ESOPs (Employee Stock/Share Ownership/Option Plans) are a kind of Employee Benefit Plan in which a firm or an organisation offers stock ownership interests to its employees on a predetermined price.
What are ESOPs and How They Work?
Employee Stock Ownership Plans offer ownership of stocks to the employees of a company through share option plans. These share option plans include ownership as direct stocks issued in name of the employee, bonus or profit sharing through these shares, which is completely up to the employer as to what can be availed and by whom. It is also called Employee Stock Option Plan because it is an option that is provided by the employer so employees may purchase the company stocks up to a certain limit at a predefined price in future (after the employees have spent a certain duration of time in the company).
It is a right of an employee but not an obligation to exercise this option after the vesting period. These stocks are offered to employees with no upfront costs and are usually lower than FMV (Fair Market Value/Market Price) of the share. If the price of the stocks go up, then the employee may avail this plan and buy shares at the pre-decided costs. If the share prices drop, then the employee may refuse to go for this option to purchase and own shares.
*Vesting Period is the time period between the date of agreement between employee and employer for exercising ESOP and the date when the employee can actually exercise it. In layman’s terms, it is the time duration an employee must work in a company to avail the employee benefit through ESOP.
The deal between an employee and an employer is agreed upon certain terms and conditions by both parties. There are certain norms laid down by SEBI that must be followed for granting ESOP such as tenure of service or that an employee must be a permanent one. It may be selective or be for all employees, completely at the discretion of the employer.
Key Terms to Know for Understanding ESOP
Grant Date – It is basically the date on which the employer grants the option to the employee for owning or purchasing stocks. In an agreement, both the employer and the employee decide the conditions for granting the Employee Share Ownership Plan, the duration after which the employee can exercise it i.e. the vesting period and the price of stocks on which it will be purchased by the employee later.
Vesting Period – As explained above, it is the period of time between the Grant Date and the date on which the employee can actually exercise the option/purchase the stocks at the decided price. It is usually 1-3 years. It can be looked at as a lock in period for an employee to work in a firm to avail ESOP.
Vesting Date – Same as the agreed on Grant Date, it is the date from when the employee can actually vest in company’s shares by buying them at the defined price after the vesting period is over.
Exercising Period – The period that follows after the vesting period, the duration of time in which an employee can exercise the ESOP. After the stocks are vested or an employee has spent the relevant time in company as well as fulfilled all the criteria required for using this option, s/he may actually purchase them during this period of time. It may vary from 1 to 2 years or more.
Exercise Date – The date when the employee actually buys the shares and exercises the option of ownership. After the vesting period is over, the employee can purchase shares whenever he wants to.
Exercise Price – It is the price at which the employees exercise the option of buying the shares which is determined in the agreement before hand, that this will be the fixed price for the employee to buy shares on the Grant Date (date of option granted by employer) or Vesting Date or Exercising Date (date when the employee purchases).
Expiration Date – The last date of exercise period after which the employee can not exercise Employee Share Option Plan and buy share options.
For instance, a company offers 80 share options to an employee. These options can be converted to shares only after an employee has worked for at least 3 years which is the vesting period. After 3 years, s/he is alloted time of another 3 years to exercise ESOP i.e. exercising period. If the vesting period is over on March 31, then the company grants the stock option from April 1 which is the grant date. The day s/he actually exercises or buys shares is the exercise date. The market price of the share currently might be ₹120 but the employee will buy at the price that was agreed upon by the employee and employer for converting options into shares, like for example ₹50. If the employee pays ₹4,000 (80 shares x ₹50), s/he then owns the 80 shares of the company.
Advantages of ESOP
Employee Benefits
- Profit Sharing
Once an employee becomes the owner of shares of a company, s/he becomes entitled to profit sharing. All shareholders have the right to get their share of profit from the dividend distribution. At times, there are also other benefits such as bonus or retirement benefits when the employee gets money payment at the time of retiring/leaving the company.
- Tax Benefits
The employee will not be taxed until and unless s/he actually exercises the ESOP. There is no chance of tax deduction in the vesting period as this option is yet not converted into shares. Also, if an employee doesn’t buy shares during exercising period, then there will be no tax deductions as even if it is a compensation offered to the employee but is a cashless one and the employee has no ownership yet
- Ownership
Holding a stake in a company gives a sense of ownership and thereby pride and succession. An employee feels a belonging to the company, as he is not just an employee but also as a part owner. One would have access to the growth potential of the company and share in its profit while adding value to the organisation and fueling its progress
Employer Benefits
- Retention of talent
Most of the firms offering ESOPs to its employees have long-term plans such as to increase retention of quality employees by making them shareholders. Stock options come with a vesting period of a couple of years so an employee must work in an organisation to receive the grant of stock option. At times, such options are available only at the end of the financial year so that the employee instead of quitting in the mid of the year is incentivised to stay and avail ESOP benefits
- Motivating employees
The sense of ownership could motivate employees to remain at the firm. The employer attempts to incentivize the employees to maintain a corporate culture and motivate them to work hard for the company’s performance and do the best for shareholders, which is them in such a case
- Cashless Rewards
Companies can offer cashless rewards to the employees through ESOPs. This keeps a check on cash outflow especially for the cash strapped firms. Companies can offer the compensation package including the option of holding stakes in the company, which makes the CTC look attractive and as per the market competition. The bootstrapping startups can take advantage of this to reduce cash compensation to employees.
Taxation
In the Employee Stock/Share Option/Ownership Plan, the employee is taxed twice. Once, when s/he exercises the option and converts it to equity shares. Second, when s/he sells them and earns profit on it.
- At the time exercising Employee Stock Ownership Scheme
When options are exercised and the shares are purchased, it is taxable at the hands of the employee who received it as a ‘perquisite’ from the employer. It is taxable at the Perquisite Value which means the difference between the Fair Market Value and the Exercise Price, For example, if the FMV is ₹120, and the Exercise Price is ₹50 at which the employee purchased shares, then the differential amount of ₹70 is subject to TDS (Tax deducted at Source)
- At the time of sale of shares
When the employee is leaving or retiring from the company, the company purchases back those shares or voids the stocks. Almost always the former is done. Company pays back the value of those shares either in lumpsum amount or periodic payments according to the FMV on that date. The differential amount between the FMV (Fair Market Value) at the time of purchase and at the time of sale is the capital gains that are for tax deduction. For eg., the market price when shares were purchased was ₹120 and if after 5 years, when the employee resigns/retires then the FMV is ₹500, then the gain is ₹380 for each share. Suppose the employee sells off 80 shares, then the total earning the employee has is ₹30,400. This amount that the employee earns is subject to TDS deduction as capital gains from equity shares.
The Union Budget 2020 has offered certain changes for taxation rules of Employee Stock Option Scheme for eligible start ups. As per the existing taxation rule, the employee has to pay tax once the shares are allotted whereas the shares of startups may not have enough liquidity event. Start-ups are generally unlisted and there is no available market to sell its shares and generate cash. Therefore, there is not enough cash flow for employees who are allotted shares and receive this benefit in kind. However, they have to pay tax from their pockets.
In order to counter this challenge for startup employees, the new rule is introduced for startups. If the bill is passed in parliament, then it shall be applicable from April 1, 2020. It proposes the tax payment as below:
- After the expiry of 5 years from the relevant financial year of share allotment to the employee
- From the date of sale of allotted shares by the employee
- From the date employee resigns/retires
In all the cases above,the tax must be deposited within 14 days from the date of the event.
