Understanding Employee Stock Options (ESOP)

Every company wants to retain its executives and key employees by rewarding them for their valuable contribution to the growth of the company. ESOP is one of the popular ways of rewarding such employees. 

What is an ‘ESOP’?  

‘ESOP’ is a scheme or plan or programme set up by a company for its employees. Employee Stock Options are options under which a company gives the right to its employees to purchase its shares at a discounted price. ESOP is a type of retirement and employee benefit plan which offers its employees, ownership interest in the shares of the company on fulfilment of certain conditions. 

Company Law defines ESOP as follows:  

“Employees Stock Option” means the option given to the directors, officers or employees of the company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.   

Private limited company registration makes it possible for employees or executives to become the shareholders of the company through ESOP. It can do so by providing derivative options to them rather than shares. The options come in the form of stock options and give the employees right to buy company’s shares at a specified price (generally lower than the market price) in future, i.e., they can convert the options into shares at a future date after paying the price. The terms and conditions for the same are written in the ESOP agreement.  

But, before a company plans to start ESOP, it must conduct a feasibility study to determine if an ESOP is financially possible or not. Also, it must evaluate its financial position to establish the prices of the shares of the company. Once, it is assured that ESOP is possible and is beneficial, the company may move to the below-mentioned steps.  

This is the step by step process of ESOP-  

1. The company frames a draft ESOP scheme and places it before the shareholders in a meeting for getting their approval.   
2. After getting the approval, it grants the stock options to the employees by providing them with a ‘Letter of Grant’. This letter contains all the details regarding the stock options like several options granted, vesting period, exercise period, exercise price, etc. 
3. At the end of the vesting period, the employees can convert the stock options into shares and become the shareholders in the company.  

Notes:  

1. Stock options: These are not shares, but the right to own shares at a future date by paying the price. 

2. Vesting period: This is the period only after which the employees are allowed to exercise the options and convert them to shares. The minimum vesting period of 1 year is prescribed for the same. During this period, the employees who have been granted the options are required to stay in the company if they want to become the shareholders in the future. 

3. Exercise period: This is the period during which the employees can exercise their right to convert stock options to shares. 

4. Exercise price/ Grant price/ Strike price: This is the price at which the employees are given shares of the company.  

5. Expiration date: ESOP is valid only for a limited period, i.e., during the exercise period. After the expiry of this period, they cannot be converted into shares. The expiration date is the date by which the employees must exercise their options. 

Tips to follow

1. Read the ESOP agreement carefully, as it may contain some clauses like partial ownership at the end of minimum vesting period and further ownership after a few more years of employment.  

2. If you are a key employee of the company, you can negotiate regarding some aspects like faster vesting or lower exercise price.   

3. Don’t let ESOP expire, it’s better to exercise. You can set a reminder for remembering the expiration date.  

4. Discuss the clauses of agreement with any financial planner or expert before exercising ESOP or selling shares.  

Benefits

1. To Employees

• Provides them with an opportunity to share in company’s success directly through ownership of shares;  
• Helps them increase their wealth by sale of profitable shares which were acquired at a nominal price;  
• Helps them to stay motivated and satisfied with their jobs.  

2. To Company

• Boosts employees’ financial well-being and motivational level, thereby urging them to serve the company in a better way; 
• Reduces the cases of employees leaving jobs in a few months;  
• Incentivizes employees to help in the company’s growth and success.  

Note: ESOP is more beneficial to start-ups, as they can’t afford to pay high remuneration packages to their employees. Instead, they can offer ESOP to them. This way, the employees get an opportunity to become shareholders of the company and they work for the company’s growth as they know they can share the profits of the company. 

Taxation of ESOP for Employees:  

Employees who exercise the option and become the shareholder of the company are taxed under the Income Tax Act, 1961. The tax liability can arise at 2 stages for shares allotted under ESOP- 

1. At the time of exercise of the option  

2. At the time of sale of shares  

A. At the time of exercise of option: When the employees exercise their right to convert options into equity shares after the end of the vesting period, the tax is charged on the perquisite value under the head ‘Income from salary’. The employer (i.e., company) computes the perquisite value of ESOP in the hands of the employee and deduct tax thereon. The employer is required to show this value and the tax deducted thereon, in Form 16 issued to the employee. 

The computation of taxable value is as follows:  

Fair Market Value of Shares (on the date of exercise of the option)

Less: Amount recovered from employees for such shares (exercise price)

Taxable Value of Perquisite

Fair Market Value is computed based on methods prescribed for the same.  

B. At the time of sale of shares:When the employees sell the shares allotted to them by the company under ESOP, at higher prices, a capital gain arises. Tax is charged on this capital gain under the head ‘Capital Gains’. The gain is either long term capital gain or short-term capital gain. Rate of tax will depend on the type of capital gain.  

The computation of capital gain is as follows:  

Sale Price of Shares

Less: Fair Market Value of Shares (on the date of exercise of the option)

Capital Gain

Conclusion

To conclude, ESOP is a great way to build the foundation of financial freedom and retirement. It acts as a motivational tool for employees to stay in the company and work towards the goal of the company. Employees feel pride in the ownership of the company and measure the success of the company as their success. On the other hand, a company gets an opportunity to retain the desirable candidates by framing Employee Stock Option Programme for them.