In an increasingly expanding career market by the day and growing more competitive by the minute, it is no wonder that companies are always looking for new methods of attracting and retaining the crème de la crème. One of such instruments that has been picking up space in India is the Employee Stock Ownership Plan, or the ESOP, to use short form. Not only is it a wage gift but, more importantly, it bestows upon the employees the status of co-owners of the company they are working for.
But what is ESOP and how can it assist in making long-term wealth? This article explains the ESOP full form, how ESOP works, a sample structure of an ESOP policy, and how it can become an outstanding tool for money for the workers.
What is the full form of ESOP?
Employee Stock Ownership Plan is the acronym applied for ESOP. ESOP stands for Employee Stock Ownership Plan. ESOP stands for an employee benefit plan awarded to such eligible employees in order to buy a specified number of company shares at a specified rate, normally lower than the current market rate prevailing at that time. ESOP stands for incentive compensation in the form of stock which aligns the interest of the employees with the interest of the company’s shareholders.
In India, ESOPs are being utilized in growth stage businesses and start-ups to recognize quality manpower, reward excellence in performance, and distribute company success to the working hands.
How does an ESOP work?
An ESOP policy will typically have a step-by-step process, as follows:
1. Granting of options
Stock options are granted to deserving employees by the company. Not possession but a guarantee that the employee will be able to purchase a specified number of shares at some future point in time at a predetermined price—that is, referred to as the grant price or the exercise price.
2. Vesting period
ESOP policy also governs vesting period, i.e., the length of time for which the employee must remain in the company before he or she can exercise the option. Vesting may be in tranches or lump sum after a waiting period (cliff vesting). For instance, an employee is awarded 1,000 shares, vesting on a four-year cycle—250 shares each year.
3. Exercise of options
4. Sale of shares
The employee can exercise the options at vesting by paying the mutual exercise price to buy the shares. This is most likely to occur if the company is performing well and the market price of the shares is greater than the exercise price so that the employee benefits out of the difference in prices.
Once bought, the shares are kept or disposed of by the employees—depending on whether the company’s listing process is ongoing. In listed firms, the shares are disposed of through taking advantage of the exchange. In non-listed firms, secondary sale or buy back must be conducted, mostly at the funding or exit stage.
Advantage to employees through ESOP
Enables long-term wealth creation
One of the most powerful advantages of an ESOP plan is the ability to accumulate long-term wealth. If the company grows and the value of the stock appreciates, then there is a possibility that the employees will make enormous capital gains when they retire and liquidate. This type of equity ownership gives a reward in addition to regular compensation.
Makes them feel like owners
ESOPs link worker performance and the profitability of the firm with a direct connection. As owners, workers go at it with an ownership mentality to get performance achieved because they realize that they will gain directly from it.
No down payment required
In comparison to purchasing the shares in the open market, the employees do not make any payment when they receive the ESOP. They pay the exercise price at exercise of options only, which is usually lower than the current market price.
Tax benefit in certain cases
Taxation of ESOPs in India has been a step in the right direction. Taxation will be two steps behind—first on exercise (as salary) and subsequently on sale of shares (as capital gain). Yet, in a few sectors such as eligible startups, the employees have been provided with tax deferral on exercise for five years or on exit or sale of the company or the shares.
ESOP policy framework: Significant features
A firm-specific ESOP policy has the following:
- Eligibility: Ties down who is eligible under the scheme—employees, directors, or advisers.
- Grant date: Date on which the company grants the option to the employee.
- Exercise price: Price at which the employee can buy the shares.
- Vesting schedule: Period when the options vest and are exercisable.
- Exercise period: Period when the vested options need to be exercised by the employee.
- Exit options: Details on which date and under what conditions the stocks are to be sold or transferred, particularly in unlisted companies.
It is important that you have good knowledge of your ESOP policy back and forth so you can make the best decisions. This involves having an ear out since you will have to exercise your options, how much tax you can incur, and when to dump stocks.
How to maximize ESOP
In maximizing your ESOP policy, the following should be done:
- Stay up-to-date: Monitor vesting schedules, company performance, and ESOP policy updates.
- Check financial needs: Ensure that your exercise and sale align with your goals of home purchase savings, retirement, or education.
- Check taxation: Know the taxation implications of exercising your options to avoid nasty surprise liability.
- Monitor share value: If your company is listed or going to the market, stay updated about changing share values in order to make a decision regarding selling or exercising at the right moment.
ESOP in start-ups vs. well-established firms
Startups provide ESOP as a compensation basket with no cash outlay at growth development phases. Expectation of future prosperity in terms of equity persuades quality individuals in spite of meager remuneration. But listed companies or established companies can provide ESOP as retention incentive or performance reward for superior jobs.
Though startup ESOPs are riskier and have greater market volatility and longer time to liquidity, they can reward much better in the end if the company performs well.
Conclusion
Employee Stock Ownership Plan (ESOP) is one among the means through which the employees are able to feel the success they drive. Familiarity with ESOP full form and policy mechanism is necessary for being able to make smart financial decisions. With foresight and timely knowledge, an ESOP can be a blessing—it can be a stepping stone to achieving long-term financial security.
Whether employed by a startup company or an established business, do not downplay the worth of your ESOP. Study the finer points of your plan, pose the correct questions, and retain a financial planner if necessary to be able to obtain the maximum benefit it has to offer.
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