ESOPs, alongside personalised perks such as employee health insurance and enhanced career advancement prospects, serve as important factors in the attraction and retention of top-tier talent.
In addition to the salary received, startups have recognised the appeal of ESOPs as a compelling incentive for individuals considering employment with a company. ESOPs not only enable employers to enhance the overall compensation package, particularly when immediate high financial rewards may not be feasible, but they also foster a sense of ownership among employees.
What is ESOP?
ESOP an acronym for Employee Stock Ownership Plans, refers to a specific form of employee compensation arrangement. This plan enables employees to acquire ownership stakes in the company gradually, typically over a specified timeframe.
Within the framework of an ESOP contract, employees are granted the opportunity to convert their ESOPs into company stocks at a predetermined rate during the vesting or option period.
It is crucial to understand that ESOPs do not grant immediate stock ownership to employees, but rather offer a structured pathway for attaining such ownership over time.
How do ESOPs Work?
ESOPs or Employee Stock Ownership Plans, operate through a structured process where employers allocate a certain number of company stocks to employees from a trust fund. The employees then have the opportunity to exercise their ESOPs upon completion of a predetermined vesting period.
To become eligible for exercising their ESOPs, employees are required to work for the organisation for the specified vesting period. In the case that the employee departs before the vesting period comes to end, they forfeit the ability to exercise their ESOPs and thereby convert them into company stock.
There are 3 significant factors to consider in any ESOP plan i.e., the quantity of shares that an employee can purchase, the price of buying the shares and the duration after which shares become available for purchase.
Let’s take an example to better understand ESOPs. Suppose a Company offers its employees the following ESOP arrangement:
100 shares at Rs. 100 per share
Vesting period: 5 years
As per this, if an employee remains on its payroll for 5 years, then they have the right to purchase 100 shares at a fixed price of Rs. 100 each notwithstanding the current market value of the company’s stock.
In some cases, small businesses and startups may implement a shorter vesting interval. For instance, 100 shares could vest over 5 years proportionately, resulting in the employee earning 20 ESOPs per year.
Types of ESOPs
The following kinds of ESOPs are usually used in the course of business:
Employee Stock Option Schemes
ESOS are a form of employee ownership plan wherein employees are allowed to purchase company stocks at a predetermined price that is after a specified vesting period. Here, participation is optional and not obligatory for employees.
Employee Stock Purchase Plans
Employee Stock Purchase Plans (ESPP) enable employees to buy company stocks at a price below the market value. The plan’s terms, including price and vesting period, are established in advance. Once employees exercise their ESOPs, they become shareholders of the company.
Restricted Stock Awards
Restricted Stock Awards (RSA) involve employees being granted a specific number of shares subject to certain conditions. If the employee meets the stipulated conditions, they gain ownership of the stock. However, failure to fulfill the conditions results in forfeiture of the awarded stock. Notably, this scheme differs from others as the employee becomes a stock owner at the time of the award.
Restricted Stock Units
Restricted Stock Units (RSU) operate similarly to RSA, with the distinction that employees do not become stock owners until the specified conditions are met and the stock is actually issued to them.
Phantom Equity Plans
Phantom Equity Plans allocate notional shares to employees at a given predetermined rate. Herein, the grant price is recorded in the books of the company but usually not directly paid to the employee. On the vesting date, the company’s employee receives the profit they would have earned from exercising the shares. Thus, the employee does not gain actual possession of the shares but earns a profit based on the hypothetical purchase of shares at a discounted price.
The Advantages of an ESOP
Implementing an ESOP policy offers numerous advantages, including:
Attracting and Retaining Top Talent:
ESOPs are a powerful tool in attracting and retaining top talent, as they provide financial incentives and ownership stakes that motivate employees to actively contribute to the company’s success, fostering a high caliber workforce.
Tax Advantages:
There are significant tax benefits that come with ESOPs for both the company and its employees. The reason being that contributions made to an ESOP are typically tax-deductible for the company, while employees are not required to pay taxes on the stock they receive until they decide to sell it.
Increased Productivity:
Research suggests that companies with ESOPs experience higher levels of employee productivity. This can be attributed to the stronger sense of commitment and ownership employees feel towards the company’s achievements, leading to greater dedication and effort in their work, ultimately driving increased productivity.
Exit Strategy:
ESOPs can serve as an effective exit strategy for business owners. By implementing an ESOP, owners can gradually sell their stake in the company while ensuring its long-term success. This allows for a smooth transition of ownership and provides a viable option for succession planning.
The Challenges of an ESOP
While implementing an ESOP policy offers several advantages, it is important to consider potential drawbacks as well:
Complexity:
Establishing and managing an ESOP can be complex and challenging. Compliance with legal and regulatory requirements requires expertise and the involvement of experienced professionals is often necessary to navigate the intricacies of ESOP administration effectively.
Dilution:
The issuance of additional shares of stock to the ESOP can result in dilution of ownership for existing shareholders, implying that their percentage of ownership in the company may decrease with more share allocation to the ESOP participants.
Funding:
Acquiring the necessary capital to purchase company stock and establish the ESOP may require careful financial planning and consideration of available resources.
Consulting with professionals experienced in ESOP implementation can provide valuable guidance in navigating these complexities and making informed decisions.
Taxability of ESOPs
Allotting ESOPs to potential talent do not have immediate tax implications. However, any expenses incurred on ESOPs can be deducted from the business income as a tax-deductible expense.
When an employee exercises their ESOPs, it is taxable based on the employee’s tax bracket. The value of the stock received is considered taxable income for the employee.
If an employee sells the shares and, on its account, makes a profit, it is classified as capital gains and if the shares are sold within 1 year of exercise, the same is subject to a 15% tax rate, like other stock transactions.
For long-term capital gains (holding period of more than one year), two tax rates apply. Without the benefit of indexation, a 10% tax rate is applicable. With the benefit of indexation, a 20% tax rate is applicable.
Way forward for ESOPs in the Startup Ecosystem
ESOPs have gained popularity in India’s startup landscape, driven by success stories of employees profiting from their holdings. Startups, facing capital constraints, find ESOPs an ideal compensation scheme to attract and retain talented staff. By offering ESOPs, startups align employee interests with company growth.
The potential for attractive profits through ESOPs further enhances their appeal. Employees who hold ESOPs can benefit significantly from share value appreciation. Overall, ESOPs have become a valuable tool for startups, addressing talent needs while providing employees a chance to participate in the company’s success. This has cemented their popularity in India’s startup-driven business trend.
The Final Note
ESOPs offer financial incentives and ownership stakes to attract and retain talent. They provide tax advantages, increase productivity, and serve as an exit strategy for business owners in India’s startup ecosystem.
ESOPs have gained popularity in India’s startup ecosystem, attracting and retaining talent while aligning employee interests with company growth. The potential for attractive profits through share value appreciation further enhances their appeal, making ESOPs a valuable tool in India’s startup-driven business trend.
For more details, connect with our experts at StartupFino.
