Employee stock ownership plans (ESOPs) and stock option plans are two types of employee benefit programmes that are commonly utilised by business owners to encourage their employees to engage in any of these employee stock plans.
Employee Stock Ownership Plans enable employees to purchase company stock, encouraging a sense of ownership and alignment with the success of the organisation. Stock option programmes, on the other hand, give employees the right to purchase company stock at a predetermined price. Both programmes aim to increase employee enthusiasm and participation in the company’s success.
ESOPs in Indian Companies
Employee Stock Ownership Plans or ESOPs are a popular qualified employee benefit plan in India, offering certain tax benefits when specific criteria are met. Indian businesses establish ESOPs to encourage a sense of ownership and motivation among their workforce. ESOPs work in Indian companies in the following way:
- Establishing the ESOP Trust: To initiate an ESOP, a company sets up a trust fund designated for its employees. The corporation then contributes cash to the trust, which is used to purchase company shares. In alternative, the trust also reserves the option of borrowing funds for acquiring shares.
- Share Distribution and Vesting: Once the trust holds the company shares, they are allocated as per policy to mostly the full-time employees, with some exceptions only. These shares are subject to a vesting period, which means that these employees have to stay with the company for a certain duration before gaining full ownership of the shares.
- Options After the Departure of Employee: When employees decide to leave the company, they can choose to exercise their vested shares. Depending on the company’s policies, departing employees may have the choice to sell their shares back to the corporation or on the open market if the company’s stocks is publicly traded.
- Valuation through Annual Appraisal: For some enterprises, an external appraisal is conducted annually to determine the share price. This valuation ensures a fair assessment of the company’s shares for the ESOP and its participants.
- Voting Control: In such a case, the company may choose to retain control over the voting rights of the ESOP trust on various matters.
To illustrate with the help of an example:
Consider an Indian manufacturing company, XYZ Industries, implementing an ESOP for its employees. The company establishes an ESOP trust and contributes INR 2,00,000 to the trust fund. The trust uses this fund to acquire company shares on behalf of the employees. Rajesh, a full-time employee, receives a share allocation of 100 shares through the ESOP, subject to a four-year vesting period.
After completing four years with XYZ Industries, Rajesh’s shares became fully vested. Now, Rajesh decides to exercise his right based on the current market price of shares being INR 1,500 per share. This makes Rajesh’s shares to be valued at INR 1,50,000 (100 shares * INR 1,500). It is now dependent on him if he wishes to sell them back to the company or go to the open market in case the company is publicly traded.
Understanding Stock Options in the Context of Indian Companies
An Employee Stock Option Plan allows employees to purchase company shares at a predetermined price within a specified timeframe after the option is granted based on a vesting schedule.
For instance, let’s consider a scenario in a company in 2015. An employee is granted the option to buy 100 shares at the current market value of Rs. 50 per share. The vesting period spans four years, with 25% of the options vesting each year. After the first year, the employee can exercise options on 25 shares.
There are two primary types of stock options:
- Incentive Stock Options or ISOs
- Nonqualified Stock Options or NSOs
ISOs offer tax advantages as they allow employees to defer tax payment on the spread (which is the difference between the grant and exercise price) until the stock is sold, subject to specific criteria. In the case of ISOs, taxes on capital gains would be applicable upon selling the shares.
On the other hand, with NSOs, the company cannot claim a tax deduction for the spread and the employee pays taxes on the spread as if it were wages. Simultaneously, the business can deduct the same amount as an expense.
Differences Between ESOPs and Stock Options
In considering equity incentive plans for Indian companies, there are distinct differences between ESOPs and stock options. These differences impact aspects such as tax benefits, funding for expansion, employee motivation, select employee retention and implementation costs. Mentioned below are the key differences:
| Factors | ESOPs | Stock Options |
|---|---|---|
| Tax Benefits and Ownership Control | In ESOPs, corporations can make tax-deductible contributions. | Limited tax benefits for business owners. |
| Funding for Expansion | Potential to secure loans to purchase newly issued stock for funding expansion, business acquisition or technology investment. | Exercising options provides cash injection if employees buy new shares, but may lead to dilution for existing shareholders. Corporations often buy back shares to maintain ownership levels. |
| Employee Motivation | Linked to improved corporate performance. Companies contribute significant amounts to the ESOP (at least 5% of annual salary). | Motivational impact may vary but is usually not as strong as ESOPs. |
| Select Employee Retention | Ownership allocation based on predetermined criteria like relative compensation. Limited discretion for individual merit-based allocation. | Offers flexibility in granting ownership based on individual merit. Attracts and retains high-performing employees through versatile ownership options. |
| Implementation Costs | Higher setup and operation costs (Rs. 25,000 to Rs. 50,000) with additional annual expenses (at least Rs. 15,000). Requires external consultants due to complexity. | Simpler and cost-effective installation.May not require outside consultants for processing and implementation. |
Comparing Stock Options and ESOPs for Indian Companies
When it comes to equity incentives in Indian companies, both Stock Options and ESOPs share certain similarities and the common features of these two equity incentive plans are:
- Ownership in the Company: Both Stock Options and ESOPs offer employees the opportunity to become partial owners of the company. Becoming a part of any of these gains a person a vested interest in the company’s future growth.
- Long-Term Benefits: Mostly, it’s best to consider the long-term perspective of both Stock Options as well as ESOPs. Allowing these incentives to mature over time tends to yield better outcomes. While you have the option to sell the stocks acquired through exercising options, short-term trading may carry higher risks. Holding onto your equity stake and letting it grow can be a more prudent approach. For ESOPs, using it before the vesting period is completed might not be permitted or might result in loss, making long-term appreciation a primary benefit.
- Treating Incentive Plans as Bonuses: It’s essential to view both Stock Options and ESOPs as supplementary rewards rather than the sole determinant for accepting a job offer. Circumstances may change during your tenure with the company, such as leaving before the vesting period concludes or unforeseen fluctuations in the company’s stock value.
While these equity incentives hold significant potential value, there are inherent uncertainties in them. Therefore, when considering these options, it is wise to evaluate various factors beyond just the equity incentives offered like the company’s financial health, growth prospects, work culture and overall compensation package.
How to Choose Between Stock Options and ESOPs?
Some employers may provide either stock options or a stock ownership plan. Factors to be kept in mind while making the choice between them are:
Profit Realisation:
Stock Options:
- Offer the opportunity for relatively quick profits.
- Can sell stocks when desired (if the company is public), no need to wait for retirement or resignation.
- Pay taxes on gains as they occur and stocks are bought at a discount, resulting in immediate profit.
Employee Stock Ownership Plan (ESOP):
- Involves receiving company stock as a bonus.
- Distributions are accessible only upon leaving or retiring.
- Taxes are deferred until the time of distribution.
Targeted Employee Groups:
- Employee ownership plans are commonly offered to executives.
- Rank-and-file workers are more likely to receive stock options.
Final Thoughts
When comparing equity incentives in Indian companies, such as Stock Options and Employee Stock Ownership Plans i.e., ESOPs, it is very important to consider various factors to make the right choice for employees. Both options provide ownership in the company and encourage long-term commitment and alignment with the company’s success. Stock options offer the advantage of relatively quick profit realisation, whereas ESOPs provide a bonus of company stock without the need for direct purchase. The timing of profit realisation, funding requirements and tax implications differ between the two.
Furthermore, considering the eligibility and availability of these incentives, as well as the motivation they offer to employees, plays an important role in making an informed decision. However, it is essential to treat these equity incentives as supplementary bonuses rather than the sole basis for accepting a job offer. Evaluating the overall compensation package, company’s financial health, growth prospects and work culture are equally important considerations.
For more information on the difference and choosing between ESOPs and stock options, connect with our experts at StartupFino.
