What is ESOP? Full Form, Meaning, Taxation, Benefits & How Does It Work

Imagine joining a startup in 2014 as a developer, along with your salary, you are offered equity through Employee Stock Option Plans (ESOPs). A decade later, that once-small company, say Swiggy, is now valued at ₹10 billion. Your 0.01% equity stake? It is now worth a whopping ₹8.3 crore.

That is the power of ESOPs; they do not just pay, they build wealth. By turning employees into part-owners, ESOPs can be truly life-changing. In this blog, you will learn more about ESOP, its benefits, taxation, and how it works. \

Quick Synopsis

• ESOP lets employees get company shares at a set price after a vesting period, allowing them to become part of the company’s growth.
• Employees benefit through potential wealth creation, ownership, and tax advantages, while companies use ESOPs to motivate and retain talent.
• Risks include lack of liquidity, market volatility, and overexposure to one asset.

ESOPs Full Form and Meaning 

An Employee Stock Ownership Plan (ESOP) is a program that provides employees with the opportunity to acquire shares in the company. Employees typically receive these equity shares at a predetermined price after working for a specific period.

This initiative allows employees to become part-owners of the company, aligning their interests with the company's growth. Once eligible, employees can receive shares and potentially earn money as the company's value increases.

How Does an ESOP Work?

Employers decide who gets ESOPs, how many shares are offered, and the price employees will pay for them. When employees receive ESOPs, the shares are placed in a trust for a certain "vesting period." 

During this time, employees need to stay with the company to earn the right to own the shares. The end of this period is the "vesting date." After that, employees can get company shares and become a part-owner. They can keep or sell the shares, making a profit if the company’s value goes up. 

However, if an employee leaves or retires before the vesting period ends, the company will buy back the unvested ESOPs at the current market price within 60 days. This system encourages employees to stay with the company while giving them a chance to benefit from its success.

Taxation of ESOPs 

While getting the advantages of ESOPs, you should not forget about the applicable taxes. Here are some of the key points you should keep in mind:

Grant of ESOP

No tax is applicable when ESOPs are granted. This is simply the promise of future ownership, not a taxable event.

Exercise of ESOP

Tax kicks in when you choose to exercise your ESOPs and buy the shares. At this point, the difference between the Fair Market Value (FMV) on the exercise date and the exercise price is treated as a perquisite and taxed as salary income.

Sale of ESOP Shares

When you sell your ESOP shares, the difference between the sale price and the FMV at the time of exercise is capital gains. If you sell the shares within 12 months, you are liable to pay short-term capital gains (STCG) at 20%. 

If sold after 12 months, the profit is long-term capital gains (LTCG) and taxed at 12.5%. Long-term capital gains up to ₹1.25 lakh are tax-free.

Special Provision for Start-ups

Employees of eligible start-ups do not pay tax when they exercise ESOPs. Tax Deducted at Source (TDS) can be deferred until the earliest of five years from allotment or the sale of shares.

Benefits of ESOPs 

These are some of the key advantages of the ESOP scheme for employees:

Wealth Accumulation

ESOPs enable employees to build wealth by sharing in the company’s stock appreciation. This is particularly advantageous for those who believe in the company’s long-term prospects and want to invest in its success.

Financial Reward

As the company’s value increases, the worth of the equity shares held by employees also increases. This can result in substantial financial benefits, especially for early employees in startups or rapidly expanding organisations, motivating them to drive the company’s growth.

Sense of Ownership

Owning company stock through ESOPs cultivates a sense of ownership, leading to greater dedication, job satisfaction, and alignment with company goals.

Tax Benefits

Many regions offer favourable tax treatment for ESOPs, such as deferred taxation or lower tax rates on gains, making them an attractive compensation option for employees.

Step by Step Process to ESOP Implementation

Here is a step-by-step ESOP implementation process in a company:

• Step 1: The process starts by establishing an ESOP trust. This is a separate legal entity that holds the shares of the company on behalf of employees. They appoint a trustee or committee to oversee its management and safeguard employee interests. 
• Step 2: The company contributes shares or cash to the trust, either by issuing new shares, purchasing existing ones, or using loans. 
• Step 3: Depending on the policy of an employer (such as salary, tenure, job role, etc.), the trust maintains shares of every individual in specific accounts within the trust. This is to ensure equal distribution according to individual efforts and contributions.
• Step 4: The company implements a vesting schedule that specifies when employees gain full ownership, either through gradual (graded) vesting or after a specific period (cliff vesting). 
• Step 5: At the end, the shares are distributed to employees upon retirement, resignation, or other qualifying events. The company may facilitate share repurchases or allow employees to sell shares, with distributions made as lump sums, instalments, or direct transfers, depending on company policy.

Final Words

ESOP is a reward for employees for their efforts and dedication to their work. As a significant shareholder, you also become a part of the growing journey of the organisation. However, you need to be fully aware of the company’s policy for ESOP so that you can make the maximum of it.

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