Understanding Employee Stock Ownership Plan (ESOP)

You must have heard stories of how some employees of big companies like TCS or Infosys became crorepatis in real life, irrespective of their monthly income. How was it possible? How can the employees of big companies become wealthy shareholders? This was all due to ESOP.

ESOP is a scheme through which an employer offers to its employees an option to buy a company's shares as a reward for their work in the progress of the company in addition to the salary.

Let us discuss the ESOP in detail.

What is ESOP?

ESOP (Employee Stock Option Plan) is a scheme through which an employer gives its employees a right (stock options) to buy shares of the company at a fixed price (price is concessional or nominal or sometimes free) in a scheduled period.

Generally, it is given to employees based on their performance or after completing a specified period in the company. For instance, Kotak Bank can offer its employee an ESOP option after an employee becomes VP in the firm. The crux behind this incentive is that the company wants its quality employees to not leave the firm and perform even more after receiving this incentive. 

Advantage of ESOP

Understanding the Vesting Date and Grant Price

In the ESOP scheme, when an employer/company gives the stock option to its employees, it is free. The ESOP scheme contains the terms and conditions according to which an employee can make use of its stock options. The ESOP contains a lock system, only after which an employee can exercise their rights (most often, the lock-in period is more than a year).

"Vesting Date" is the date on which an employee can exercise their right to acquire shares. The rights of an employee may vest partially or fully over the vesting period. For instance, an employee of an IT firm is given an option of 2000 shares on 01/04/2018, which an employee can exercise in stages like 10% after one year, 30% after two years and the rest after three years. The ESOP may give a different or same grant price/exercise price for the vesting. The grant price/exercise price is generally fixed and is mostly lower than the prevailing market price.

The employee is given a period during which they must exercise their right; otherwise, their rights may lapse. The date on which the employee exercises their rights of stock options is known as "exercise date."

Types of ESOP

Employee Stock Option Scheme (ESOS)

This is the most used ESOP variant. The option given under this scheme provides the right and no obligation to the employee. Stock options are depending on terms and conditions, which includes vesting, required continued service for the company, etc. After the vesting period, the employee can exercise their right to stock options, and they will get shares by paying the predetermined exercise price of the scheme.

Employee Stock Purchase Plan (ESPP)

ESPP scheme allows the employee to buy the company's shares mostly at a lower price than the market price. This scheme is framed for offering shares to the shareholder in the process of public issue. The terms and conditions determine the period and exercising price of the company's shares by the employee.

Stock Appreciation Rights (SARs) or Phantom Equity Plan

This is a different kind of scheme, in which employees are provided with cash payments. The cash payment is equal to the appreciation of the company's stock over a specified period. Therefore, compared to other ESOPs, SAR gives employees the benefit of equity upside without any exposure equity downside. SARs does not give equity ownership to the employees permanently.

Restricted Stock Units (RSU)

RSU plans awards employees with the right to receive shares on a predetermined date conditioned to the occurrence of a specified event or fulfilment of specified conditions. An RSU employee does not get shares immediately. In a certain and future event, the employee may also get partial dividends.

What are the tax implications of ESOPs?

• The option given by the employer to the employee is not taxable. 
• The vested option is also not taxable.
• When an employee exercises his right of buying shares, then the difference between the prevailing market price and the exercise price is taxable, according to the tax bracket under which an employee's income falls.
• The selling of shares by the employee is considered as capital gains. Now, if the employee will sell the shares within one year, then a 15% tax will be charged against the capital gains. If the employee sells after one year, it will be considered as long term capital gains, and no charge will be charged against that.
• If an employee has ESOPs in a foreign company (a company based abroad), and if they will sell the shares of that company, it will be considered as short-term capital gains, and this will be added to the income of the employee who will be taxed according to the tax bracket under which their income falls.
• In the case of capital gains being a long term, 10% tax will be charged without the benefit of indexation or 20% tax will be charged with the benefit of indexation.

Closing Words

ESOPs are plans which create a solution through which everyone can benefit, be it the employer/company or the employee.

In case your employer is giving you that option, you should give it thorough consideration as it can give you handsome fortunes. ESOP are of several types, and the scheme which your employer is giving you will have terms and conditions. It is highly likely that, through the offered scheme, the employer will give more importance to the company's benefits. Hence, it again becomes important to give it a deep thought.