What is ESOP? Features, Benefits & How Do ESOPs Work.

What is ESOP?

ESOP meaning when an employees receive an ownership interest in the company primarily in the form of stock shares is known as an employee stock ownership plan or ESOP shares.

ESOP shares encourage the employees to perform to their optimum capabilities because they know that the company's success will be financially rewarding for the employees too. It also helps employees feel valued for their work and get better rewards. 

ESOPs are a way to push employee compensation beyond basic pay. Companies typically tie plan payments to vesting, which gives employees long-term rights to employer-provided assets. Other versions of employee ownership include direct purchase programs, stock options, restricted stock, phantom stock, and stock appreciation.

The main objective of ESOP shares is to motivate the employees and align their interests with other company stakeholders. From a management perspective, an ESOP provides certain tax benefits and motivates employees to focus on company performance.

Features of ESOP

• ESOPs are typically included in an employee's compensation package without cost to them. They are integrated into the Cost to Company (CTC) structure.
• Two key dates in ESOPs are the Vesting Date, when employees can convert ESOPs into company shares, and the Grant Date, when the ESOP agreement is formalized.
• Employees have the flexibility to exercise their ESOPs fully or partially.
• Employers decide which employees receive ESOPs based on their recruitment strategy.
• ESOPs can be exercised gradually over a specified period.
• The price for purchasing company shares through ESOPs is called the Exercise Price or Grant Price.
• While exercising ESOPs isn't mandatory, employees are typically obligated to do so after the vesting period.

Employee Stock Ownership Plan(ESOP) Eligibility

Every employee, except directors and promoters holding over 10% equity, is eligible for ESOP if they meet any of the following criteria:
• Full-time or part-time Director of the Company.
• Current employee of the Subsidiary, Associate, or Holding, whether based in India or abroad.
• Permanent employee working in an Indian or Foreign office of the company.

How does an ESOP work?

An organization grants an ESOP to an employee to a specified number of company shares at a specified price after the option period (a specified number of years) expires. A predefined vesting period must elapse before the employee can exercise the option. The vesting period implies that the employee must work for the company for a pre-decided minimum term until they can exercise some or all of their stock options. 

The employer decides the number of ESOP shares that any employee gets. During the vesting period, the offered ESOPs lie with a trust fund. Once the vesting period expires, the employee will be entitled to exercise their ESOP. The date on which the vesting period expires is called the vesting date. Employees may exercise an ESOP to purchase company stock at an allotted price below market value. Employees can also sell their ESOP shares to earn profits.

The company has obligations to buy back the ESOP shares at a fair market price within 60 days if the employee leaves the organisation or resigns before the end of the vesting period. 
 

Advantages of ESOPs

ESOPs provide benefits to both employees and employers. 

Advantages of ESOPs for Employees

1. Stock ownership: ESOPs give employees the right to hold a part of the company’s share capital. With ESOPs, they can enjoy the ownership benefits in the company under which they are employed.
2.  Dividend income: Companies distribute a part of their profits as dividends to their shareholders. Since ESOPs allow the employees stock ownership, they can earn additional dividend income.
3. Opportunity to buy shares at a discounted rate: Employees pay a nominal amount to buy the shares while exercising the ESOPs allotted to them. Thus, allowing them to invest at an advantageous rate over others. 

Advantages of ESOPs for Employers

1. Employee retention: Employees holding the ESOP must wait till the vesting period before exercising their ESOPs. This measure makes employee retention easier.

2. Increase in productivity: The ownership opportunity in the company captivates the employees to gain from the company’s profits. It can potentially increase employee productivity and consequently benefit the company.

3. Attract talents: ESOPs act as an additional compensation that attracts and retains employees. Often, the ESOP option compensates for low packages in start-ups.

ESOP Up-front Costs and Distributions

Typically, companies do not charge anything to employees for ESOP ownership. The company can hold the offered shares with a trust for security and growth until the employee decides to part ways with the company.

Companies often tie plan distributions to vesting to entitle employees to company assets. They typically earn an increasing percentage of equity for each year of service.

When a fully vested employee retires or resigns, the company "buys back" the vested shares. Depending on the plan, the company pays a lump sum or an equal periodic payment. When a company buys shares and pays employees, the company redistributes or voids the shares. Employees who voluntarily leave the company do not receive shares and are paid in cash only.
 

How to Cash Out of an ESOP?

Vesting does not give employees the right to cash out their ESOP at any time. It is possible only when you resign voluntarily, retire, pass away, or become disabled. A penalty is often involved if you cash out your ESOP share before maturity. The ESOP plan’s guidelines mention the withdrawal specifics.

Tax implication of an ESOPs?

ESOPs are taxable in the two below-mentioned instances.
1. When the employee exercises their rights and buys the company’s shares. When an employee exercises an option, the difference between the fair market value (FMV) at the time of exercise and the exercise price is taxed as a fringe benefit.
2. When the employee sells their shares. A capital gain tax is imposed based on the holding period. The holding period refers to the time between the exercise date and the sale date.

What is an example of ESOP?

ABC Corporation rolled out the ESOP scheme for the key managerial personnel under which the eligible employees shall have to continue the employment agreement for three years. After three years, the employee can leave and sell the shares.

The ESOP scheme is put before the eligible personnel, and they have given three months to decide whether to opt in or not. The exercise price was INR 400, and the market price of the shares was INR 500. The shares will be issued after one year and employees have three months period to decide. The expected market price is INR 1000 after 3 years of the declaration of the scheme.

In this case, ESOPs will be taxed in two ways-

1.    At the time of issue of shares, i.e., after 1 year of declaration and they are to be taxed as perquisite under salary.
Perquisite = Market Price – Exercise Price
●    Perquisite  = INR 500 – INR 400
●    Perquisite  = INR 100

2.    At the time of sale it will be taxed under capital gains, which are calculated as under 
Capital Gain = Expected Market Price – Market Price at the time of Exercising the Option
●    Capital Gain = INR 1000 – INR 500
●    Capital Gain = INR 500
 
 

Why Company offers ESOPs to their employees?

Employee stock ownership programs are a common strategy used by organizations to draw in and keep top talent. Typically, organizations distribute the stocks gradually. As an example, a business might give its workers stock at the end of the fiscal year as a perk for sticking with the company and earning that award. Businesses that provide ESOPs have long-term goals

Employers want to keep their staff members around for the long run, but they also want to turn them into stakeholders. The worrying attrition rates of the majority of IT organizations could be reduced with the use of ESOPs. Startups use stocks as a tool to draw in talent. These companies frequently lack funding and are unable to provide competitive compensation.
 

What Happens to ESOPs When the Company is Listed?

Once a company transitions from private to public through an IPO (Initial Public Offering), the structure and valuation mechanism of ESOPs undergo substantial changes. Here’s how ESOPs behave in such scenarios:

1. Liquidity Event Activation
Listing provides employees with the first real liquidity window. Once the shares are publicly traded, vested ESOPs can typically be exercised and sold on the secondary market, subject to lock-in periods, if any, specified in the offer document or company policy.

2. Valuation Shift
In private companies, ESOPs are priced based on internal or third-party valuations (such as FMV under Rule 11UA in India). However, post-listing, the share price is market-driven. This transparency allows employees to gauge real-time value, improving financial planning and exit timing.

3. Regulatory Compliance
Upon listing, ESOPs must comply with SEBI (SBEBSE) Regulations, 2021, which standardise grant, vesting, and disclosure practices. For example, any grant post-IPO must be approved by shareholders, and detailed ESOP disclosures must be made in the annual report and offer documents.

4. Lock-In Restrictions
In many IPOs, promoters and key managerial employees might face a lock-in period (e.g., 6–12 months). While ESOP holders are typically not bound by the same lock-in restrictions, certain strategic employees may be subject to internal policy restrictions or contractual agreements.

5. Taxation Upon Exercise
The listing creates a direct pathway for short-term or long-term capital gains taxes, depending on the holding period post-exercise. Employees must also factor in the perquisite tax liability at the time of exercising options (calculated on the difference between FMV and strike price on exercise date), especially under Indian tax laws.
 

Other Forms of Employee Ownership

While ESOPs are the most popular form of equity-based incentive, they are not the sole method of employee ownership. Alternative structures cater to different organisational goals and employee profiles:

1. Stock Appreciation Rights (SARs)
SARs offer employees the monetary equivalent of the appreciation in stock price over a pre-defined period, without giving actual equity ownership. It’s a cash-settled benefit, ideal for companies that prefer to preserve cap-table integrity but still want to reward performance.

2. Restricted Stock Units (RSUs)
RSUs grant actual equity (not options) after certain vesting conditions are met. Unlike ESOPs, RSUs do not require the employee to pay a strike price. They are increasingly used by late-stage startups and public companies due to their simplicity and guaranteed value.

3. Phantom Equity
Phantom equity is a contractual agreement promising a cash payout equivalent to a specified number of shares upon a liquidity event. While it mimics real equity value, no shares are issued—this simplifies administration and cap-table complexity.

4. Employee Ownership Trusts (EOTs)
Popular in the UK and gaining traction elsewhere, EOTs allow the transfer of a company’s ownership to a trust held on behalf of employees. This model is ideal for succession planning, especially in founder-led or closely held private firms.

5. Direct Stock Purchase Plans (DSPPs)
These allow employees to purchase company stock directly, often at a discount or with favourable terms. It promotes ownership among broader staff but lacks the motivational power of performance-based equity awards.
 

Conclusion

In conclusion, ESOPs offer several benefits to salaried employees. ESOPs provide an opportunity for wealth creation by increasing equity exposure in one's financial portfolio, allowing for long-term wealth accumulation. Additionally, ESOPs foster a sense of ownership and belongingness with the company, as employees directly contribute to its growth and share in its success.

Furthermore, ESOPs provide flexibility in timing investments, allowing employees to maximize profits by exercising options when market prices exceed the grant price. Overall, ESOPs can be a valuable tool for employees to enhance their financial well-being and align their interests with the company's success.