company.
– Directors (or their relatives/entities) holding over 10% of the company’s equity shares, directly or indirectly.
Exceptions: Startups are exempt from these restrictions for 10 years from incorporation.
ESOP Issuance Process
Governed by Section 62(1)(b) of the Companies Act, 2013 and Rule 12, the steps for issuing ESOPs are:
1. Draft the ESOP Scheme: Align it with the Companies Act and Rules.
2. Board Meeting Preparation:
– Issue a board meeting notice to directors 7 days in advance.
– Propose resolutions for ESOP issuance, pricing, and scheduling a general meeting for shareholder approval.
3. Post-Board Meeting Compliance:
– Circulate draft meeting minutes to directors within 15 days.
– File Form MGT-14 with the Registrar of Companies (RoC).
4. General Meeting:
– Notify shareholders, auditors, and directors 21 days beforehand.
– Pass a special resolution approving ESOP issuance.
5. Post-Approval Compliance:
– File Form MGT-14 with RoC within 30 days of the resolution.
– Issue ESOP options to eligible employees/directors.
6. Record-Keeping: Maintain a Register of Employee Stock Options (Form SH-6) detailing grants.
Note for Private Companies: Ensure the Articles of Association (AoA) permits ESOPs. If not, amend the AoA via an Extraordinary General Meeting before proceeding.
Download Sample ESOP Scheme Plan/ ESOP Scheme Template
Download form MGT-14
Key Stages of ESOP Allotment
1. Grant: The company offers stock options to employees, specifying the exercise price.
2. Vesting: Employees gain the right to exercise options after a minimum 1-year gap from the grant date.
3. Exercise: Employees purchase shares during the exercise window. Shares may have a lock-in period post-exercise.
– Note: Employees do not enjoy shareholder rights (dividends, voting) until shares are issued.
Mandatory Disclosures in ESOP Proposals
The explanatory statement for the special resolution must include:
– Total stock options to be granted.
– Eligible employee categories.
– Vesting requirements and timelines.
– Exercise price and process.
– Lock-in periods (if applicable).
– Maximum options per employee.
– Valuation methodology for options.
– Conditions for lapsing of options.
– Compliance statement with accounting standards.
Cost of ESOPs and Distributions
Legal fees, accounting fees, and administrative expenditures may be included in the initial costs of an Employee Stock Ownership Plan (ESOP) in India.
The cost of establishing and sustaining an ESOP varies according to the plan’s size and complexity.
Furthermore, ESOP distributions in India may occur in a variety of ways.
When an employee exercises their stock option to obtain shares, they have the option of selling them immediately or storing them for future appreciation.
If the employee decides to sell the shares, the proceeds, less any taxes due on the gain, will be sent to them. If the employee agrees to keep the shares, they will own a piece of the company and may be eligible for dividends or capital gains if the stock price rises.
Why Company offers ESOPs to their employees?
Organisations often use Employee stock ownership plans as a tool for attracting and retaining high-quality employees. Organisations usually distribute the stocks in a phased manner. For instance, a company might grant its employees the stocks at the close of the financial year, thereby offering its employees an incentive for remaining with the organization for receiving that grant. Companies offering ESOPs have long-term objectives.
Not only do companies wish to retain employees for the long term, but also intend to make them the stakeholders of their company. Most of the IT companies have alarming attrition rates, and ESOPs could help them bring down such heavy attrition Start-ups offer stocks for attracting talent. Often such organisations are cash-strapped and are unable to offer handsome salaries. But by offering a stake in their organisation, they make their compensation package competitive.
ESOPs from an employee’s perspective
With ESOPs, an employee gets the benefit of acquiring the shares of the company at the nominal rate, and selling them (after a defined tenure set by his employer) and making a profit. There are several success stories of an employee raking in riches together with founders of the companies. A very notable example is Google when it went public. Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions too.
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Stock Ownership
Employees can enjoy ownership in the company that they work for as ESOPs give them the right to own a part of the company’s share capital.
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Dividend Income
A part of the profit earned by the company is distributed among the shareholders in the form of dividends. Employees can, therefore, earn additional dividend income and also get the direct benefit from the efforts that they put toward the company’s profitability.
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Buy Shares at a Discounted Rate
At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the shares allotted to them. This, therefore, allows them to invest in the company at a preferential rate.
ESOP Taxation
ESOPs have dual tax effects:
- When an employee exercises their rights and purchases company stock
- When the employee sells the stock after purchasing it
Let’s take a closer look at these examples:
Tax treatment at the time of buying the shares
Employees can purchase shares after the vesting date at a price less than the share’s Fair Market Value (FMV) on that date. As a result, the difference between the FMV and the exercise price of the share is considered a pre-condition in the employee’s hands and taxed at his income tax slab rate.
However, in the case of new businesses, the government has softened the tax implications of ESOPs.
Employees at the start-up would not have to pay the tax on the perk in the year in which they exercised the ESOP. TDS on ESOPs would be delayed until the sooner of the following dates:
- Five years from the date of the ESOP grant
- When does the employee sell the ESOP?
- Date of departure from the company
Employees can buy the shares after the vesting date at a rate lower than the Fair Market Value (FMV) of the share as of that date. As such, the difference between the FMV and the exercise price of the share is treated as a prerequisite in the hands of the employee and taxed at his income tax slab rate.
ESOP Example
Exercise date | January 1, 2022 |
FMV | Rs. 150/share |
Exercise price | Rs. 85/share |
Taxable value of perquisite | 150 − 85 = Rs. 65/share |
Number of shares exercised | 1,000 |
Total taxable perquisite | 1,000*65 = Rs. 65,000 |
Tax payable (assuming a tax slab of 30%) | 30% of 65,000 = Rs. 19,500 |
In the case of start-ups, however, the government has relaxed the tax implications on ESOPs.
Start-up employees would not have to pay the tax on the perquisite in the year when they exercise the ESOP. For them, TDS on ESOPs would be deferred to the following dates, whichever is earlier:
- Completion of five years from the ESOP grant date
- Date when the employee sells the ESOP
- Date of leaving the company
Tax treatment at the time of selling the shares
If the employee sells the shares, the difference between the selling price and the FMV on the date the share was exercised is taxable as capital gains.
If you sell your shares within a year of buying them, you will have to pay a 10% tax on any profits over Rs.1 lakh. If the shares are sold within 12 months, the profits are taxed at 15%.
In the above example, if the employee sells the shares, here’s how the tax would be calculated:
Exercise date | January 1, 2022 |
FMV as of January 1, 2022 | Rs. 150/share |
Case 1: Shares sold on October 1, 2022 | |
FMV on October 1, 2022 | Rs. 165/share |
Difference between the FMVs | 165 − 150 = Rs. 10/share |
Number of shares | 1,000 |
The total amount of short-term capital gain | 1,000*10 = Rs. 10,000 |
Short-term capital gains tax payable | 15% of 10,000 = Rs. 1500 |
Case 2: Shares sold on February 2, 2023 | |
FMV on February 2, 2023 | Rs. 180/share |
Difference between the exercise FMV and sale FMV | 180 − 150= Rs. 30/share |
Number of shares | 1,000 |
The total amount of long-term capital gain | 1000*30 = Rs. 30,000 |
Long-term capital gains tax payable | Nil as the gain is below Rs. 1 lakh |
Taxation of foreign ESOPs in India is also similar, and you would be taxed in India on the perquisites earned from a foreign company.
Benefits of ESOPs for the employers
Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee to put in his 100%. Although motivation, employee retention and awarding hard work are the key benefits which ESOP brings to employers, there are several other noteworthy advantages too. With the help of ESOP options, organisations could avoid cash compensations as a reward, thus saving on immediate cash outflow. For organisations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.
ESOPs are favourable for employers too. Here’s how:
Employee Retention
Since employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain employees.
Better Productivity
Since employees themselves stand to gain from the profits earned by the company, ESOPs can boost employee productivity and make the company more profitable.
A Tool for Attracting Talent
ESOPs are additional compensation plans that help employers attract and retain talented employees. In fact, for start-ups, ESOPs help lure in good talent in the initial days when high pay packages are not feasible.
ESOP and Other Forms of Employee Ownership
Stock ownership plans provide packages that act as additional employee benefits and embody the corporate culture that company managements want to maintain. Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.
- Direct stock purchase plan (DSPP)- lets employees purchase shares of their respective companies with their personal after-tax money. Some countries provide special tax-qualified plans that let employees purchase company stock at discounted prices.
- Restricted stock- gives employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.
- Stock options- provide employees the opportunity to buy shares at a fixed price for a set period.
- Phantom stock- provides cash bonuses for good employee performance. These bonuses equate to the value of a particular number of shares.
- Stock appreciation rights- give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.
FAQs on ESOPS
What Does ESOP Stand for?
ESOP stands for employee stock ownership plan. An ESOP grants company stock to employees, often based on the duration of their employment. Typically, it is part of a compensation package, where shares will vest over a period of time. ESOPs are designed so that employees’ motivations and interests are aligned with those of the company’s shareholders. From a management perspective, ESOPs have certain tax advantages, along with incentivizing employees to focus on company performance.
How Does an ESOP Work?
First, an ESOP is set up as a trust fund. Here, companies may place newly issued shares, borrow money to buy company shares, or fund the trust with cash to purchase company shares. Meanwhile, employees can accumulate a growing number of shares, an amount that can rise over time depending on their employment term. These shares are meant to be sold only at or after the time of retirement or termination, and the employee is remunerated by receiving the cash value of their shares.
Are ESOPs Good for Employees?
Yes, ESOPs can generally be considered a benefit for workers. These programs tend to be adopted by companies that don’t chop and change staff frequently and often result in a bigger payout and greater financial compensation for employees.
Conclusion
ESOPs are a powerful tool for attracting and retaining talent while also aligning the interests of employees with the growth and success of the company. They offer employees a sense of ownership, motivate performance, and allow for wealth creation. However, they also come with risks, especially if the company’s stock value doesn’t perform well. The process of implementing ESOPs is regulated by laws and requires careful planning and compliance.
By understanding the nuances of ESOPs and their implications, both companies and employees can leverage this program to their advantage, ensuring long-term growth and success.
