0 hidden charges. 0 forex
debit-card

What Is An ESOP? How Does An ESOP Work?

FACT CHECKED
Reviewed by
.
Created on
October 20, 2022

Summary

What’s Inside

ESOPs are becoming a very popular mode of recruiting and retaining talent in startups and major companies across the country. An Employee Stock Ownership Plan (ESOP) is a good incentive for the employees to work harder — so that, in the long run, the value of these stocks rises and helps create a significant financial corpus. But how do ESOPs work? Let's understand that in more detail.

What is ESOP?

An ESOP provides employees with stock shares representing ownership in the business. It is a type of employee benefit plan that encourages employees to excel at their work, reflecting their stake in the company. Employers frequently use ESOPs as a corporate finance approach to balancing the interests of the employees with that of their shareholders.

The employer grants certain business shares to the employee at a lower price through these schemes. These shares stay in the ESOP trust fund until the employee exercises their option to purchase them, leaves the firm or institution, or retires.

How does an ESOP work?

ESOPs are established as trusts and can be financed in several ways by businesses, including by adding freshly issued stocks into them, paying cash to purchase existing shares, or borrowing funds through the corporation to do so. Companies of diverse sizes, including several sizable publicly traded enterprises, use ESOPs.

  • An ESOP is first established as trust funding. 
  • Companies can deposit freshly issued shares here, borrow money to purchase them or put cash into the trust to buy them. 
  • Employees can accrue a rising number of shares, and the total amount depends on the length of their work. 
  • Employees get compensated by receiving the cash worth of their shares. This encashing usually occurs at or after the moment of retirement or termination.

Key terminologies to know with ESOPs

  1. Employee - A person who works for the organisation in India or abroad. This also includes affiliates or subsidiary company’s directors as well as the workers.
  2. Grant - This refers to giving the employees the stock under the ESOP scheme.
  3. Vesting period - The time during which the ESOPs granted to the employee mature; where full rights are issued to the employee.
  4. Exercise - An employee's request for the company to issue shares in return for the option that has vested in accordance with the ESOP is referred to by this phrase.

What Are ESOP Shares And What Are Their Benefits?

Organisations typically distribute stocks in stages.

For instance, a business might provide its employee's shares at the end of the fiscal year as an incentive to stick with the company in exchange for getting that award. Businesses that provide ESOPs have long-term goals. Companies want to keep their employees for a longer period, but they also want to turn them into shareholders. Plus, startups offer stocks to entice talent.

What are the Benefits of ESOPs?

The following are the benefits of ESOP:

  • An organisation may give its staff stock options as a kind of motivation. This would motivate the employee to give it their all because they would profit if the company's stock prices rose. 
  • Although the main advantages ESOP offers to companies are incentives, employee retention, and rewarding effort, there are several additional vital perks, like receiving dividends and getting shares at a discounted value.
  • Organisations could avoid paying cash rewards as a reward with the aid of ESOP possibilities, saving on an immediate cash outflow. 
  • ESOPs give employees a sense of ownership, which keeps them engaged since they have a say in the success and growth of their company. They believe they are much more than employees doing a job. Employees feel more a part of the company since they have a genuine stake in its future success.
  • ESOPs aid in enabling employees to achieve full financial independence. Employees can build a sizable corpus through ESOPs, whereas monthly salary and other savings schemes can assist them in covering their everyday needs. 

ESOP Tax Implications

Shares become the employee's property (vested) after a specified amount of time has passed since the award date, and the employee has been given the unrestricted right to acquire the shares. Such options become exercisable once they become vested in the employee (exercise). Upon an employee exercising their shares, the company allocates the shares to them (allotment). India grants ESOPs per SEBI Guidelines from 1999.

The tax on ESOPs gets evaluated twice. First, when shares are allocated to an employee after they exercise their option at the end of the vesting period. Second, when an employee decides to sell the ESOP shares they've been allotted.

The Various Forms Of Employee Ownership

Plans for stock ownership offer packages that serve as extra perks for employees and reflect the workplace culture that management wants to uphold. Direct-purchase programmes, stock options, restricted stock, phantom stock, and stock appreciation rights are further forms of employee ownership.

1. Employees may buy stocks of their respective firms through a DSSP or direct stock purchase plan using their own after-tax funds. Some nations offer unique tax-qualified arrangements that enable employees to buy business stock at a discount.

2. Employees with restricted stock have the option to obtain stocks as a present or a purchase after fulfilling certain requirements, such as serving for a predetermined amount of time or exceeding predetermined performance goals.

3. Employees who have stock options have the chance to purchase shares for a predetermined amount of time at a specified price.

4. Phantom stock offers financial rewards for strong employee performance. These bonuses are equivalent to the price of a specific quantity of shares.

5. Employees have the option to increase the value of a specified number of shares through stock appreciation rights. Typically, companies pay for these stocks in cash.

Up-Front Expenses and Distributions for ESOPs

Employees are frequently given this ownership by their employers with no upfront expenditures. Until the staff retires or quits, the corporation may place the issued share in a fund for growth and protection.

As time passes, distribution from the plan gets frequently linked to vesting, which grants employees access to employer-provided assets. Typically, employees receive an increasing percentage of shares for each year of service.

Key Highlights to be noted

  • ESOP or employee stock ownership plan provides employees with shares of stock that represent ownership in the business.
  • Employee stock ownership plans (ESOPs) motivate staff to work hard since they benefit financially when the business succeeds.
  • Additionally, they support employees in feeling more valued and well-paid for the work that they perform.
  • Most businesses link plan distributions to vesting, which gradually grants employees access to employer-provided assets.
  • It's crucial to study your ESOP's agreements because they may vary and contain different regulations.
  • Direct-purchase programmes, stock options, restricted stock, phantom stock, and stock appreciation rights are further forms of employee ownership.

The Bottom Line

ESOPs typically encourage increased work and dedication in exchange for larger financial benefits, benefiting both employers and employees. They are not always simple, though, and if the participant doesn't completely get the specifics of their strategy, it can be frustrating.

Every ESOP is different. To make the most out of this benefit — and avoid losing out on a sizable additional bonus — it's crucial to be informed of the rules on actions like vesting and withdrawals, which can differ.

Frequently Asked Questions

1. Is ESOP good for employees?

Yes, ESOPs are typically regarded as a benefit for employees. Companies that don't routinely cut and replace personnel are more likely to implement these programmes, resulting in higher employee payouts and financial incentives. ESOPs have been successfully used to hire, retain, motivate, and compensate employees. It is crucial to ensure that ESOPs appeal to employees, are simple to understand and administer and convey the employer's overarching message.

2. Why would a company do an ESOP?

A business gives its employees ESOPs in return for purchasing a predetermined amount of shares of the business after a predetermined number of years at a predetermined price following the option period. The predetermined vesting period must be completed before a worker can exercise any or all of their stock options, which means the individual must work for the company during that time.

3. How does ESOP payment work?

The shares may be issued, paid for in cash, or paid for with both. If shares are issued, the employee has 60 days to sell the stock directly to the business before it expires. You must give the employees stock certificates if they opt for stock distribution.

Wherever stocks are traded, as in a market or in the primary market following an IPO, employees may sell their shares. If they decide to pay cash, you can do it in one lumpsum ESOP payment or over the course of two years.

4. What happens to ESOP when I quit?

If you quit your job or take voluntary retirement, you would have the option of taking your vested retirement savings distributions in one lump sum or in equal year payments.

5. How does an ESOP work?

When a company offers ESOPs, they are held in trust for a specific amount of time. The vesting term is the time frame in question. Employees may then exercise their ESOPs after the vesting time has passed. The employers determine the number of shares that may be offered, their price, and the recipients.  Following this, the chosen employees will have the opportunity to exercise the ESOPs and purchase company shares at allowed prices, which are below market value.

6. What is the major problem with ESOPs?

The following are the major problems or risks associated with an ESOP:

  • Employee stock ownership programmes are subject to intricate regulations and demand close monitoring. 
  • Although ESOP Third Party Administration companies and external advisers could manage this function through outsourcing, the ESOP company still needs inside staff to spearhead this programme. 
  • If a company lacks the personnel to carry out the ESOP task properly, they run the risk of problems and even breaches.
  •  Following the creation of the ESOPs, the business requires adequate administration, which includes third-party administration, a trustee, valuation, and legal fees. The management and shareholders of the company must be attentive to continuing expenses.
  • The ESOP scheme isn't a good fit for such a corporation if the cash flow allocated to ESOPs restricts the funds available to be reinvested in the firm over the long run. 
  • Companies that need a considerable amount of additional capital to operate must stay away from ESOPs. 
  • The cash flow of the business is used by ESOP plans to finance the acquisition of shares from shareholders. The ESOP transactions would conflict with a company's need for more capital expenditures or working capital, which would put the management in a difficult situation.

Disclaimer

Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.
Share this article
Copied Link!
Blog
>
Work & Money
>
What Is An ESOP? How Does An ESOP Work?

Sources

View similar articles in
Work & Money
Get the Fi app