Do you know why employers generally reserve 13% to 20% of equity for their employees? So that they can offer these shares to proficient employees at discounted rates without any upfront cost. Well, this is simply what ESOP simply refers to.
Employee Stock Ownership Plan (ESOP) is a kind of reward program invented by San Francisco lawyer and economist Louis O. Kelso with a brilliant financial brain to trick top-notch employees to stick to the company for the long run.
As ESOP is a beneficial plan for employees which offers an ownership interest in the company and aids in influencing the employees to leave the organization, every employee today working in a company desire to have ESOP as a part of their remuneration structure.
In this article you are going to read about: What are the features of an ESOP, how it works, what are its advantages and disadvantages for employees and employers, and finally how it is taxed. Let’s get started!
Features of Employee Stock Ownership Plan
ESOP is not only a part of the employee’s salary package, it has some other key features you should know about. These are as follows:
- The main objective of offering ESOP is to motivate employees, which is a reward for outstanding performance, or retaining the very best employees.
- ESOPs are offered to employees at discounted rates and are a part of their CTC structure.
- Employees can exercise their ESOP power as they want, i.e., either in full (all at once) or in part (installments).
- ESOP can be used as a technique of wealth creation by employees, as the employees can hold on to the stocks and sell them at a higher market price.
How Does an Employee Stock Ownership Plan work?
The owner or employer of the company decides the number of shares to be offered under Employee Stock Ownership Plan (ESOP) scheme, their price, and the qualified employees. After deciding all these, the stocks of the company are allotted to the employees and a grant date is provided.
The employees do not have the right to exercise their ESOPs before the expiry of the vesting period and it is also required that they should stay with the organization for the vesting period to avail of the ownership rights of the stocks under ESOPs. The employees get the specified quantity of company shares at a defined price (i.e., discounted rate without any upfront cost) after the vesting period.
The vesting period is the duration of time that you must be an active employee with your current employer to gain the benefits of the ESOP Scheme.
Advantages and Disadvantages of ESOP for Employees
ESOPs provide advantages but also have some disadvantages for both the employer as well as the employees. Let’s explore them!
Advantages of ESOP
Below mentioned are a few advantages of ESOPs for employees:
- Sense of ownership: ESOPs offer ownership rights to the employees of the organization, which motivates employees to perform better to increase the overall profits of the company.
- Motivates employees: ESOPs are a form of non-cash rewards for the employees which helps in boosting their morale to perform better and is one of the factors to keep them motivated.
- Gets shares at discounted rates: Employees are offered ESOPs at discounted rates which is ultimately a better and preferential gain for them as compared to the other shareholders.
- Extra Income: ESOPs can be an extra source of income for employees.
- Investment benefit and wealth creation: ESOPs provides investment benefits and wealth creation opportunity for employees.
Disadvantages of ESOP
A few disadvantages, must be considered before deciding on ESOPs:
- No guaranteed return: There is no guaranteed return in the ESOPs as their values are inconsistent and fluctuate with the company’s success/failure.
- Timings play a crucial role: If an employee wants to gain the most profit from its ESOP, they must exit timely based on the company’s performance.
- Value of the shares is not consistent: As the shares are traded in an open market, the share values are not consistent and fluctuate with market demand and supply.
Advantages and Disadvantages of ESOP for Employers
Advantages of ESOP
ESOPs are advantageous for employers too in the following ways:
- Provides liquidity: ESOPs help organizations prevent immediate cash outflows and they can avoid cash compensations as a reward, thus the funds remain with the company leading to an increase in liquidity.
- The employer can control the transition process: The employer only controls the transition process for the ESOPs, which eradicates the dilution of the controlling authority.
- Confidentiality: The ESOPs are offered to employees who are part of the organization and also, and they do not share the employee’s information. In this way, the data of the company remains utmost confidential and secure.
- Employee retention: When a company offers ESOPs, the employee turnover ratio decreases, which leads to better employee retention.
- Better productivity: ESOPs can boost the employee’s productivity as they become the shareholders of the company that gains the profit earned by the company.
Disadvantages of ESOP for Employers
Here are some disadvantages of ESOP for Employers:
- Separate management required: Separate management is required for the handling of the ESOPs, which is an increase in the expenses of the company.
- Fluctuation in market prices: The value of the shares changes with the fluctuation in market prices and employees might blame management for tricking them by giving given rewards in the form of ESOPs.
Conclusion
Let us inform you that ESOPs are a win-win situation for both parties involved. You can avail of tax incentives on ESOPs. Also, there are several other benefits of ESOPs for the employer as well as the employee which have been discussed above in the article along with the drawbacks that it possesses.
There’s a lucrative wealth creation side of the Employee Stock Ownership Plan (ESOP) but do keep in mind the market risk associated with it. Let us know if you found this article helpful and feel free to suggest any other ideas to minimize the risk factor.
FAQs
1. Who is eligible to participate in ESOPs (Employee Stock Ownership Plans)?
Eligibility criteria for participating in ESOPs may vary from company to company. But generally, after completing a certain period with the company or when one becomes a permanent employee of the company is then eligible to participate in ESOPs.
Usually, these are designed to cover full-time employees, executives, or senior managers who agree on the vesting period suggested by the company. Also, ESOPs are offered to employees who have magnificently performed by meeting certain goals or targets and received positive feedback from customers. It is a form of reward or compensation offered by companies to their employees.
2. What are the risks associated with ESOPs for employees?
There are several risks involved with Employee Stock Ownership Plans (ESOPs) that employees should be aware of like, stock price risk, diversification risk, leverage risk, and company performance risk. As values of the stocks held by the employees are controlled by the market forces of demand and supply, which is an uncertain risk.
ESOPs do not allow diversification, it concentrates wealth in one particular company and if that company’s performance declines it will result in significant loss to the employee. If the significant amount of your retirement portfolio is, this will limit the ability to diversify.
3. How are ESOPs regulated?
The Employee Stock Ownership Plans or ESOPs are regulated by the Internal Revenue Service (IRS), The Employee Retirement Income Security Act (ERISA), The Securities and Exchange Commission (SEC), The Department of Labour (DOL), the Companies Act 2013 and SEBI (SBEB and Sweat Equity Regulations) Guidelines, 2021 as well as state laws. Companies that offer ESOPs need to comply with a range of legal requirements.
Overall, it is subjected to a complex set of regulations and requirements. Employees who participate in ESOPs should also consult with financial and tax professionals to understand the tax implications and risks associated with their investment.
