Good employees are the company’s assets; therefore, the company does its best to retain its key employees by giving them certain benefits like employee stock ownership plans, health insurance, compensation packages, and other growth options. ESOPs have been one of the widely used strategies to attack and retain employees. Let us delve into ESOPs in detail.
This article talks about ESOPs, their essential features, types, taxability of ESOP, how ESOP works, its benefits, how is ESOPs from the investment point of view, and what happens to ESOPs when an employee quits.
What is ESOP?
ESOPs were pioneered by the IT Sector for the employees by making the employees partner in the growth and development of the company to ensure that the employees take responsibility and ownership for their work. However, other companies’ sectors such as manufacturing, capital goods, consumer goods, banking, financial services, etc., are also following the trend.
The main idea behind giving stock options to the employees is to build a sense of ownership with the company and boost the employees’ confidence and performance level. These practices also inculcate satisfaction and motivation among the employees.
Therefore, many IT employees prefer companies that provide ESOPs.
Employee Stock Ownership Plans (widely known as ESOPs) give the employee an option to buy a particular share of the company at a pre-decided price over time (option/vesting period).
How do ESOPs work?
In ESOPs, the employer allows a certain number of stocks or shares of the company to the employee from their trust fund. The employee can exercise their ESOP’s (buy the shares) as and when they complete the option or vesting period.
To be eligible to exercise the ESOPs, the employee has to work with the organization for the vesting period.
Suppose the employee does not work with the company during the vesting period or leaves the company before the vesting period. In that case, such a person will not be eligible to exercise the ESOPs and convert it into the company’s stock.
The employee has no option but to wait until the vesting period. There are limited options to cash out ESOPs. This could be in terms of an acquisition by another company, a company announcing a buyback, a new fundraise which allows the existing shareholders to cash out. If the startup fails, the ESOP will become worthless. Therefore, in a startup, it is not easy to exit.
The 3 most essential elements of ESOPs to be kept in mind are:
1. How many shares can the employee buy?
2. What was the price at which the shares were purchased?
3. When can the employee buy the share or the time period for buying the shares?
4. When can the employee sell his shares?
ABC Ltd. offers the following ESOPs to its employees:
· 100 shares at Rs. 50
· Vesting/option Period: 4 years
This means if the employee has been working with ABC Ltd. to date, then after 4 years, he/she can buy 100 shares of the company at Rs 50 each, irrespective of the company’s stock market value.
What are the essential features of ESOPs?
To understand ESOPs, let us look into their essential features.
- ESOPs are a part of the employee’s Cost to company (CTC) structure. Therefore, employees are given ESOPs without any cost.
- Every company has its own ESOPs plan. They can provide ESOPs to selective employees or key employees.
- ESOPs can be exercised in a phased manner or fully.
- Vesting date means the date when the employee can exercise the ESOPs. In contrast, a grant date is when the employee is granted ESOP through an agreement with the employer.
- Grant price or exercise price is when the employee can buy the company’s shares.
- Exercising ESOPs is optional and not mandatory for employees.
What are the types of ESOPs?
Having looked into the meaning and essential features of ESOPs, we will now discuss the different types of ESOPs.
There are 5 types of ESOPs:
Employees Stock Option Schemes (ESOS)
This is the commonly used ESOP. The employees buy the company’s shares at a fixed price after the vesting period. However, the employee doesn’t need to invest in the company’s shares.
Employee Stock Purchase Plans (ESPP)
In this plan, the employees can purchase the company’s share at a lower price than the market value. The vesting period and the cost of the stock are predetermined by the company. The employee becomes the shareholder of the company once they exercise their ESOPs. It is mainly used for a listed company.
Restricted Stock Award (RSA)
In this plan, the employee is awarded certain shares upon fulfilment of certain conditions. If the specified requirement is fulfilled, the employee becomes the owner of the share. However, if the employee fails to fulfil the condition, the awarded shares will be forfeited. Therefore, in this plan, the employee becomes the owner of the shares when they are awarded.
Restricted Stock Unit (RSU)
This plan is similar to Restricted Stock Award. The only distinction is that the employee becomes the owner of the shares or stock only to fulfil specific conditions and the actual issuance of the shares to the employee.
Phantom Equity Plan
In this plan, the shares are allotted to the employee notionally (theoretically) at a predetermined price. However, the exercise or grant price is recorded in the company’s book and is not paid to the employee. So, when the employee exercises ESOPs, they are paid out of profit on the vesting date. Therefore, even though the employee is not given the ownership of the shares, they can earn profit by notionally buying stocks at a discounted rate.
Is ESOP Taxable?
Yes, ESOPs are taxable as a prerequisite (i.e., benefits over and above regular income) as a part of an employee’s salary. However, the employer deducts the tax amount at the perquisite value. This means when the employee exercises its option after the vesting period.
ESOPs can be taxed as capital gains. Capital gains mean profit earned by the employee after selling the shares.
ESOPs are taxed as per the Fair Market Value. For listed Companies, Fair Market Value (FMV) is determined based on the price per share quoted on the stock exchange on which the company is listed. The listed company earns short-term capital gains if the shares are sold within one year of vesting. Therefore, long-term (sold after one year of vesting) capital gains are exempted from tax (Depending on the employee tax bracket). In contrast, short-term capital gains are taxed 15%.
Whereas, for unlisted Companies valuation of shares is estimated to determines the Fair Market Value. There is no Security Transaction Tax (STT) in unlisted shares. Here, short-term capital gains are added to the employee’s total income, and the marginal tax rate is levied. In the long-term (holding after 36 months), capital gains 20% tax after indexation is applied.
Advantages of ESOP (for Employer and Employee)
ESOPs are advantageous to the Employees as well as the Employers or the Companies. Nevertheless, there are some disadvantages of having an ESOPs. Let us now discuss the pros and cons of ESOPs.
Pros of having ESOPs are as following:
- It acts as a financial reward for long term savings and ownership structure for the employees;
- It motivates the employee to perform well and give their best, as the more productive the employee is, the more the profitability which would, in turn, increase the company’s stock value and thereby the employee can earn higher profits.
- Creates ownership and association with the employee and managers,
- It also acts as an additional source of income as the employee can earn a dividend on their stocks.
- It retains the key employee and reduces staff turnover; as the employee can exercise their ESOP only after the vesting period, the employee does not leave the company until they encash their shares.
- It acts as compensation for a lower salary and reduces pressure on the company’s cash flow.
- Increases sense of responsibility and loyalty for the company;
- It increases the shareholder value of the company,
- Improves communication between the managers and employees and thereby increases participation and cooperation.
Disadvantages of having ESOPs are as follows:
- If the company’s share price does not move or change, it will affect the confidence and performance of the employees.
- The share ownership gets diluted as the number of employees who get the share increases. (More the number of shares issued to the employees, lesser the percentage of share ownership).
- Employees cannot influence or predict the share prices even if they perform well.
- Employees cannot encash their shares before the vesting period.
How are ESOPs from the investment point of view?
As stated earlier, each company has its own ESOPs rules.
Suppose the company gives shares to its employees free of cost through ESOP. In that case, the employee should definitely participate in ESOPs.
ESOP is a good investment as the employee can sell its shares before leaving, even if the company is not making a profit and has nothing to lose.
Suppose the employee does not want to stay with the company until the vesting period. In that case, you will only have to forfeit your share to the company before leaving.
So, if the company requires its employees to contribute financially or make investments, then the employee should keep the following criteria in mind, namely;
· Do you have to purchase the shares at a fixed price or at a discount rate?
· Do you believe that your company will progress or make profits in future?
· Do you think you would regret investing in the company?
ESOPs are pretty risky. Therefore, if the employee can purchase the shares at a discounted rate and the company is making a profit, then investment in ESOP is excellent. As it also acts as an additional income that gets paid during retirement.
What happens to ESOPs when an employee quits or retires?
When an employee leaves the company, the company has two options, namely;
- Purchase all the shares of the employee and give cash in return. E.g., If the employee owns 100 shares of the company, that is worth 50 Rs. They would receive Rs. 5000 when he leaves or retires.
Then the company can sell or redistribute these shares to other employees.
- Give the value of the employee’s share before leaving the company and pay the actual amount to the employee over a specific period of time. This acts as an additional income at the time of retirement.
ESOPs are the most popularly used by IT/ITeS companies with the primary intention to attract and retain key employees. It works as an encouragement to boost the employee’s performance by creating a sense of ownership. It has proved to be beneficial to both the employees as well as the company. Therefore, ESOPs have to be structured crucially, keeping in mind the company’s objective, applicable laws, the culture of the organization, and the business structure. ESOPs that are poorly structured have proved to discourage the employees.