ESOPs: How do They Work and What are its Benefits to Employees

May 10, 2022 By Sonali Sheikh

The significance of Employee Stock Ownership Plans (ESOPs) as an employee encouragement and reward mechanism is growing given its numerous benefits. An increasing number of companies are tapping on the tool to ensure that employees are rewarded for their loyalty and for working with a sense of ownership in the company.

How do ESOPs Function?

ESOP is a type of employee benefit plan or an incentive tool that gives the right to employees to purchase a certain number of the company’s shares at a predetermined price after the expiration of a predetermined period (popularly known as the vesting period). ESOPs as a part of compensation strategy, not only help in creating wealth for employees but also, ensure that employees’ objectives are aligned with the company’s vision.

Following are the key features of ESOPs:

  • ESOPs are given at a discounted rate to employees and are a part of the employee’s CTC structure.
  • Employers can give ESOPs to all employees or selective ones depending on the recruitment strategy. EKI Energy Services Ltd gives ESOPs to all the employees without any organizational hierarchies.
  • In some cases, ESOPs can be exercised in installments over a specified period.
  • Employees are not bound to exercise their ESOPs.
  • Stocks will dilute if an employee leaves the company during the vesting period.

Before we dig deep, let us first understand some major terms related to ESOPs

  • Grant: Offering ESOP Options from company to employee
  • Vesting: Process through which employee becomes eligible to exercise options
  • Exercise: When an employee applies to the company for getting shares allotted

Once stock options are granted, there is a vesting period which is usually 1 year. The right to convert the stock options into equity i.e. vesting activates once the vesting period has lapsed. Thereafter, subject to the ESOP scheme issued by the employer, the employee has a right to exercise his vested options by paying an exercise price

Once the stocks are vested, an employee can choose to:

  • Sell the stocks right away but since ESOPs are taxable, one should ideally opt diligently.
  • Exercise loan facility or ESOP funding against ESOPs.
  • Lastly, the employee can hold on to the stocks and wait for the share prices to rise before selling them. This is a popular choice among employees who are granted ESOPs. Many companies give additional stocks to employees as a reward or bonus at timely intervals, leading to more stocks in hand and the scope of more wealth creation.

ESOPs Benefits for Employees

ESOPs benefit employees in the following ways:

  1. Stock Ownership: ESOPs give employees the right to own a part of the company’s share capital, hence, they can enjoy ownership of the company which helps them stay motivated. It also gives employees a sense of belonging as they get a stake in the company’s growth trajectory.
  1. Additional Income Source: As employees can acquire stocks at a low cost or absolutely no cost, it creates an additional income source for them. They can either sell off these stocks at a higher market value to earn profits or hold on for long-term returns. In addition, companies distribute a part of their profit among the shareholders in the form of dividend which generates additional profits for employees.

Wondering what companies see while granting ESOPs?  There are various parameters such as loyalty, designation, performance, present & potential contribution and opportunity cost.

Who is Entitled to ESOPs?

Let us understand what kind of employees are actually entitled to ESOPs. This includes employees of the company, its holding & subsidiaries and foreign employees. ESOPs may be issued to:

  1. A permanent employee of the company working in or outside India; or
  2. A whole-time director; or
  3. Non-executive non-promoter directors

Following are the ones who are not covered:

  • A director who directly or indirectly, owns more than 10% of the outstanding equity shares of the company; or
  • A person belonging to the promoter group or an employee who is a promoter; or
  • Contractual employees; or
  • Independent directors

Who Can Exercise the Options?

No person other than the employee to whom ESOPs are granted can exercise the option. However, in case of the death of the employee, while he is in employment, all the granted options get transferred to the nominees. Further, if the employee faces a permanent incapacity during his employment, all the granted options shall vest in him on that day. In case of termination or resignation, the employee can exercise the options granted to him. However, options not vested in the employee on that day shall expire.

Tax Involvement

There are two levels of taxation in the case of ESOPs. The first stage is when the ESOP option is exercised – the employer is required to deduct tax from the employee on the difference between the exercise price and the market value of the security which is considered a perquisite in the employee’s hand. The second stage is when the shares are eventually sold as the difference between the selling price and the fair market value of the shares on the day they were exercised is liable to capital gains tax upon its sale.

ESOPs: A Great Option to Opt For

ESOPs are beneficial to both employees and employers. While companies leverage ESOPs as a growth multiplier, employees benefit immensely from the reward and monetary benefits. It boosts their personal wealth, helps them grow professionally, improves job security and satisfaction and makes them more responsible for their job. Employees must however keep themselves abreast on the performance of their shares at the stock market to be able to realize its full potential.

Note: The above interpretation is based on our view. Taxation rules & regulations will be applicable as per local land laws.