What is ESOP Or Employee Stock Ownership Plan? Types & Benefits Explained

You must have heard of the news of more than 500 employees of a company becoming Crorepatis overnight. Yes, you heard it right. But you must be wondering how did it all happen? Well, it was because of a simple concept known as Employee Stock Ownership Plan (ESOP). This happened when Indian SaaS company- Freshworks, recently got listed in the Nasdaq stock exchange, creating millions in wealth for its employees through its listing. 

You must still be wondering how these two are still connected. In this article, I will take you through the basics of the Employee Stock Ownership Plan (ESOP) and examine the advantages and disadvantages of it from the perspective of Employers and Employees. Keep reading to find out more.

What is an ESOP or Employee Stock Ownership Plan?

ESOP is a strategy to align the interest of its employees with the interests of the company. This is an employee benefit plan where employees are given an ownership interest in the company. This is done by giving the employees shares of stock of the company. This can be done based on the performance and tenure of the employees or as a form of bonus. At times these shares are also offered at lower or discounted rates which remain in the ESOP’s trust fund.

This encourages employees to perform better and do what’s best for stakeholders since the employees themselves own stock. Stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others. 

The employees are granted the right to shares, which rise over time depending on the term of their employment. These shares are sold at the time of retirement or termination, and the employee is remunerated for the cash value of their shares. 

Another important term that comes up here is vesting or vested. Generally when employees are awarded these ESOP’s they are given full ownership of the shares only after a tenure say for eg. 3 years. Here the employee fully owns all the shares given only after 3 years. In other words, the shares are vested after 3 years.

When a fully vested employee retires or resigns from the company, the firm “purchases” the vested shares back from them. The money goes to the employee in a lump sum or equal periodic payments, depending on the plan. Once the company purchases the shares and pays the employee, the company redistributes or voids the shares. 

The Law Behind ESOP’s

Employee Stock Ownership was first introduced by way of clause 15A in section 2 of the Companies Act, 1956. In 1999, The Securities and Exchange Board of India (SEBI) which is the governing body for ESOPs set guidelines with respect to such issues by companies. 

ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares.

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What Kind of Companies Give ESOP’s?

Traditionally, Employees Stock Ownership Plans were extended by Listed companies. In recent times, ESOPs are used by companies of all sizes, including Startups. Often such organizations are cash-strapped and are unable to offer high salaries to their employees.

But by offering a stake in their organization, they make their compensation package competitive and retain talent. In its initial stages, an unlisted start-up may grant ESOPs at a very low price to reward those taking the risk of working for a firm when it’s still at a developing stage.

Similarly, if a private company wants to issue ESOP, then it should ensure that the Articles of Association (AoA) authorises for issuance of shares through ESOP. If the AoA does not authorise, then the company should first hold an Extraordinary General Meeting to alter the AoA to include the provisions of issuance of shares through the Employee Stock Ownership Plan. For Example – Zomato Limited

What are the Types of Employee Stock Ownership Plan?

Although the concept seems straightforward, surprisingly there are many different types of Employee Stock Ownership Plan. Here are some of the top ESOP’s: 

• Non-leveraged ESOP 

This type of ESOP does not involve borrowed funds to acquire the sponsoring employer’s stock. It is funded by contributions of cash or stock directly from the employer sponsor. Shares of stock contributed by the corporation are freshly issued shares. Generally, a non-leveraged ESOP is established to promote the growth of the company by creating tax deductions with newly issued shares, thus improving cash flow and reducing taxes. 

• Leveraged Buyout ESOP 

This form of leveraged Employee Stock Ownership Plan is a lot like the fresh Issuance ESOP, except the financing is used to buy stock from a selling shareholder. The tax incentives that accompany these types of transactions include tax-deferred capital gains, tax-favoured financing. 

• Issuance ESOP 

An “Issuance ESOP” uses financing to acquire newly issued shares from the employer sponsor. The shares are allocated to the participants’ accounts as the loan is repaid. The principal borrowed to buy the stock effectively becomes tax-deductible by virtue of it being repaid via plan expense/contributions. The company is, therefore, able to borrow money this way on a fully deductible basis. 

• Restricted stock 

The type of Employee Stock Ownership Plan gives the employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets. 

• Phantom Equity Plan(PEP)/ Stock Appreciation Right (SAR) 

In a Phantom Equity Plan (PEP) or a Stock Appreciation Right (SAR), employees are offered shares of the company in theory, In which the employees will receive the cash value that is equal to the price appreciation over the grant price, once they achieve their vesting conditions.

What are the Benefits of Using ESOP’s?

ESOP’s have multiple benefits which vary according to the party using them. These are mentioned in detail below.

Benefits for the employers 

The most important benefit of Employee stock ownership plans is when it is used as a tool for attracting and retaining high-quality employees. 

From a management perspective, ESOPs have certain tax advantages, along with incentivizing employees to focus on company performance. Companies may use ESOP to borrow money at lower after-tax costs. The contribution towards ESOP is tax-deductible as they are used to repay the loan amount i.e Principal and Interest.  

Benefits for the employees 

Companies often provide employees with such ownership with no upfront costs. With ESOPs, an employee gets the benefit of acquiring the shares of the company at a discounted rate and selling at the higher market rate, making a profit. The company holds the provided shares in a trust for safety and growth until the employee retires or resigns.

Companies typically tie distributions from the plan to vesting, which gives employees rights to these assets over time. Due to the vesting period, employees also get job stability which, in turn, drives up employee satisfaction.

But is Everything Smooth Sailing When it Comes to ESOPS?

Despite ESOP’s having multiple advantages they also bring with them some demerits. 

Flipside of ESOPs for the employers 

Employee stock ownership plans have complex rules and need significant oversight. In case a company doesn’t have the staff to do the ESOP work properly, they could risk issues and potential violations. Once the ESOPs are established, the company needs a proper administration including the third-party administration, trustee, valuation, legal costs.

The ESOP schemes use the cash flow of the company for funding the purchase of shares from its shareholders. In case a company requires the funds for additional working capital or capital expenditures, the ESOP transactions would compete with this necessary requirement, creating a crisis situation for the management. 

Flipside of ESOPs for the Employee 

ESOPs become taxable when the employee exercises their options. The difference between the market value of the shares and the exercise value of the shares is charged to tax as per their tax bracket.

When the employees sell their shares and make some profit out of it then that profit is taxable considering how long the employee has held the shares. If the shares are held for less than a year, it will be a short term gain. For shares that are held more than that, it will be a Long term gain.

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Closing Thoughts 

Now that you have some basic idea about ESOP, you can make an informed decision about exercising your right. Having both upside and downside, an Employee Stock Ownership Plan can prove to be beneficial for the employees. It is an easy way for the employees to get an ownership stake in their own company.

However, you must remember to weigh the pros and cons before exercising your right as an employee. Happy Reading!