What is ESOP Meaning, Benefits & How it works?
An Employee Stock Ownership Plan (ESOP) is a benefit plan that gives employees ownership of company stock. It is often used as a way to align employees' interests with the company’s growth and success. Through ESOPs, employees can participate in the company’s profitability by owning shares. This plan not only motivates employees but also provides them with a long-term investment opportunity. In this blog, we will explain the meaning of ESOPs, how they work, their benefits for both employees and employers, and other important details.
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What is ESOP Meaning?
ESOP (Employee Stock Ownership Plan) is a program where companies offer their employees the opportunity to own shares in the company. It’s a way for employees to benefit from the company’s growth and financial success. ESOPs are typically used as an employee benefit plan that works in addition to salary and bonuses. The company may grant employees company shares either as a part of their compensation or as a retirement benefit. Over time, as employees stay with the company, they build equity in the business.
How Does an Employee Stock Ownership Plan (ESOP) Work?
An ESOP works by allowing employees to purchase company shares, often at a discounted price or as part of their salary package. The shares are usually held in a trust until the employee meets certain criteria, such as staying with the company for a set number of years (vesting period). Employees can then sell their shares for profit when they leave the company or during a liquidity event like an IPO (Initial Public Offering). ESOPs can also help businesses raise capital by offering stock to employees.
ESOP Initial Costs and Distributions
Setting up an ESOP involves initial costs, including setting up the trust, administrative fees, and legal expenses. Companies must also allocate shares and manage the plan’s structure. Over time, as employees are granted stock options or company shares, the company may distribute shares based on the employee's service, performance, and position. Distributions are made when employees retire, leave the company, or when certain financial milestones occur, such as an IPO.
Benefits of ESOPs for Employees
1. Ownership in the Company
Employees become partial owners of the company through an ESOP. This creates a sense of responsibility and engagement, as employees benefit from the company's growth. As the company performs better, the value of the shares increases, benefiting the employees financially in the long run.
2. Financial Security and Retirement Benefits
ESOPs act as a long-term retirement savings plan. The shares granted to employees can appreciate over time, creating a valuable asset. This provides a financial cushion for employees when they retire or leave the company, as they can sell their shares for a profit.
3. Motivation and Increased Productivity
By owning shares in the company, employees are more likely to feel motivated to work harder and contribute to the company’s success. This increased sense of ownership can lead to better performance, as employees know their efforts will directly impact the company’s profits.
4. Tax Benefits
Employees benefit from certain tax advantages under ESOP plans. For example, tax deferral allows employees to delay paying taxes on the stock until they sell their shares. The tax is usually based on the capital gains of the shares, which may be lower than ordinary income tax rates.
5. Job Satisfaction and Loyalty
ESOPs foster employee loyalty. Since employees can build wealth through their ownership, they are less likely to leave the company. This leads to higher job satisfaction and reduces turnover rates, helping the company retain talented employees.
Benefits of ESOPs for Employers
1. Employee Motivation and Retention
By offering ESOPs, employers can motivate employees to work towards the company’s success, knowing that their performance will directly affect their financial gains. ESOPs also help retain valuable employees by giving them a stake in the company.
2. Tax Deductions for the Company
Employers who offer ESOPs can enjoy tax deductions on the contributions made to the employees' accounts. This makes ESOPs a cost-effective benefit for businesses, especially startups or smaller companies.
3. Attracting Talent
Offering ESOPs can be a competitive advantage for employers when trying to attract top talent. It is an attractive benefit for new recruits, especially when competing with other companies in the market.
4. Aligning Employee Interests with Company Goals
ESOPs create a direct link between employees’ efforts and the company’s growth. When employees become shareholders, their focus shifts to long-term success, benefiting the company in terms of productivity and innovation.
Why Do Companies Offer ESOPs to Their Employees?
Companies offer ESOPs as a way to reward employees for their contributions while also aligning their interests with the company’s growth. ESOPs are an attractive employee benefit, which can boost productivity, lower turnover, and help recruit top talent. Additionally, companies can use ESOPs to raise capital, as the plan gives them a new way to offer shares to employees. It also creates a stronger sense of loyalty and motivation among staff, which is beneficial for the company's overall success.
How to Cash Out of an ESOP?
Employees can cash out of an ESOP in several ways:
- Selling Shares When Leaving the Company: Employees can sell their shares after leaving the company or retiring. The company usually buys back the shares.
- Liquidity Event: Employees can sell their shares during an IPO or acquisition, when the company goes public or is sold to another company.
- Market Sale: If the company is publicly traded, employees can sell their shares in the open market once the shares are vested.
What Happens to ESOPs if I Leave the Company?
When you leave the company, the treatment of your ESOP shares depends on your vesting schedule and the company’s policies:
- Vested Shares: If you have vested shares (those you’ve fully earned), you can sell them or transfer them. Typically, the company will buy back these shares or allow you to sell them in the market if the company is listed.
- Unvested Shares: If you leave the company before your shares are fully vested, you may lose those shares. Unvested shares typically revert back to the company.
- Retirement: If you retire, the treatment is similar to leaving the company, but you may have more flexibility in selling or holding your shares, depending on the company’s policies.
Tax Implications of ESOPs
ESOPs have tax implications for employees:
- At Grant: No tax is due when shares are granted, unless the shares are sold or transferred.
- At Vesting: The employee may need to pay tax when the shares are vested and accessible.
- At Sale: When shares are sold, employees must pay capital gains tax based on the sale price minus the price at which they bought the shares.
ESOP Example
Example:
Suppose you work for a company that grants you 1,000 shares at ₹100 per share when the market price is ₹150. Over the next few years, the share price rises to ₹300. After your vesting period, you sell your 1,000 shares for ₹300 each, making a profit of ₹200,000 (₹300 * 1,000). The tax you pay depends on the capital gains tax on the ₹200,000 profit.
Tax Treatment at the Time of Selling the Shares
When you sell your ESOP shares, you need to pay capital gains tax on the profit you made. If you sell the shares after holding them for more than a year, the gain is considered long-term capital gain (LTCG), which is taxed at a lower rate. If you sell the shares before a year, the gain is short-term capital gain (STCG), taxed at a higher rate.
What Happens to ESOPs When the Company is Listed?
When a company is listed (goes public), employees holding ESOP shares can sell them on the stock market. The company’s stock becomes liquid, meaning employees can trade their shares like any other publicly traded stock. The shares are also valued according to the market price, allowing employees to sell their holdings and potentially make a profit.