To begin with, the Employee Stock Ownership Plan (ESOP) is a contract that gives an employee in a company the right to buy its shares at a discounted price after a pre-set number of years. This is commonplace in start-ups. Also known as the Employee Stock Option Plan (ESOP),it is a reward program devised by HR and Financial brains.
The contract allows one to buy the shares only after what is known as a vesting period. This ensures the employee sticks to the organisation given his ownership in the company, which can be availed in future.
An option is simple. It gives one a choice. The choice to take it or leave it. On similar lines, the employee can choose to buy shares of the company but is in no way obligated to do so.
The ESOPs can be exercised only after a specific number of years called the vesting period. This holding period ensures the employee is retained in the organisation given the right to buy shares at a discount. The number of shares purchased could be a part of the exercisable rights or the entire number of shares represented by the contract.
The gains/ losses remain unrealised on paper till the owner of the ESOPs decides to liquidate the shares, which, simply put, is to sell the shares. ESOPs are said to be liquidated when one leaves or retires from the company.
“Trust” to take it forward
For the company looking at ESOP as a rewards pathway, it begins by setting up a trust. A trust is a type of company that works for a specific cause or welfare. The company pours funds into the trust by debt (loans raised through various channels) or its capacity (equity).
The trust then deploys the acquired funds to buy shares and serves as a container to hold the shares. What can a trust do?
1. Present shares to incoming employees and current employees
2. Buys back shares from exiting employees
In the process, the trust acts as a fiduciary for the company. Fiduciary duty refers to the trust’s act of working as a manager of shares in the best interests of the company because the company places its faith in the newly set up entity.
Buying shares at a discount to realise gains sounds like easy money. This is not as easy as it sounds because a lot of hard work goes behind the scenes to raise the company’s profitability and thus its valuation and thus its share price. In this backdrop, it is key to remember that ESOPs are offered to only a select group of employees, typically Key Managerial Personnel (KMP).
The way ESOPs are distributed to employees in every company differs. The basis is usually grade of an employee; contribution of the employee to the organisation; length of association with the company;
If you tick any of the following buckets, you are eligible to receive ESOPs:
1. A permanent employee in your organisation or in its subsidiary company
2. Directors on board
3. Investor/ Advisor on the board of directors
4. Promoters/ Founding members of start-ups recognised by Department for Promotion of Industry and Internal Trade (DPIIT)
When the shares are raised through equity, ESOPs are said to be unlevered.
When the shares are raised through debt, they are termed as leveraged ESOPs.
Finally, when existing ESOPs are diluted through actions such as stock split or bonus, this increases the number of stocks as a result. The resultant shares are called ESOPs through issuance.
ESOPs motivates employees as it serves a source of income that can be tapped in future in return for sticking with a company while aiding in its growth journey. Employees tie this with their efforts and see the program as a favourable return.
ESOPs remain as diversification of assets for oneself. This will provide additional cash boost in future when one avails and sells the stock at a premium to the purchase price.
Employees begin to closely monitor the valuation of the company, which will in turn affect the stock price. This inherently motivates them to align their goals with the organisation’s goals. The company’s performance is influenced by the collective performance of the people it is made up of. The better they perform, the stock grows in value.
On the other side of the coin, the retention rate improves for the company since employees remain devoted to the organisation for a longer time to avail of shares at a discount post the vesting period.
The construct of the program can attract top talents to lead young enterprises. Scarcity of liquidity with young companies would restrict them from hiring niche or top talent. With ESOPs, they can draw the talent pool they want.
As the staff own a piece of the business through ESOPs, they are pushed intrinsically to put in their best. In the process, they tend to spread the good word around. Besides giving the employees a strong reason to stay, added publicity does a great deal of goodness for the marketing department.
The mechanism of a “trust” to handle the shares ensures the company’s longevity. Founders of typical start-ups would want to see their fledglings grow and thrive even after they exit or retire. As the trust is responsible for redistributing shares on a continual basis, the mechanism ensures ownership is provided to KMP, who will align themselves with the company’s growth goals anytime.
By restricting the ownership of shares to a select group of employees based on criteria formed by the company, a stable group of owners arise for the shares. This creates a stable market for the buying and selling of shares. With less or zero float, i.e. less or zero publicly traded shacompany’s performance entail for infant companies progressing to the public market.
For the promoters, the ESOP contribution would not outweigh their contribution to the company, which means the corporate structure will not be upset due to the ESOP construct.
Crucially, ESOPs provide a tax deduction for the cash outflows from a company. The cash flows could be for share buy-backs or more capital in trust to buy further shares. Even if the cash outflow from the company to the trust was to serve as a mere cash reserve, it is eligible for a tax deduction. Besides, dividends paid and loans repaid through ESOPs are also tax-deductible. In short, there is a huge cash flow advantage for the company.
Employers are bound to chip in a contribution for their employees as part of their salary for rainy days post-retirement. Rather than parking cash as an expense for this contribution, organisations could provide ESOPs of commensurate value. The boost in cash reserves helps the organisation manage its cash requirements better. It could allocate funds for areas where it cannot afford to provide ESOPs, such as capital expenditure, investment in office infrastructure etc.
Consider an employee gets shares on a particular date. This is known as the share allotment date. From this date, the following tax slabs are applied per provisions of Section 111A of the Income Tax Act, 1961, basis the holding length of shares by the employees. To differentiate between Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG), one must look at the company’s listing status.
|Listed Company Sales of Shares within 1 year: STCGBeyond 1 year: LTCG
|10% without indexation (i.e. adjustments for inflation) where gains exceed Rs 1 lakh
|Unlisted Company Sales of Shares within 2 years: STCGBeyond 2 years: LTCG
|Regular Income Tax slab as per income of employee
|20% with indexation
Now that we have delved in this topic for quite some time, we can summarise that ESOPs are rights over shares. Shares are typically liquid assets. This means if you owned a share of a company, you could buy or sell it anytime you wish to buy or wish to avail the liquidity. ESOPs transform an inherently liquid asset into an illiquid asset by inserting clauses like vesting periods. Sometimes the creative innovations may be viewed as overly restrictive by certain employees/ prospective talents. Thus, to ensure the construct is a fair deal for both parties is the basic and foremost challenge for employers.
Ensuring the program is easily understood by employees is essential for a successful buy-in of the program. Start-ups generally rely on this program to remunerate their top talents and hold them for a longer time period. If the fine print is complicated or the product is structured over-creatively, the talents tend to drift away rather than get drawn towards the organisation. Recruitment as a goal becomes a shot widely off target.Thirdly, Assuming the price of the stock rises after the vesting period, the program works to be a lucrative deal for the employee. If there is value depletion with regards to the company, for unknown or known reasons, the ESOP holders who believed in the company begin to stare at mounting losses on paper. The worries add with further headwinds that threaten the growth of the company. It would take a lot of effort and even more time to reverse the losses and see comforting figures.
In essence, reasonably structured ESOPs work out to be a win-win for both the employee and the employer. The employee is able to realise higher gains on his holdings over time while the organisation would be able to boost its valuation while also managing to retain top talent. The benefits for both parties have been discussed in this article amongst which the monetary reward is a strong reason for employees to stay. For the employer, cash flow advantages arise through multiple fronts via ESOPs. This article has also highlighted the way ESOPs work from the perspective of an employee and an employer who uses the route of a separate entity called the Trust. Since the benefit cannot be doled out for all, the program is usually offered to only top management so as to recruit them and retain them in the organisation. Tax implications are applicable for the ESOPs as per the listing status of the company and depending on the holding period of shares by the employee. Overall, ESOPs need to balance the interests of the employees as well as the organisation. A tightrope walk indeed! (based on trust)
ESOP is an opportunity for an employee to own a part of his/her company
No, it can be offered as and when required.
One can sell it to the trust, which would later redistribute it to other employees or newcomers.