The Power of Employee Ownership: Exploring ESOPs

Employee stock option plan (ESOP) is a type qualified plan that offers employees an ownership interest in the organisation. It is a way for employees to become owners of the company and share in its success. ESOPs are often used as a tool for business succession planning, as well as a way to motivate and retain employees.

How does an ESOP work?

Under the ESOP draft plan and with the approval of shareholders, an ESOP trust is set up and the company contributes the trust or else the trust borrows money from a bank. If trust borrows the money, the arrangement is called a leveraged ESOP. The option is given to individual employees through a Letter of Grants accounts based on a formula determined by the plan. A letter of grants contains key details for exercising stock options including:

1. The number of shares allotted to the employees;
2. Vesting period (Period for which employee has to work with organization before exercising stock options);
3. The predetermined price at which shares can be brought (also known as exercise price);
4. Exercise Period; Restricted Stock Units

After the expiry of vesting period, employees gain the right to exercise the stock options at the exercise price.

Benefits of ESOPs

Increased employee motivation and engagement: In effect, ESOPs hold out the guarantee that employees with stock options will become part-owners of their organisation after a certain period of time. This aligns the incentives of such employees with the company’s goals and ensures that employees are interested in making sure that the company does well (since the company’s performance will directly affect the financial rewards they will get).

Improved company performance: Companies with ESOPs tend to have better financial performance than those without, as employees have a vested interest in the company’s success.

Business succession planning: ESOPs can be a useful tool for business owners looking to gradually transition out of the company, as they provide a way for employees to gradually acquire ownership.

Tax Implication for employees

On the time of exercise of Option – as a prerequisite and as a capital gain when employees who have been allotted the shares and sell those shares at the value above than FMV – Fair Market Value at that time in market.

The capital gains would be taxed depending on the period of holding. This period is calculated from the date of exercise up to the date of sale. Equity shares which are listed on the recognized stock exchange are considered as long-term capital if they’re held for more than 12 months i.e. 1 year. In case the shares are sold within 12 months, these are then considered as short term. Presently, long-term capital gains (LTCG) on the listed equity shares are exempt from tax. However as per the recent amendments in Budget 2018,
Sale of equity shares that are held for more than a year on or after 1st April 1, 2018 would attract tax at the rate of 10% and cess of 4%. Short-term capital gains (STCG) are taxed at a rate of 15%.

Conclusion

Employee Stock Ownership Plans (ESOPs) can be a powerful tool for motivating and retaining employees, as well as for business succession planning. ESOPs give employees a stake in the company and align their interests with those of the company, which can lead to improved company performance. They can also provide tax benefits for both the company and the employees.

However, it’s important to keep in mind that ESOPs may not be suitable for every company and that it’s important to carefully consider all the factors involved before deciding to implement an ESOP. The process of setting up an ESOP can be complex and costly and there are also risks involved such as a decline in the value of the company stock. Additionally, ESOPs are not commonly used in India and not many companies have adopted it. Consulting with professionals and carefully weighing the pros and cons can help ensure the success of an ESOP