What is an ESOP Scheme: Its benefits and working

In today's world, employees are not just limited to receiving paychecks. To incentivise employees to work harder and pledge their loyalty to the company, employers have started using Employee Stock Ownership Plans, or ESOPs, as a successful tool. So what does ESOP mean in the share market?

ESOPs explained

An ESOP is an employee benefit plan designed to grant ownership stake to employees. In an ESOP, the company allocates a small share to the employee, which is kept in the ESOP trust fund. The employee can build up his ownership over time and also have gains.

Benefits of the ESOP Scheme

ESOP schemes can be beneficial for both the employer and the employee.

Benefits for employees

• Ownership in the company - Owning the company's stock can allow employees to enjoy rewards when the company experiences financial growth. It motivates the employees to contribute more to the company because they get direct benefits from its economic success.
• Retirement Benefits - Employees who accumulate company stocks over time and remain in the company for the vesting period can earn a significant amount of wealth. Once they retire, they can sell the stocks and use that to support their retirement.
• Portfolio Diversification - ESOPs can also be a great way to diversify your portfolio from usual financial investments like stocks, mutual funds and ETFs. An additional benefit is that employees get to exercise their company's Employee Stock Ownership Plan and buy stocks at a discounted rate.

Benefits for employers

• Incentivising employees- ESOPs are a great way to motivate and directly incentivise employees to work harder for the company's interests. They can be a great way to build a dedicated team and fuel an entrepreneurial environment among the employees.
• Employee loyalty- With employees having a vested interest in the company's performance, ESOPs can be successfully implemented to retain more employees. This can increase the number of long-term employees and, thus, positively affect the company's overall growth.
• Attract great minds- ESOPs can be a great way to attract talented individuals to the company. This is especially true for fast-rising companies and can be a great way to build a strong team and gain an edge over the competition.
• Tax deductions- According to the provision of Section 37(1) of the Income Tax Act, ESOPs are tax deductible. This can lower the total taxable income of the company.

How do ESOPs work?

Now that we know what an ESOP scheme is let us see how it works.

Set up an ESOP trust fund

The first step is for the company to create a separate trust fund, specifically to hold the company's stocks on behalf of the employee.

Funds contributed to the trust fund

The company then contributes to the ESOP trust to buy the shares. The contribution could be in the form of cash, stocks, loan or a combination.

Selection of employees

Individual employees are then chosen to allocate the ESOP stocks.

Vesting period

The day the employee agrees to own stocks under the ESOP scheme, a grant date is given. From this day onwards, the vesting period begins. During the vesting period, the employee must stay employed in the company in order or lose the right to exercise their ESOPs.

Allocation of stocks

Once the vesting period is over, the stocks are transferred to the employee's account within the trust fund.

Employees exercise their right

Employees can now buy the stocks at a much lower rate than the fair market value or sell their shares.

In Conclusion

ESOPs foster employees' loyalty, commitment and innovation - all that is needed to push a company towards success. Employees can also be a part of the company's success and earn dividends if it does financially well while diversifying their portfolio.

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Frequently asked questions

1. How ESOPs work?

With ESOPs, companies allocate stocks to employees and give them partial ownership of the company. Employees have to wait until the vesting period to exercise their ESOPs.

2. How are ESOP shares allocated?

ESOP shares are allocated to the employee's account within the ESOP trust fund.

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