Employee Stock Ownership Plans (ESOP) have become popular recently due to the various benefits they provide the company and the employees. It is a well-known fact that we tend to care about the things we own and providing employee stock options in the company makes your employee feel a sense of ownership in your company.
Hence, many companies have started providing ESOP to their employees in a bid to retain talented employees to gather more interest in their work and the overall company’s success. It helps in garnering long-term interest, thereby reducing employee turnover.
It also provides them with an investment option and motivates them to work harder. The company redistributes shares in addition to the employee compensation package which employees receive, creating a win-win environment.
What is ESOP (Employee Stock Ownership Plan)?
The Employment Stock Ownership Plan (ESOP) provides employees with stock options as a part of their benefits plan to help them stay invested in their company and work towards improving company performance and turnover. Additionally, ESOP also provides them with added incentive to stay longer with their organization, thereby reducing employee turnover.
Since the ESOP scheme provides the staff with stock options, they would be actively involved in their work since it benefits them directly. On the other hand, the company gains loyal staff who would feel appreciated, since the company is offering them stock options in return for their services.
How Does ESOP Work?
ESOPs are granted by employers to their employees as a form of employee compensation to ensure long-term loyalty and improved productivity. Hence, the management, administration, and the HR department consult with each other to decide the number of shares to be offered, their pricing, as well as the beneficiaries of these stocks.
Once these factors are decided, the eligible employees themselves are intimated about their inclusion in the ESOP and a grant date is decided.
Once the ESOP is approved, they remain in a trust fund for a specific duration, defined as a vesting period. The employees are required to stay in the company within this vesting period to avail the full ownership interest of the stock.
At the end of the vesting period, the employees are given the right to exercise their ESOPs. One should note that the employees are required to buy the shares after the vesting period expires for owning them. They can even sell these shares for a profit later.
What are the Associated Costs?
There are no ESOP up-front costs associated with providing ESOP to the employees. The company may even choose to hold the shares on behalf of their employees in a trust, and later hand them over to the staff member when they leave the company.
Due to such a vesting date, the employee becomes eligible to earn an increasing amount of equities every year, until they remain in service with their company. When the employee leaves the company, the company can ‘buy back’ their shares from the staff member. Based on company policies, the organization can pay a lump sum amount for buying the stock back.
How to Register an ESOP?
Following are the steps to be following while registering for an ESOP:
1. Create the ESOP Blueprint
Creating a blueprint of the Employee Stock Ownership Plan outlining the exact ESOP rules is essential for granting ESOP benefits to your employees. This blueprint will outline which employees are to be included under the ESOP, under which conditions they become eligible for ESOP and what happens when their employment with the company is terminated.
2. Documentation and Approvals
Once the blueprint is created, it is proofread thoroughly and documented to avoid any loopholes. The blueprint is then shared with the board of directors and other stakeholders in the company for their approval. They may even suggest some changes if required and the modified document is once again sent for approval.
3. Draft Director’s Resolutions
Every time a new option is granted to an employee, you should discuss it with management perspective and your director for collecting their resolutions in writing, which approves the grant of options to a specific staff member.
4. Share the Grant Letter
Once you receive the grant letter from the director, you can issue the ESOP certificate to the employee. The grant letter lets the employee understand the tax benefits of their Employee Stock Ownership Plan as well as the number of stocks granted to them. It also provides them with proof of ownership of their stocks.
5. Update Register
The company should maintain a register of all stock options provided, the employee to whom it was shared, grant date, expiry date (if any), exercise dates, etc. Maintaining a record of these values helps the company keep a track of the shares vested with their employees.
Tax Implications of ESOP
ESOPs are covered various tax implications as follows:
➔ Exercise Tax
When the employee chooses to exercise their Employee Stock Ownership Plan and buy the share, they are required to pay tax on the difference between the ‘exercise price’ and the ‘fair market value (FMV)’ or market value of the share at the time of exercise. This tax is calculated as per the employee’s income tax slab rate. The fair market value or the market price of the shares are decided by various factors.
➔ Capital Gains Tax
If the employee sells the ESOP shares, then capital gains tax is applicable. Hence, the employee will have to pay the short-term capital gains taxes, depending on the holding period of the shares. If the employee sells beyond a span of 12 months after the initial purchase, a 10% capital gain tax would be applied over gains of ₹1 lakh. On the other hand, if the shares are sold within a year, the gains are subjected to a tax rate of 15%.
➔ Dividend Tax
If the organization is paying dividends on the shares held by their staff member, it is taxable as per the applicable tax rates. While the dividends are taxable, the employee is still able to reap the profits of the company by holding the shares allocated to them.
Advantages of ESOP for Employee
There are multiple advantages of enabling Employee Stock Ownership Plan (ESOP) for your employees. While it surely contributes towards enhanced loyalty and employee productivity, there are multiple other benefits which the company can enjoy by enabling ESOP for staff members.
Similarly, even the employee enjoys multiple benefits by owning a certain amount of company stocks. Let us understand the advantages of Employee Stock Ownership Plan for the employees:
1. Stock Ownership
A major advantage of providing ESOP for employees is that they can own stocks in the company. It provides them with the opportunity to own a part of the company. Hence, they feel an added responsibility towards their organization and work harder to ensure that it runs successfully.
2. Dividend Income
The profits earned by the company over a specific duration are shared amongst senior employees and its shareholders in the form of dividends. Since the employee is also a shareholder of the organization, they are also eligible to earn additional dividend income. Hence, they would be directly benefiting from the gains accumulated from their work in the business.
3. Tax Benefits
Since the employees are not required to pay taxes on the contributions to an Employee Stock Ownership Plan, they automatically get capital gain as tax benefits. They are only required to pay taxes on the capital gain and the distribution from the ESOP after their retirement or when they leave the company.
4. Retirement Benefits
Since the ESOP provides employee ownership of company shares and if the fully vested employee retires, it will serve as a retirement benefit over time if the company performs well.
On the other hand, since the employee has a personal stake in gaining maximum returns on their shares, they would work harder for improving the corporate performance of the business, creating a solution where everyone benefits, while they can retire at the normal retirement age set by private companies.
Advantages of ESOP for Employers
Employee Stock Option Plan also provides various advantages for employers apart from gathering dedicated and long-term staff members. Some of the major benefits of ESOPs for the employers include:
1. Employee Retention
Since the employees are gaining the benefits of company shares, they are bound to stay longer with their company. The true benefits of shares are visible over a longer period, ensuring reduced employer turnover.
Additionally, ESOPs make the staff direct beneficiaries of the company’s profitability in the form of dividends, which leads to loyal employees, creating a culture of highly engaged staff, and thereby helping the company retain employees.
2. Improved Productivity
Since the employees have a personal stake in gaining more profit, it leads to a productive class of staff, with talented employees who work better to gain maximum profit. As a result, the company performs well, providing greater value for the ESOP and the shares allocated to the staff.
3. Better Employer Branding
Due to the retirement savings and better productivity, the company will improve its overall branding among its clientele or consumers. Additionally, the employees will want to stay longer with their company due to long-term benefits from the shares allocated to them. As a result, it enhances fair market value and the employer branding of the company, making it a better place to work for.
Disadvantages of ESOP
While both employees and employers benefit from ESOPs, there are some disadvantages to using them. A few drawbacks of implementing ESOPs in companies are:
1. Diversification Challenges
Due to ESOPs, the employees fail to diversify their investment portfolio. While it is mostly an issue with the individual employee accounts rather than the company itself, it creates issues for them if the company fails to perform well.
Additionally, it also creates resentment in their hearts towards their company. The issue is aggravated since employees cannot leave the company while their shares are fully vested employee as they may not receive their profit.
2. Dilutive Shares
The shares provided to the employees under ESOP are dilutive in nature. As new employees join the company and are taken under the ESOP, the percentage of ownership is reduced for each share. As a result, the ownership percentage of the older shares keeps on reducing as an increased number of employees who purchase company shares are taken into the ESOP.
3. Complicated Implementation
It is extremely complex to implement SOPs as it involves various legal complications. Additionally, they are costly to implement with the most basic of plans costing about ₹ 40,000 to implement for a mid-size company. Additionally, if the company is using the legal counsel of third-party service providers, the additional cost incurred in undertaking it makes it a deterrent for many companies.
Other Employee Benefit Plan
Now that we have discussed the disadvantages of the Employee Stock Ownership Plan (ESOP), we can look at the other direct purchase programs, which provide the employees of private companies with similar monetary benefits, while providing the company with a better outlook on their financial transactions and monetary stability. Some of the common forms of employee ownership include:
➔ Phantom Stocks
In the phantom stock concept, the employee is provided with cash bonuses for their good performance. However, instead of providing them with cash, they are given company shares which are equal in value to their cash bonus. In this case, the employees still profit from the company’s shareholders’ dividends, cash flow and company profits, while they do not have additional ownership rights over the whole company’s share capital.
➔ Direct Stock Purchase Plan (DSPP)
Direct Stock Purchase Plan (DSPP) lets the employees purchase their company stock at a discounted rate or purchase company stock themselves. However, in this case, the employee is purchasing the stocks by spending their hard-earned money. The company is simply providing discounts on fixed price of these stocks as they are being bought by their employee.
➔ Stock Appreciation Rights (SAR)
Stock Appreciation Rights (SAR) is a type of employee benefit plan option which is linked to a specific period. However, in this type of employee stock option, employee benefit plan and compensation, the employee is promised the money as per the share value.
For example, if they were allocated 50 shares of a company for a specific period, they will be paid the cash equivalent of the 50 shares after the period. Hence, the employee gains a profit if the company has performed well in the duration.
➔ Restricted Stocks
Restricted stock provides the employee shares as a reward for fulfilling certain tasks such as achieving targets or specific sales figures. The company can set these targets and share the task and reward details with everyone to motivate them to ‘win’ the shares, gamifying the whole process.
ESOPs or Employee Stock Ownership Plan provides the employees with a chance to own a part of the company which they work for. It motivates them to work harder as they receive the direct benefits of their work in the form of better value for the shares.
Hence, many companies implement ESOPs despite their legal complexity. It ensures long-term and loyal employees who have a personal ownership stake in making their company profitable.