What is ESOP?

ESOP stands for Employee Stock Ownership Plan. An Employee Stock Ownership Plan, shortly ESOP, is a plan that allows employees to own shares in the company they are working for. An ESOP is designed to have employees work towards the betterment of the company since their interests are aligned with the growth and profitability of the company. While acting as a form of compensation, ESOPs make the employees themselves proprietors of the organization. Thus, they will be more directly interested in the performance of the organization, enhancing loyalty, morale, and long-term commitment. This additional incentive has become quite clear to companies looking to woo and keep top performers while increasing productivity and profitability.

How Does an Employee Stock Ownership Plan (ESOP) Work?

ESOPs are structured by the company, thereby determining how many shares to allocate, at what price, and to which employees. The shares, once given, lie in trust until vesting is complete. Only if an employee remains with the firm over the period can he or she claim the shares.

Subsequently, ESOPs become exercisable by employees after the vesting period as employees buy their shares at the predetermined price, usually below their true market value. They can thereafter be held for possible appreciation or sold to realize a gain. Should an employee leave or retire before the vesting period elapses, the company becomes liable to repurchase the shares at their then-current fair market value within a set time frame.

ESOP Initial Costs and Distributions

The setup of an ESOP includes initial legal, accounting, and administrative fees. Each of these costs varies in its relative complexity based on the size of the ESOP.

Distributions are exercises of options wherein the holder acquires shares. This could either be sold or held. When sold, an immediate distribution will occur with the money delivered to the employee after deducting applicable taxes. When held, he will now be entitled to dividends and possible capital gains dependent upon the performance of the company.

Benefits of ESOPs for Employees 

ESOPs empower employees with a stake in the company, providing financial growth and a sense of belonging. Here are three notable benefits for employees:

1. Ownership: ESOPs grant employees ownership in the firm and a feeling of belongingness.
2. Dividend Earnings: There could be earnings on dividends from shares held, which again would be additional income to employees.
3. Discounted Purchase: Workers normally buy shares at below the market price, enhancing their investment potential.

Benefits of ESOPs for Employers

ESOPs serve as a strategic tool for employers to retain talent, boost productivity, and attract skilled professionals.Here are three specific ways ESOPs benefit employers:

1. Retention Strategy: Longer vesting periods make the employee more likely to remain for longer.
2. Greater Productivity: With a personal stake in the enterprise, employees will be more interested and willing to contribute more towards the organization.
3. Talent Acquisition: The best talent goes into ESOPs, more so in start-ups, where competitive salaries are hard to come by.

Advantages of ESOPs

ESOPs offer a win-win scenario by aligning the interests of both employers and employees, fostering a shared sense of ownership. Here are four key advantages of ESOPs:

1. Interests Alignment: There is an alignment of interests due to co-ownership by the employees and the employer.
2. Employee Loyalty: Ownership tends to increase the loyalty of employees and reduces their turnover.
3. Tax Benefits: The company and the employees may benefit from preferential tax treatment.
4. Flexible Financing: ESOPs provide firms with a means of financing ownership transitions and the ability to reward employees.

Tax Implication of ESOPs

There are two phases of taxation of ESOPs:

1. At the time of exercise of option: The difference between the exercise price and the fair market value of the share on the vesting date is regarded as taxable income in the hands of the employee and would be charged to income tax.
2. At the time of sale of shares by employees: Gains obtained at the time of selling the shares are subjected to tax on capital gains according to the difference between the selling price and the FMV at the date of exercise.

What is an Example of ESOP?

Suppose a technology start-up, XYZ, offers ESOP to its senior developers. The developers are granted 1,000 shares each, at an exercise price of ₹100 per share with a current market price of ₹150. At the end of a four-year vesting period, such developers can exercise these options and buy shares at ₹100 rate.

Now, if the developer exercises his ESOPs and the market price at that moment is ₹200, he may hold onto the shares in anticipation of further appreciation or sell them immediately, realizing a gain of ₹100 per share.

However, in most cases, the ESOP agreement requires that in case a developer leaves XYZ before the completion of the vesting period, all his or her unvested shares are returned to the company. In this regard, XYZ would buy back the ESOPs at the current fair market value by paying the departing employee regarding the value of the shares at that particular time without allowing him or her to exercise the ESOP fully.

This structure thus allows the staff to benefit from the growth of the company, and at the same time, it provides the company with a mechanism for regaining control of its equity in case of early termination of employment by the employee before he or she has fully vested.

Conclusion
ESOPs are a solution where both the employee and the employer win. By giving employees a share in the company, ESOPs increase their loyalty, motivation, and retention; simultaneously, they turn into an effective tool for employers to attract and retain better human capital that will drive the growth of the company. Finally, for all these a reliable online trading app may help you to meet your investing and trading needs.