Compensation & PerksPerks

What are ESOPs? Learn All That’s to Know

An employee benefits program that grants employees a stake in the company is an ESOP (Employee Stock Ownership Plan). Employee Stock Ownership Programs are given out as direct stock, profit-sharing schemes, or bonuses, and it is entirely up to the business to decide who is eligible to participate. However, Employee stock ownership plans are just options that could be purchased at a specified price before the exercise date. Employers must abide by the guidelines and restrictions outlined in the Companies Rules when offering Employee Stock Ownership Programs to their staff members.

How do ESOPs work?

After the option period, an organization gives its employees ESOPs in exchange for purchasing a predetermined number of its shares at a specified price (a certain number of years). The predefined vesting term must be completed before an employee can exercise their option. That is the individual must continue to work for the company until all or part of the stock options is exercised.

ESOPs From an Employee’s Perspective

With ESOPs, a worker can benefit from purchasing firm shares at a nominal price, selling them (after a certain period stipulated by the employer), and making a profit. There are numerous success stories of employees making fortunes alongside business owners. One particularly notable instance is Google’s IPO. Sergey Brin and Larry Page, the company’s founders, rose to the status of the world’s wealthiest people. Even the stock-holding staff made millions.

Benefits of ESOPs For The Employers

An organization may offer stock options to its employees as a form of employee motivation. Employees would be motivated to give their all because they would benefit if the company’s stock price rose. Organizations could avoid cash compensations as a reward with the help of ESOP options, saving on immediate cash outflow. For organizations starting or expanding their business operations on a larger scale, awarding their employees with ESOPs is more feasible than cash rewards.

Why do Companies Offer ESOPs to Their Employees?

Employee Stock Ownership Plans are frequently used by businesses to attract and retain high-quality employees. Organizations typically distribute stocks in stages. For example, a company may grant its employees stock at the end of the fiscal year as an incentive to stay with the organization in exchange for receiving that grant. Companies that offer ESOPs have long-term goals. Companies want to make their employees not only long-term employees but also shareholders in their company. Most IT firms have alarming attrition rates, and ESOPs could help reduce such high attrition. Start-ups provide stock options for attracting talent. Such organizations are frequently cash-strapped and unable to offer competitive salaries. However, providing a stake in their company makes their compensation package competitive.

Tax Implication of ESOPs

In terms of taxation, Employee Stock Ownership Plans are considered perquisites. When an employee exercises his option, the difference between the Fair Market Value (FMV) and the exercise price is taxed as a perquisite. While selling, the capital gain is realized. After purchasing shares, an employee may decide to sell them. If he sells these shares at a price more significant than the FMV on the exercise date, he will be subject to capital gains tax.

Long Term Vs Short Term Capital Gains

The capital gains would be taxed based on the holding period. This period runs from the date of exercise to the date of sale. Long-term capital is defined as equity shares that have been held for more than 12 months, or one year, on a recognized stock exchange. If the shares are sold within a year, they are considered short-term. Long-term capital gains (LTCG) on listed equity shares are currently tax-free. However, as per Budget 2018 amendments, the sale of equity shares would be subject to a 10% tax and a 4% cess if held for more than a year. This would be applicable on or after 1 April 2018. Short-term capital gains (STCG) are taxed at a 15% rate.

Problems Related to ESOPs for Employers

It is simple to sell the benefits of ESOPs to companies considering liquidity and succession options. However, there are some compelling reasons to avoid ESOPs. Employee Stock Ownership Plans have complicated rules and require extensive oversight. Although external advisors and ESOP TPA (Third Party Administration) firms could manage this function, the ESOP company requires some internal personnel to champion this program. If a company lacks the personnel to carry out the ESOP work properly, it risks issues and potential violations.

Once the ESOPs are in place, the company requires proper administration, which includes third-party administration, trustee, valuation, and legal costs. The company’s owners and management must understand the ongoing costs. If the cash flow dedicated to ESOPs limits the cash available for long-term reinvestment in the business, the ESOP scheme is not a good fit for such a company. Companies that require significant additional capital to carry on business operations should avoid ESOPs. The company’s cash flow is used to fund the purchase of shares from its shareholders in ESOP schemes. If a company needs additional working capital or capital expenditures, ESOP transactions will compete with this requirement, creating a crisis for management.

Conclusion

After an employee completes the placement period, they can purchase the stock online at the allotted price, which is relatively lower than the market value. On the other hand, if an employee leaves the company or retires before the vesting period, the company must buy back those shares from their employees within 60 days at the total market value. Also, employees can purchase shares at the allotted price after completing the vesting period. And Employees must consider the vesting period and allotment price of the shares before opting for an ESOP.

FAQs

1. What are the objectives of ESOP?

The goal of an ESOP is to motivate employees to perform better and increase shareholder value. Aside from providing financial benefits to employees, ESOPs foster a sense of belonging and ownership among employees.

2. Do ESOPs motivate employees better?

With the implementation of an ESOP, there may be an average 4 to 5% increase in productivity, but there is a wide range of outcomes around that average. Several studies have found that employee-owners have higher satisfaction, commitment, and motivation levels.

3. What is ESOP buyback?

If a company believes its valuation can rise further, it may choose an ESOP buyback to provide an exit for employees or listing gains. Employee stock options, also known as ESOPs, have been around for a while. However, the recent surge in startup ESOP buybacks has brought it to the forefront.

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