ESOP Meaning
An employee stock ownership plan is a sort of employee benefit plan, designed to reward them with an ownership interest in the company. In other words, an employee stock ownership plan is a profit-sharing plan, a strategy used by companies to align the interests of the employees and the shareholders. In this case, a company sets up a trust fund, into which it contributes new shares of its stock or cash to buy existing shares. ESOPs give the company, the employees and other participants several tax benefits.
An ESOP is usually formed to aid succession planning in a closely held company by allowing employees the opportunity to buy stocks. Employee stock ownership plans are set up as trust funds, funded by companies with newly issued shares into them, using cash to buy existing company shares, or borrowing money through the entity to purchase company shares. ESOPs are used by companies of all sizes, including blue-chip ones.
How Does an Employee Stock Ownership Plan (ESOP) Work?
An Employee Stock Ownership Plan (ESOP) works by allowing employees to acquire ownership in the company they work for, typically through shares. The company creates an ESOP trust and contributes newly issued shares or cash to buy existing shares for the employees. Employees do not buy shares directly; instead, shares are allocated to them based on criteria such as tenure or salary. Over time, as employees accumulate shares, they become vested according to the company’s vesting schedule. When employees leave the company or retire, they can sell their shares back to the company or on the open market, depending on whether the company is publicly listed. ESOPs not only incentivise employees by aligning their interests with the company’s performance but also provide a long-term wealth-building opportunity.
Why do companies use ESOPs?
As ESOPs are part of the company remuneration package, companies can use ESOPs to keep all the participants focused on the company’s performance and the share price appreciation. By including employees at all levels engaged, even at the company’s stock level, the participants do what’s best for company shareholders, as they are now shareholders. To sum it up, an employee stock ownership plan gives an employee a sense of ownership in the company, which in turn boosts his confidence and pushes him to work harder for the organization.
Employee stock ownership plans are used to buy shares of a departing owner. Secondly, employee stock option plans can be used to borrow money at a lower after-tax cost. The ESOPs can borrow cash, which they could use to buy company shares or shares of existing owners. Employee stock option plans are also used to create additional employee benefits. A company can issue new or treasury shares to an ESOP, deducting its value from taxable income.
Cost and tax implications for ESOPs
Companies usually provide employee stock ownership plans to employees with no upfront costs. The company may keep the stocks in a trust for safety and growth until such time the employee resigns or retires. The companies tie distributions from planning to vesting – the proportion of shares earned for each year of service.
Employee stock ownership plans are often taxed. When an employee exercises his option, the difference between the exercise price and Fair Market Value (FMV) as of the date of exercise is taxed as a perquisite. Employee stock ownership plan is considered perquisite concerning taxation.
While selling, if the employee sells these shares at a price higher than the FMV on the exercise date, he would encounter capital gains tax. The capital gain is again taxed as per the period of holding. This period is calculated from the date of exercise up to the date of sale.
However, employee stock ownership plans supposedly have several tax benefits. For example, companies can get a tax benefit by issuing new shares or treasury shares to the ESOP. Secondly, a company can contribute cash on a year-to-year basis and take a tax deduction for it. The contribution is often used to buy shares from current owners or to build up a cash reserve in the employee stock option plans for future use.
Advantages and disadvantages of ESOPs
| Advantages of ESOPs | Disadvantages of ESOPs |
| Acts as an incentive for employees, motivating them to work harder. | Managing ESOPs through a third-party firm can lead to compliance issues and potential violations. |
| Helps in employee retention by providing a long-term benefit. | Ongoing costs associated with ESOPs can be high. |
| Rewards employees without immediate cash outflow, making it cost-effective for employers. | ESOP cash flow commitments may limit funds available for business reinvestment. |
| A suitable option for companies expanding their business instead of offering cash rewards. | Companies requiring additional capital may find ESOPs unsuitable. |
| Aligns employees’ interests with company growth and success. | During financial crises, ESOP-related expenses can create a financial burden. |
Benefits of ESOPs for Employees
ESOPs offer employees a chance to become part-owners of their company, aligning their interests with business success. They provide financial benefits through share ownership, which can appreciate over time, leading to wealth creation. ESOPs often boost employee morale, enhance job satisfaction, and foster a sense of loyalty, as employees directly benefit from the company’s growth and profitability.
Benefits of ESOPs for Employers
For employers, ESOPs can be an effective tool for retaining talent and enhancing productivity. By offering ownership stakes, companies can align employee interests with corporate goals, driving performance. ESOPs also provide tax benefits to companies, as contributions to the ESOP trust are tax-deductible. Moreover, ESOPs can serve as an alternative exit strategy for business owners, ensuring stability and continuity.
ESOP Example
Consider a technology startup that introduces an ESOP for its employees. The company sets up an ESOP trust and allocates shares to employees based on their tenure and performance. For example, an employee who has been with the company for 5 years might receive 500 shares. The company’s vesting schedule dictates that shares vest over 4 years, meaning the employee gains full ownership of 25% of their shares each year. If the company grows and its share price increases, the employee’s shares also appreciate. When the company goes public or is acquired, the employee can sell their shares, potentially generating substantial financial returns. This example highlights how ESOPs can transform loyal employees into stakeholders, promoting both individual wealth and corporate success.
What Happens to ESOPs when the Company is Listed?
When a company is listed on the stock exchange, ESOP holders may benefit significantly. Typically, vested ESOPs can be converted into publicly traded shares, allowing employees to sell them on the open market. This liquidity event often leads to wealth realisation for employees, especially if the share price appreciates post-listing. However, there might be lock-in periods during which employees cannot sell their shares immediately. Additionally, tax implications arise on the capital gains made during the sale of ESOP shares, which employees should consider.
Conclusion
There are also other forms of employee ownership such as stock options, restricted stocks, phantom stocks and stock appreciation rights. However, ESOPs are considered to be beneficial for companies with a long-term objective. It is a definite way to make the employees stakeholders of the company. Companies that are unable to offer handsome packages could use ESOPs to make their compensation package look attractive and competitive.
FAQs
What is an ESOP?
An Employee Stock Ownership Plan (ESOP) allows employees to own shares in the company they work for. It aligns employee interests with company performance, offering financial benefits through share ownership.
How do employees benefit from ESOPs?
Employees gain potential wealth creation through share price appreciation and profit-sharing. ESOPs also boost job satisfaction and a sense of ownership.
Can employees sell ESOP shares if the company is listed?
Yes, once the company is listed, employees can typically convert their ESOPs to publicly traded shares. However, there may be a lock-in period before they can sell.
Are ESOPs taxable in India?
Yes, ESOPs are taxed as per the income tax rules, with tax implications at both the time of exercise and when shares are sold. Tax rates depend on whether gains are short-term or long-term.
