17 December 2021 13:44:42 IST

How ESOPs pay off in the long run

When employees own a part of the company, it's an investment in the company’s success and potential future.

The stock market, in recent months, has been buzzing with huge successes of Initial Public Offerings (IPOs), of companies such as Zomato and Freshworks. Wondering what led to the making of this new wave of high-net-worth individuals (HNIs)? Enter ESOPs.

ESOP, Employee Stock Ownership Plan, refers to an employee benefit plan which offers employees an ownership interest in the organisation. ESOP is an option given, a right and not an obligation, to the employees of the company to purchase the company’s shares at a fixed price during a specified period. These can be issued as,

  1. Direct stock , where the employees can purchase the shares directly from the company without the intervention of stockbrokers,
  2. Profit-sharing plans or bonuses , in which the employees are given a share in the profit of the company in addition to the regular salary in the form of allocation of shares.

The employer exercises complete discretion in deciding who could avail these options. They are generally allocated in proportion to the compensation and years of service of the employees, their performance or contribution, including potential future, to the organisation.

ESOPs are offered by companies with long-term goals. ESOPs have been recognised as an important tool for employee wealth sharing and motivation around the globe. By offering ESOPs, they turn employees into responsible stakeholders. When the employees own a part of the company via equity shares, then they will be more engaged, focussed, and keen to make the company succeed.

Regulatory requirements

The primary legislation which governs the issue of ESOP is the Companies Act, 2013. Further, these ESOPs remain tax neutral in the hands of the employees, the ESOPs should also comply with the guidelines issued under the Income-tax Act, 1961. SEBI, in respect of listed companies, imposes various restrictions and conditions for implementing ESOP. Thus, a company must adhere to the various statutory requirements before granting ESOPs to its employees.

How it works?

Starting with the basics, an organisation grants the option (ESOPs) to its employees for buying a specified number of shares of the company. It must be noted that options are the right to own shares but not shares till the right is exercised and shares allotted. A vesting period is the specified period an employee must wait to be able to exercise their option to buy a share of the company. The waiting period is to give the employee an incentive to perform well.

Vesting follows a pre-determined schedule that is decided by the company at the time of granting of options. Coming to the final part, exercising the option means buying the shares of the company using the rights given in the form of ESOPs. This too has a specified time known as the exercise period where the employee can buy the shares at a pre-determined price known as grant-price.

Settlement mechanism

The following are the categories of ESOP and its methodology for settlement,

  • Equity-settled : The employees receive shares in this plan.
  • Cash-settled: Here, the employees receive cash based on the price (or value) of the enterprise’s shares.
  • Phantom stocks: The employees receive mock stock that follows the price movement of the company’s actual stock and pays out the profits.
  • Employee share-based payment plans with cash alternatives : Here, either the enterprise or the employee has a choice of whether the enterprise settles the payment in cash or by the issue of shares.

Tax on ESOPs

ESOPs are considered as perquisites with respect to taxation. On the other hand, for an employee, ESOPs are liable to be taxed at two different stages —first when exercising as a perquisite. When an employee exercises his option, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxed as a perquisite.

Perquisite value of ESOP (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted

Then again when selling in the form of capital gain. An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax.

Capital gains = Sale proceeds – FMV of ESOP – expenses incurred by employee.

Encashment and exits

Now, coming to the exit process for ESOPs, there are three popular ways, the company can buy-back its shares, they can go for public issue or third-party buy back. Many companies, align their exercise period with the public issue period to enable employees to exercise their vested options and encash them at the market price in the public issue.

ESOP buy-back is a win-win for both employees and the company. The company gets back its shares for future negotiations and regulates dilution, and the employees have a great option for wealth creation. ESOPs are a perfect blend of benefits to the company, employees, and investors, and lately, many companies are reaping those benefits to build their way to growth and success.

In India, Infosys pioneered giving ESOPs to its employees in the ‘90s. Over the years, the ESOPs granted have created quite a few millionaires including some non-technical staff. The recent IPOs from companies such as Freshworks, Zomato and Paytm are reported to have created hundreds of crorepatis. The ESOP beneficiaries who become angel investors for start-ups could potentially create the next wave of millionaires says a recent study. Welcome to the new India.

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(The writer is CA Article Assistant, RVKS and Associates, Chennai.)