ESOPs Unraveled: The Mechanics to Employee Stock Ownership Plans

"ESOPs are a powerful tool that aligns employee ownership with company success, fostering a culture of shared responsibility and collective achievements." - Richard Branson

The idea of ESOPs as a part of compensation though existed, has exponentially increased over the past few years. With them, employers get the chance to trade substantial cash outflows for higher wages when their resources are constrained. This also incentivizes employees across all levels to excel and contribute to the company's success, as they directly benefit from its prosperity.

However, while employee stock ownership plans may seem enticing, they come with strict requirements, limitations, and obligations, making them unsuitable for everyone. Your organization's eligibility to implement such a plan depends on its structure, as not all companies meet the necessary legal criteria.

Before we go into the details, let us start off by understanding how ESOPs work.

The 6-Step Process of Establishing ESOPs

Establishing ESOPs is a very intricate process from ideation to its actual implementation, let us take a look at this process step by step.

1. Shareholder Approval is Requested

Prior to implementing an ESOP benefit plan, the company must present it at a shareholders' meeting and seek its approval.

2. Determination of ESOP Allocation Formula

The company needs to decide on the method for allocating ESOPs to eligible employees, which typically considers factors such as years of service, compensation, or a combination of both.

3. Establishment of an ESOP Trust

An Employee Stock Ownership Trust (ESOT) is established to hold the shares allocated to the employee stock ownership plan. The company can allocate new shares or use cash to purchase existing shares.

4. Allocation of Stocks to Employees and Determination of Grant Date

Individual employee accounts receive the transferred stocks, and a grant date is set. This date marks the agreement between the company and the employee, granting the employee the right to own the shares at a predetermined price on a future date (subject to certain conditions).

5. Establishment of Vesting Period

A vesting period is established, specifying the minimum duration of employment required before an employee can take ownership of the ESOP shares allocated to their account.

6. Distribution of Shares

Upon an employee's departure, retirement, or eligibility for a distributable event, the shares allocated to their ESOP account are distributed to the employee, typically in the form of cash or company stock. It is worth noting that some ESOP arrangements may include a "Leaver" clause, allowing departing employees to sell their ESOP shares back to the company at fair market value.

Now after seeing how ESOPs work, let us look at a few of the approaches on how to grant ESOPs.

Both of these approaches are quintessential and whether to take a bottom-up approach or a top-down approach will depend upon the company size as well as ESOPs pool size. Now let us shift our focus toward different types of ESOPs.

Varieties of Employee Stock Ownership Plans (ESOPs)

There are several types of Employee Stock Option Plans (ESOPs) that facilitate employee ownership within an organization. These plans provide opportunities for employees to acquire company stocks under specific conditions and terms. Here are the different types of ESOPs:

By implementing these various ESOPs, organizations can offer their employees different avenues to become shareholders, fostering a sense of ownership and alignment with the company's performance.
Now let us look at the advantages and disadvantages of ESOPs.

What Are the Benefits of Employee Stock Options?

ESOPs offer a range of benefits. They promote employee engagement, long-term financial security, and retirement savings for employees. For employers, ESOPs contribute to enhanced recruitment and retention, a stronger company culture, and effective succession planning. Together, these benefits create a win-win scenario, fostering a mutually beneficial relationship between employees and employers. Let us look at them in detail.

Benefits for Employees:	Benefits for Employers:
1. Enhanced Employee Engagement and Productivity: When employees have a stake in the company's success through ESOPs, they become more engaged and motivated to contribute to its growth. The sense of ownership fosters a strong work ethic, increased productivity, and a commitment to achieving common goals.	1. Improved Employee Recruitment and Retention: Offering ESOPs can attract top talent and enhance employee retention rates. Prospective employees are often attracted to companies that offer employee ownership opportunities, considering it a valuable benefit that demonstrates the employer's commitment to their long-term success and well-being.
2. Long-Term Financial Security: ESOPs provide employees with long-term financial assets as they accumulate shares in the company over time. As the company prospers, the value of its ESOP holdings can appreciate, potentially leading to substantial wealth accumulation and financial security in the future.	2. Stronger Company Culture and Loyalty: ESOPs foster a sense of camaraderie, shared purpose, and loyalty among employees. Employees feel a greater sense of pride and loyalty toward the company, resulting in increased dedication, collaboration, and a positive corporate culture.
3. Retirement Savings and Wealth Creation: ESOPs serve as an effective retirement planning tool, allowing employees to build a significant nest egg through their participation in the program. The ability to sell ESOP shares upon retirement can provide a substantial source of income and contribute to a comfortable post-retirement lifestyle.	3. Cost Management: During the early stages or periods of financial constraints, effectively managing costs plays a crucial role in preserving the company's cash flow and allocating equity instead of cash-based incentives, enabling businesses to strategically allocate resources and alleviate immediate financial burdens. This approach allows companies to conserve cash flow and make prudent decisions to navigate challenging financial situations.

What Are the Drawbacks of Employee Stock Options?

After understanding some of the pros let us look at some of the cons of ESOPs.

Disadvantages for Employees:	Disadvantages for Employers:
1. Limited Liquidity: ESOP shares are typically not readily tradable on public markets, which can restrict employees' ability to convert their ownership into cash. Employees may face challenges in assessing the value of their ESOP shares when they need immediate funds or wish to diversify their investment portfolio.	1. Limited influence of ESOPs on non-participating employees: Non-participating employees, who do not have stock ownership, may experience a reduced impact on their motivation and engagement. This discrepancy in benefits can create a sense of inequality within the workforce, potentially impacting overall employee morale and collaborative efforts.
2. Dependency on Company Performance: The value of ESOP shares is closely tied to the performance of the company. If the company experiences financial difficulties or a decline in its market position, it can negatively impact the value of employees' ESOP holdings. This dependency on the company's success introduces a level of risk to employees' investments.	2. Uncertainty: Whe2. Uncertainty: When an employee chooses to leave the company, the company is obliged to purchase its stock options at market price, resulting in a negative impact on the firm's cash flow position. Consequently, companies are compelled to maintain a significant amount of cash reserves, resulting in lost opportunity costs.
3. Timing Considerations: Employees need to carefully time their departure from the company to maximize the value of their ESOP shares. If they leave when the share price is low, they may receive a reduced payout. Therefore, timing plays a crucial role in determining when to sell ESOP shares.	3. Complexity in an Exit strategy: An ESOP can be challenging for employers, particularly when there is a need to alter the company's ownership structure or undergo a merger or acquisition. Unwinding the ESOP can entail navigating intricate legal and administrative obstacles, potentially requiring the repurchase of shares from employees or exploring alternative methods to manage the transition of ownership. These complexities can impose financial strain on the company and disrupt its day-to-day operations.

It's important to note that while there are potential disadvantages associated with ESOPs, these drawbacks can be mitigated through effective planning, communication, and ongoing management. Both employees and employers should carefully evaluate the implications of implementing an ESOP and seek professional advice to ensure the best outcomes for all parties involved.

After understanding some of the pros and cons of ESOPs let us look at how they are taxed.

A Brief on Taxation of ESOPs

Legal compliance is crucial in every aspect of a company, including the implementation of an Employee Stock Ownership Plan (ESOP) scheme. The following regulations must be adhered to when implementing an ESOP scheme:

• SEBI (ESOP Guidelines)
• Companies Act
• Income Tax Act
• Accounting Guidelines (ICAI, IFRS, US GAAP)
• FEMA (Foreign Exchange Management Act)

In India, based on the schemes and rules ESOPs are taxed twice,

1. First Levy - Tax on Allotment:

When shares are allotted to an employee after exercising their ESOP option at the end of the vesting period, the tax is levied on the difference between the fair market value (FMV) of the shares on the exercise date and the amount paid by the employee. This difference is known as the Perquisite value. The Perquisite value is subject to taxation and is considered part of the employee's salary. The company deducts TDS on this amount, which is reflected in the employee's Form 16 and Form 12BA.

2. Second Levy - Tax on Sale:

When an employee chooses to sell the shares allotted under the ESOP, the profits made from the sale are treated as capital gains. The capital gains are calculated by deducting the FMV of the shares on the exercise date from the sales consideration of the shares. These capital gains are taxable based on the applicable capital gains tax rates, depending on the holding period of the shares. If the holding period is less than 12 months, the gains are classified as Short-term Capital Gains.

To better understand this let's consider an example to understand how ESOP is taxed.

On July 1, 2021, an employee named X was granted an option under the ESOP to purchase 10,000 shares of ABC Ltd. The option could be exercised after 3 years, on July 1, 2024, with an exercise price of Rs. 60 per share. At the time of share allotment on July 1, 2024, the fair market price of ABC Ltd shares was Rs. 100. Later, on January 31, 2025, X decides to sell the shares at Rs. 120 each.

Taxability of These Shares Under ESOP:

ESOP Taxation - Exercise of Shares:

The perquisite value of ESOP (on the date of share allotment) is calculated as follows:

Perquisite Value = (Fair Market Value per share - Exercise price per share) x Number of shares allotted.

In this case, the perquisite value is (100 - 60) x 10,000 = Rs. 400,000.

This amount is considered part of X's salary and is taxable in the year of share allotment. The employer is responsible for deducting TDS from this amount, which will be reflected in X's Form 16 and Form 12BA.

ESOP Taxation - Sale of Shares:

The capital gains from the sale of shares are calculated as follows:

Capital Gains = Sale Proceeds - Fair Market Value of shares at the time of allotment.

In this case, the capital gains are (120 - 100) x 10,000 = Rs. 200,000.

Since the holding period of shares is less than 12 months, the gains are classified as Short-term Capital Gains and are taxable according to X's normal slab rates.

Please note that this is an illustrative example, and the actual tax implications may vary based on individual circumstances and applicable tax laws.

Conclusion

Numerous organizations employ employee stock options (ESOs) as a means to entice highly skilled individuals to join their ranks. When  considering the inclusion of ESOs in your compensation package, it is crucial to diligently review the terms and conditions outlined in your agreement. Moreover, conducting comprehensive research on the company's fundamentals is essential to maximize the advantages associated with ESOs.

The problematic issue is that because an ESOP is a customized solution, not every firm would benefit equally from it. Therefore, it is essential to speak with an experienced specialist about the potential of this model before starting. To get the consultancy for your ESOPs systems, book a demo today!