What is ESOP? How do ESOPs work?

The ESOP full form is the Employee Stock Ownership Plans. It is essentially a type of incentive or compensation plan in which you, as an employee of any organisation, have the option to earn equity from your company over a set period.

When your employer offers you an ESOP benefit, you can convert it into stock at the rate specified by your employer. Also, the duration in which you can exercise this option is specified.

How do your ESOPs work?

Under this scheme, your company will offer you a certain number of stocks  at a fixed price which is also referred as exercise price or grant price. You may exercise your ESOP which means, you may agree to buy the stocks at the exercise price only after you have completed a specified number of years of service with your current employer.

Let’s look at an example to get this concept better.

Assume you work for XYZ Ltd., which offered you an ESOP based on your excellent performance. The following is a description of this plan.

• Shares offered under ESOP – 1000 shares
• The rate at which you can buy these shares (Exercise Price)– Rs 100 per share
• Vesting period – 3 years

According to this description, after completion of three years from date of grant, you can buy 1000 shares for Rs 100 each. The best part about the ESOP is that even if the price of the  company’s share rises, you will still be getting the shares at the exercise price and you won’t have to worry about the market value.

What is ESOP? How do ESOPs work?

Features of ESOP

• ESOPs are allotted without any additional charges. It is usually a part of your CTC structure. Some companies offer this benefit based on your performance. 

• The two crucial dates in the ESOP are the vesting date and the grant date. The former is the date after which you can exercise your power. Whereas the grant date is the date on which the ESOP is offered to you by your company.

• You can exercise your ESOP power in full or in part.

• The price at which you can buy shares under the ESOP is known as the exercise price. 

• Various companies allow their employees to exercise their ESOP power in stages. It means you can buy stocks in instalments rather than all at once.

Benefits of ESOPs to employers

Acquiring skilled employees

When entrepreneurs do not have enough funds to hire skilled employees during the company's initial phase, they offer ESOPs as part of the CTC. As a skilled employee, if you believe that the company has the potential to grow and that share prices will unexpectedly rise, you will join that company. On the other hand, your employer benefits in this situation by hiring talented employees at a lower initial cost.

Increase employee ownership

When an employer offers an ESOP, they are essentially increasing the employees’ ownership stake in the company. It significantly boosts employees’ confidence, and as a result, they deliver their best maximising their productivity, which adds to the company’s profitability.

Employee retention

Since employees are only eligible to exercise their ESOP option after the vesting period has been completed, employee attrition is significantly reduced.

Benefits of ESOPs to employees

Higher profits

You can exercise the ESOP option at a much lower rate compared to the market value of the shares. If your company has tremendous growth potential, holding the shares for an extended period of time can help you make a huge profit.

Additional income source

When you become a shareholder in the company, you gain voting rights based on your holdings. In addition, becoming a shareholder entitles you to dividend income when the company achieves prominence. Dividend income serves as an additional source of income, which you can then invest in any scheme to increase your profitability.

Job stability

ESOPs provide job satisfaction, and you can expect your job to be secure during the vesting period unless and until you are involved in a major violation of the company’s code of conduct.

How are ESOPs taxed? 

ESOPs are taxed at 2 instances:

• AT the time of exercising the ESOPs
• AT the time of selling those shares which are allotted after exercising the ESOPs

Let’s understand both of them one by one.

When you exercise your ESOP,  the difference between the market price as on day of exercise (also referred as Fair Market Value – FMV) and the exercise price is the notional profit you make. This notional profit is considered as Perk given to you by your company and a perquisite tax is  required to be paid by you as per  your income tax slab. This amount also reflects in your Form 16

2^nd Instance of tax is Capital gain tax which arises when you sell your holdings. This gain is calculated considering the FMV as your cost price. Hence the profit from the sale which is Sell price – FMV will be treated as either short term capital gain ba OR Long term capital gain based on your holding period. Two important points to be noted here is that

• Cost price for calculation of perk tax is the FMV as on day of exercise and not the exercise price.
• The date of purchase is the date of exercise and not the grant date.

To conclude

Employers can use ESOPs to hire skilled workers at a lower initial cost while lowering attrition. In the context of employees, ESOPs provide job stability, as well as the opportunity to earn a high profit with a low investment. If you are an employee, you must first open a demat account; otherwise, you may be unable to exercise this power.