As businesses evolve, the ways to ensure employee engagement and motivation get innovated. Employees in the modern workplace receive more than mere pay stubs. One of those benefits is ESOPs. The full form of ESOP is employee stock option plan.
Recently, Paytm (One 97 Communications) granted 1.7 million new employee stock Option plans to its workforce. A few days ago, e-commerce giant Flipkart announced ESOP payouts worth $700 million to its 19,000 employees after the separation of PhonePe and Flipkart.
In recent news, Food delivery platform Swiggy announced the buyback of shares worth $50 million from 2,000+ employees. If you work for the right company, you may be able to build your financial nest through ESOP schemes.
The intrigue of ESOPs lies in an approach fostering a sense of ownership. However, ESOPs may not be uniformly favourable at first glance. There are a few factors that employees should know to capitalise on their ESOPs effectively.
With this exploration, you can delve into ESOP meaning, mechanism and its significance for employees.
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What is an employee stock option plan (ESOP)?
ESOPs grant employees ownership stakes in the company, enabling them to become its partial owners. Generally, the shares of the company are offered against ESOP plans at a low or no additional cost to encourage their employees’ engagement by fostering a sense of ownership.
To ensure employees’ commitment to their long-term success, companies implement a vesting period as per their choice. Following this lock-in period, employees must be with the company for a certain period. After this vesting period, they can fully own their ESOP shares to retain or sell them.
This is an investment in the company’s fortunes. This approach goes beyond typical employment relationships as companies build trust by granting shares to employees.
Explanation of how ESOP works
Companies allocate ESOP shares based on various factors, including an employee’s performance, seniority, or position. Employers decide the number and price of shares to be offered under the ESOPs plan.
The value of ESOPs is closely related to the company’s performance and its prospective growth, as these plans gain value when employees contribute to the company’s overall performance well. This active participation not only impacts the company’s overall health but the effectiveness of ESOPs.
Let us explain with an ESOP example of a company called XYZ Solutions. The company allocates ownership shares to its employees based on service years, pay levels, and performance, subject to a vesting period of five years.
As the company’s performance continues to improve, its share value rises to Rs.150 per share, leading to financial rewards for ESOP-holding employees. After five years, they can choose to cash out these shares.
For instance, an employee with 1,000 ESOPs offered at the exercise price of Rs.100 per share can buy shares at this price irrespective of their future market value.
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Buyback of ESOPs
Companies can repurchase their own shares that were previously allocated to employees via ESOPs. The announcement of the buyback of ESOPs holds significance for employees as companies provide liquidity to their employees by buying back their vested ESOP shares.
Employees seeking to monetise their ESOP shares before a public offering can consider this beneficial. Additionally, buybacks help companies improve their earnings per share by decreasing their outstanding shares.
If the company is not publicly listed, employees can sell their shares when the company goes for its initial public offering (IPO), fundraising rounds, or buyback programs.
Taxability of ESOPs
ESOPs are taxable in the hands of employees as a perquisite under Section 17(2) of the Income Tax Act, 1962. The taxability of ESOP in India is in the hand of an employee (option holder) and involves the following two aspects:
1. While exercising ESOPs
Employees can exercise their ESOPs at a preset exercise or strike price. They are liable to pay taxes on the amount calculated as the difference between the allotted shares’ FMV (Fair Market Value) and their preset price.
Additionally, as per Rule 3(8), Income Tax Act, the calculation of FMV of the shares depends on the company’s listing on a stock exchange.
- If the company is listed, the FMV is the average of opening and closing share prices at the time of exercising.
- If the company is not listed, the FMV is the value determined by a merchant banker on the specified date.
The calculated difference is deducted as TDS (tax deduction at source) on salary.
2. While selling shares
If the option holder decides to sell their shares after exercising them, the resulting profit is subject to Capital Gains tax. Profit is the difference between the current FMV and sale consideration.
- In the case of listed shares, if the holding period is 12 months or less, the profit is short-term capital gain (STCG) taxable at @15% as per Section 111A, Income Tax Act.
If the holding period is over 12 months, the holder is liable to pay tax long-term capital gain (LTCG) @10% without indexation, as per Section 112A of the Income Tax Act.
More on indexation here: How much tax do you pay on stock market gains?
- In the case of an unlisted company, if the holding period is 24 months or less, the profit is considered STCG and taxable as per the standard and applicable income tax slab rates.
If the holding period is more than 24 months, it is considered LTCG taxable @20% with the benefit of indexation.
Risk and considerations associated with ESOPs
- Primary objective: Some companies might also offer ESOP schemes to compensate for situations when they are unable to offer competitive salaries in the industry.
- Company’s growth prospects: If the company fails to perform well, the potential returns on ESOPs may remain unrealised. Therefore, employees must evaluate the prospects of a company before exercising their options.
- Vesting and exercise parameters: Look at the vesting – the time an employee needs to work with the company to get full ownership of the offered ESOPs. Also, consider the exercise price that needs to be paid to acquire the company’s shares.
- Exit possibilities: In the case of unlisted stocks, employees should be aware of the exit possibilities. Look at funding rounds and buyback track records of the company.
The conclusion
ESOP plan is a transformative mechanism, like investing in a brighter future, where companies and employees prosper together. By embracing ESOPs, companies can ignite the passion of their workforce and unlock a new realm of engagement and shared success.
