What is ESOP’s full form?
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The meaning of “ESOP” is “Employee Stock Ownership Plan.”
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What is ESOP?
By Bajaj Broking Team
February 12, 2025
8 mins read
Share Market
Synopsis:
The term “ESOP” stands for “Employee Stock Ownership Plan,” which is a powerful way for a company to reward its employees. By granting ESOPs to its employees, Read more...a company allows them to purchase its stock at a lower price than its fair market value. However, employees have to work for their employer for a certain number of years to exercise ESOPs. ESOPs are a great way to align employees’ performance with that of their organisation. When employees perform well, their employer’s performance also gets a boost, thereby improving the market value of its shares. Then, the employees can exercise their ESOPs to gain from the growing value of their employers’ shares, creating a win-win situation for themselves and their organisation. Read less
“Employee Stock Ownership Plan” or “ESOP” is increasingly becoming a popular way for companies to reward their employees. When a company grants ESOPs to its employees, it provides them a chance to acquire a stake in the company so that their goals can be aligned with those of their employer. Read this blog, as it takes a deep dive into the concept of ESOPs, how they vest, their benefits, and tax implications.
What is the Meaning of ESOPs?
ESOPs are an effective way for an organisation to reward its employees by aligning their goals with that of the organisation. Through an ESOP, an organisation offers its employees its shares at low or no additional cost.
The employees who have ESOPs have an option to exercise them at a specific price after a certain period. As ESOPs provide employees an ownership stake in their organisation, they feel motivated to work harder for their employer. Hence, it creates a win-win situation for employees and their organisation.
ESOPs are usually granted to employees based solely on the discretion of their employers. Having learnt ESOP’s full form and their meaning, let us delve deeper into this topic.
How Does an Employee Stock Ownership Plan (ESOP) Work?
When a company grants ESOPs to its employees, there typically is an option period, which extends for a certain number of years. An employee must work through this period for the company, which has granted him ESOPs, for him to exercise these options in part or entirely.
If an employee does not work for his employer through this pre-defined vesting period, how will he work for the benefit of his employer? The main objective of ESOPs is to create a win-win for both an employer and his employee. Hence, the vesting period is essential.
To reward employees, ESOPs allow them to purchase a company’s shares at a lower than market price. Having bought the shares, employees can sell them and earn profit. Besides, if an employee ends up leaving or retiring before the completion of the vesting period, his employer has to buy back ESOPs at fair market value within a period of 60 days. Now that you have learnt what ESOP is and how it works, let us discuss about its costs.
ESOP Initial Costs and Distributions
In India, ESOPs require an organisation to incur legal fees, accounting fees, and administrative expenses. Further, the cost of creating and managing an ESOP depends upon its complexity and size.
Meanwhile, ESOPs can be distributed in various ways. For example, when an employee exercises ESOPs, he can sell the shares he receives immediately or keep them in anticipation that their price will increase in the future.
If he sells ESOP shares, he will receive the sales proceeds after deducting any applicable taxes. However, if he keeps ESOP shares, he will own a stake in his organisation, which will entitle him to receive dividends in the future. Further, he can also sell those shares later to earn capital gains.
Benefits of ESOPs for Employees
ESOPs provide many benefits to employees, which are explained below:
Ownership in their firm: Employees can gain ownership of their firm by exercising ESOPs. Moreover, ESOPs allow them to buy their company’s stock at a lower than market price, which is another benefit.
Dividend income: An employee can earn dividends on the shares he receives after exercising his ESOPs, which can provide him an income stream for a long period.
Can benefit from their employer’s growth: An employee can benefit from his organisation’s growth through ESOPs. There are many examples of a young company offering ESOPs to retain its employees. As the company does well over a period, its employees end up earning remarkable benefits of ESOPs through capital gains and/or dividends.
Benefits of ESOPs for Employers
ESOPs offer many benefits to employers as well, some of which are explained below:
Help attract talented employees: When a company provides ESOPs, it shows its intention to reward its employees, which helps it attract a talented workforce. ESOPs help startups attract employees, especially when they cannot offer high packages for being in the nascent stage of business.
Boost employees’ morale: ESOPs help motivate employees to work hard for their organisation by boosting their morale and productivity. Employees know that their company will do well if they perform better, which will help them gain through ESOPs.
Help in employee retention: ESOPs require employees to continue working for their employer through the vesting period. Hence, they help companies retain employees. Otherwise, employee turnover becomes an issue in many industries.
Tax Implication of ESOPs
There are two specific points in time an employee has to pay taxes on his ESOPs. First, when he exercises ESOPs and purchases his employer’s stock. Second, when he sells those stocks after purchasing them.
Tax implications when an employee exercises ESOPs
When an employee exercises ESOPs after the completion of the vesting period and purchases his employer’s shares at less than the fair market value (FMV) of those shares, the difference between the FMV and the exercise price is known as a “pre-condition,” which is taxed based on his income tax slab rate. However, for startups, the government has relaxed tax rules on ESOPs.
A startup’s employee does not have to pay any tax on precondition in the year of exercising his ESOPs. For such employees, the tax deducted at source (TDS) is deferred on ESOPs to the earliest of the following dates:
Date at which an employee sells his ESOPs.
a) Date at which he leaves his organisation.
b) Date at which the period of 5 years is completed from the ESOP grant date.
Tax implications when an employee sells the shares he received through ESOPs
When an employee sells the shares he received through ESOPs, he has to pay a tax on capital gains, which are the difference between the selling price of shares and the FMV of those shares on the date when ESOPs were exercised.
If an employee sells shares after one year of purchasing them, he has to pay a tax at the rate of 10% on his profits exceeding ₹ 1 lakh. However, if shares are sold within one year, the resulting profit is taxed at 15%.
Example of an ESOP
Let us understand how ESOPs work and are taxed based on the example in the table below:
Exercise Date | December 1, 2023 |
Fair Market Value (FMV) | ₹ 200 per share |
Exercise Price | ₹ 150 per share |
Taxable value of precondition | 200 – 150 = ₹ 50 per share |
Number of shares exercised | 2,000 |
Total value of taxable precondition | 2,000*50 = ₹ 1 lakh |
Payable tax (assuming a slab tax of 20%) | 20% of 1 lakh = ₹ 20,000 |
The above table explains how precondition is calculated on ESOPs and how tax is applied to it. This example is valid for a company, which is not a startup. As already explained earlier in the blog, the tax laws for startups are lenient and different from those applicable to other companies.
Suppose we take the same example as given above but the difference is that the employee sells the shares. In this case, the tax will be calculated like this:
Exercise Date | December 1, 2023 |
FMV as on December 1, 2023 | ₹ 200 per share |
Case 1: Shares sold on June 1, 2024 |
|
FMV on June 1, 2024 | ₹ 210 per share |
Difference between the FMVs | ₹ 10 per share = 210 - 200 |
Number of shares exercised | 2,000 |
The value of short-term capital gains (STCG) | 2,000*10 = ₹ 20,000 |
Tax on STCG | 15%*20,000 = ₹ 3,000 |
Case 1: Shares sold on January 1, 2025 |
|
FMV on January 1, 2025 | ₹ 220 per share |
Difference between the exercise FMV and sale FMV | 220 – 200 = ₹ 20 per share |
Number of shares exercised | 2,000 |
The value of short-term capital gains (LTCG) | 2,000*20 = ₹ 40,000 |
Tax on LTCG | Zero because the value of LTCG is less than ₹ 1 lakh. |
What Happens to ESOPs when a Company is Listed?
If you have acquired an unlisted company’s shares through ESOPs, selling them can be difficult because you may find only a few takers. Besides, the FMV of such shares is determined by merchant bankers. Not only that, capital gains on such shares are taxed as per the rules applicable to debt funds.
However, it is much easier to sell the shares acquired through ESOPs of listed companies. This is because you are likely to find more takers for such shares. Besides, the FMV of such shares is based on stock market movements. Hence, you should understand all that you can about ESOPs – how they work, their advantages and tax laws, their vesting period, etc.
Remember ESOPs can end up being an extremely important component of your compensation package. Hence, you should understand them thoroughly to understand their true value.
Conclusion
If you have a demat account and participate in the stock market, you must understand the role of ESOPs in shaping a company’s performance. A well-run company can grant ESOPs to its employees so that they can benefit from its growth. To analyse a company’s financials, you must learn how ESOPs affect its cash flows and financial statements. That said, even if you do not participate in the market, it is a good idea to understand the concept of ESOPs because they can form a vital part of your compensation structure.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Frequently Asked Questions
How Do ESOPs Work?
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ESOPs are granted to an employee entirely at the discretion of his employer. When an employee gets ESOPs, he has to work for his employer for a certain period, known as the vesting period. After that period, he can exercise his ESOPs and purchase his organisation’s shares at less than their market price.
How are ESOP Shares allocated?
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ESOP shares are allocated by an organisation’s board of directors or its pay committee based on factors like an employee’s seniority, performance, or position. Often, it is necessary for employees to fulfil certain requirements to exercise ESOPs to purchase shares.
How to Calculate the Value of ESOPs?
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To calculate the value of ESOPs, we need to know the FMV of a company’s shares. Then, we should allocate the number of shares to the ESOP and find out the vesting period. After that, we need to know the exercise price of ESOPs and also calculate the applicable tax.
Is ESOP part of the CTC of an employee?
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Yes, typically, ESOPs are a part of an employee’s CTC. However, it depends upon a company. At times, companies offer ESOPs in the CTC of an employee. However, at times, companies provide ESOPs later depending upon the performance of an employee.
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