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What is ESOP: ESOP full form, meaning and taxation
An Employee Stock Ownership Plan (ESOP) is a powerful tool that allows employees to own a stake in the company they work for. By offering company shares as part of an employee's CTC, ESOPs encourage long-term commitment and contribute to shared success. This article explains the full form of ESOP, how it works, and the taxation rules you need to know when offering ESOPs to your employees.
ESOP full form and meaning
ESOP stands for Employee Stock Ownership Plan. It is a benefit program that gives employees a stake in the company. These plans can be offered as direct stock, profit-sharing, or bonuses, and the employer decides which employees are eligible.
In most cases, employees are given the option to buy them at a fixed price before a certain date. This gives employees a chance to benefit from the company’s growth. Employers must follow specific rules and regulations under the Companies Act when offering ESOPs to their employees.
How does ESOP work?
Employers determine how many shares they can offer through ESOPs, set the price, and select eligible employees. After making these decisions, they grant ESOPs to the chosen employees and specify a grant date.
The shares offered under ESOPs are held in a trust for a specified period, called the vesting period. Employees must stay with the company during this period to gain the right to purchase the stock by exercising their ESOP.
Once the vesting period ends, employees can exercise their ESOPs, meaning they can buy the company shares at a predetermined price, often lower than the market value. Employees can also choose to sell these shares, potentially making a profit. However, if an employee leaves the company or retires before the vesting period ends, the company is required to repurchase the ESOP shares at fair market value within 60 days.
Benefits of ESOP for employers and employees
ESOPs offer a win-win solution for both companies and their employees. For employers, ESOPs can boost employee motivation, and align the workforce with the company’s long-term goals. For employees, these plans provide a chance to own part of the company and benefit financially from its success. Let’s take a look at how ESOPs benefit both sides.
Benefits of ESOP for employers
Organisations offer stock options to motivate their employees. Since employees stand to gain when the company’s share price increases, ESOPs encourage them to put in their best effort. While employee retention and recognizing hard work are key advantages, there are additional benefits for employers as well.
Employee Stock Ownership Plans allow companies to reward employees without immediate cash payouts, helping them conserve cash. This is especially beneficial for businesses that are expanding or scaling up operations. Offering ESOPs instead of cash rewards can be a more practical and cost-effective solution for these companies.
Benefits of ESOP for employees
Employees benefit from ESOPs in three main ways:
- Retirement benefits: Employees receive company-funded retirement savings without needing to make personal contributions.
- Job security: ESOPs provide greater stability and can lead to fewer layoffs during transitions or economic downturns.
- Increased commitment: Ownership stakes boost employee loyalty and motivation to drive company success.
How to set up your company's ESOP policy?
Here are the essential steps you need to follow to establish an ESOP for your company:
Step 1: Develop an ESOP plan
The first task is to design an Employee Stock Ownership Plan (ESOP). Your lawyer or legal firm will assist in drafting the plan. Discuss key aspects such as the vesting period, cliff, ESOP pool, and other relevant terms with your legal counsel.
- Cliff refers to the minimum period an employee must work at a company before they are eligible to start receiving any stock options. Essentially, it's a waiting period before any portion of the ESOP vests or becomes available to the employee.
- An ESOP pool (Employee Stock Ownership Plan pool) is a reserved portion of a company's shares set aside specifically for employees.
It’s important to ensure the terms are fair to employees. Consider the following points when developing the ESOP plan:
- Vesting period: The typical vesting period is 3 to 4 years. While you can choose a longer vesting period to retain employees, it’s essential to balance this with their interests. A vesting period that’s too long (e.g., 6 years) could discourage potential talent.
- Vesting schedule: It specifies how much of the stock options the employee can claim at different points in time. You can distribute stock options either evenly or in increasing amounts over time. Some companies follow an increasing schedule, but many startups now adopt an even schedule to make ESOPs more appealing.
- Vesting frequency: It determines the intervals at which the vesting occurs, meaning when the employee legally gains the right to own a percentage of the granted stock options. The common types of vesting frequencies are annual, quarterly and monthly vesting. A more frequent vesting schedule (e.g., monthly) provides employees with smaller, regular portions of their stock options, while less frequent schedules (e.g., annual) give larger portions at longer intervals.
Another critical decision employers need to make is the size of the ESOP pool, which is often determined during fundraising. Start with a pool size of 5-10% and adjust it based on your hiring needs. Finally, consider the cliff period, which is the minimum time an employee must work before any stock options vest. In India, a 12-month cliff period is mandatory by law.
Step 2: Obtain a valuation certificate
When setting up an Employee Stock Ownership Plan, you’ll need to determine the strike price and obtain a valuation report for accounting and audit purposes. Any valuation conducted within the last 6 months is generally valid, unless there has been a new funding round or liquidation event. If you are creating the ESOP during fundraising, the same valuation report can be used.
Step 3: Secure board approval
After finalising the ESOP plan, seek approval from your board of directors. It is advisable to create the plan early on, rather than waiting until a funding round. Delaying this could lead to complications, such as being unable to offer ESOPs to early employees at the promised price due to investor expectations. Ensure that the board formally approves the plan to avoid conflicts later.
Step 4: Obtain shareholder approval
Once the board approves the ESOP plan, the next step is to gain approval from the shareholders. In India, this requires passing a special resolution during an extraordinary general meeting (EGM), as mandated by the Companies Act, 2013. The resolution must receive at least 75% of the votes to pass. After the EGM, you must file the board and shareholder resolutions with the Registrar of Companies (RoC) within 30 days, which can be done online using eForm MGT-14.
Step 5: Start granting ESOPs
After completing all the necessary steps, you can begin awarding ESOPs to employees through a grant letter.
ESOP taxation
In India, ESOPs are taxed at two stages: first when employees purchase the company shares, and second when they sell them. The tax treatment varies depending on the holding period and the employee's income tax bracket. This section will break down the key tax considerations at each stage, helping you understand the ESOP taxation rules.
When employees purchase company stock
Employees can buy shares at a price lower than their Fair Market Value (FMV) after the vesting period. The difference between the FMV and the exercise price is considered taxable income and is taxed according to the employee’s income tax slab. However, the government offers tax relief to employees of eligible startups. In these cases, employees don't have to pay tax on the ESOP benefit in the year they exercise the option. Instead, the tax is deferred until the earliest of the following events:
- Five years from the ESOP grant date
- When the employee sells the shares
- When the employee leaves the company
For example, suppose an employee of an Indian startup is granted ESOPs with an exercise price of ₹100 per share. On the vesting date, the FMV of the share is ₹400. The difference of ₹300 (₹400 - ₹100) is considered a taxable perquisite. If the employee is in the 30% tax bracket, they would typically owe ₹90 (30% of ₹300) per share in tax. However, since the employer is a startup, the employee can defer this tax liability until one of the above events occurs.
ESOP tax calculation example
Assume an employee working at a listed company was granted ESOPs with an exercise price of ₹200 per share. On the exercise date, the FMV of each share was ₹500. Later, the employee sold 100 shares at a price of ₹800 per share.
There are two scenarios for the sale date: in Case 1, the employee sells the shares after 18 months, which qualifies for long-term capital gains treatment; in Case 2, the employee sells the shares within 8 months, which is subject to short-term capital gains taxation.
Case 1: Long-term capital gains (Held for more than 12 months)
| Particulars | Value |
| ESOP exercise price (per share) | ₹200 |
| FMV on exercise date (per share) | ₹500 |
| Selling price (per share) | ₹800 |
| Capital gains (per share) | ₹800 - ₹500 = ₹300 |
| Total capital gains | ₹300 X 100 = ₹30,000 |
| Exemption | No tax on gains up to ₹1.25 lakh |
| Taxable amount | No taxable amount (₹30,000 is below the exemption threshold) |
Case 2: Short-term capital gains (Held for less than 12 months)
| Particulars | Value |
| ESOP exercise price (per share) | ₹200 |
| FMV on exercise date (per share) | ₹500 |
| Selling price (per share) | ₹800 |
| Capital gains (per share) | ₹800 - ₹500 = ₹300 |
| Total capital gains | ₹300 X 100 = ₹30,000 |
| Tax rate | 20% |
| Taxable amount | 20% of ₹30,000 = ₹6,000 |
Key takeaways
Setting up an ESOP can be a strategic move for your company. It empowers employees by giving them a direct stake in the company's success and cultivates a culture of shared goals and values. By carefully designing and managing your ESOP, you can build a solid foundation for your company’s growth while ensuring your employees feel valued and invested in their work.
Frequently asked questions on ESOP
1. What is a vesting period in ESOP?
In an ESOP, the vesting period refers to the timeframe that begins when the ESOP shares are issued. During this period, employees must wait before they can exercise their stock options. Typically, ESOPs have a vesting period of at least one year, but it can extend to five years or even longer, depending on the company's policy.
2. What is ESOP in salary?
ESOPs are an important part of an employee’s compensation package. They are a benefit that grants employees the opportunity to own a share of the company through equity shares, aligning their interests with the company's success.
3. How to calculate your ESOP valuation?
To calculate the valuation of your Employee Stock Ownership Plan (ESOP), you can use the following formula:
ESOP value = Number of ESOP shares × current stock price
This formula helps determine the total value of an employee’s ESOP holdings. For example, if an employee owns 100 ESOP shares and the current stock price is ₹50, the ESOP value would be 100 × ₹50 = ₹5,000. This calculation highlights the direct relationship between the number of shares an employee holds and their market value, providing a clear method for assessing the financial benefit of the ESOP.