What are ESOP shares?
In the 90s, companies like Wipro and Infosys introduced the concept of the Employee Stock Ownership Plan (ESOP), where an employee can own a stake in the company he works under. ESOP created massive returns for the organizations and proved profitable for the employees in the future. Due to ESOP shares, organizations get to attract only talented individuals and retain them in the long term. Companies with a stable management plan and consistently improving financial performance are best suited for ESOPs.
But what is ESOP in the share market? And how does it work?
ESOP, meaning in share market, is quite important to understand as, under this plan, an employee gets to own the stocks of the organization it works for and gain capital by investing in the company’s growth. An employer decides the number of shares it plans to offer and which employees must be eligible for the ESOP.
Eligibility for ESOP Shares:
- IRS (Indian Revenue Service) guidelines state that employers may require employees to be 21 years old to be eligible for ESOPs.
- Directors and promoters with more than 10% stake are not eligible for ESOP.
- An employee who has completed the required time of service to the company is eligible for an ESOP after the vesting period.
Procedure for Issuing an ESOP:
- Granting stage:
At this stage, an employee is informed of his/ her eligibility for ESOP. While the employers determine the price, the employee gets to choose whether to buy the stocks or not. Hence, in the granting stage, stocks are granted to the employees.
- Vesting stage:
In the vesting stage, employees have the right to apply for the shares granted. However, there is a time duration, also called the vesting period, which lasts from one to two years. It is only after completing this period in the company that the employee is eligible to own the stocks.
- Exercise stage:
As the name suggests, it is the period during which an employee has the authority to exercise the choice of buying shares in the company. After the company decides the formal regularities of issuance, an employee benefits from the legal stake in the company in the long term.
ESOP can prove to have significant returns for an employee. A lot of companies have generated tremendous profits through ESOPs. Some notable examples are Google, Myntra, Flipkart, etc.
Important Link:
Types of Employee Stock Ownership Plans:
All transactions that occur in Employee Stock Ownership Plans are of one of the below-mentioned types:
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Non-leveraged ESOP
When the funds are not leveraged but are directly provided by the employee in cash or stock, it is categorized as a non-leveraged ESOP. The main benefit of a non-leveraged ESOP is that it reduces tax payments and helps in structuring retirement plans for future benefits.
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Leveraged ESOP
In a leveraged ESOP, funds are borrowed to purchase company shares. The borrowing takes place through a bank or other private institution. It can be used to acquire shares in private companies from retiring owners, buy them out, or finance new ventures. Companies that do not have the funds to provide for the ESOP buying opt for leveraged ESOP.
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Issuance ESOP
The company uses external financing to purchase new shares in this transaction. ESOPs are advantageous to corporations because they increase capital formation, pay tax advantages on purchases of capital goods, or expand through mergers or acquisitions.
Also, read – What is Delisting of Shares?
Tax implication on buying /selling of ESOP shares:
When investing in an ESOP, an investor must know that tax is levied at two stages of investment. A) At the time of exercise of ESOP B) and when shares are sold.
When shares are allotted on the exercise date, the difference between fair market value on the exercise date and the amount an employee has paid for the exercise is calculated and taxed. This value is termed the prerequisite value. The prerequisite value at the exercise stage is taxed in the year of allotment of the shares.
Later, when the employee sells the shares under ESOP, the tax is levied on the amount of profit he has gained from the transaction. This gain or profit is called the “Capital Gain” and is divided into “Short-term gain” and “ Long-term gain,” depending on the holding period.
If ESOP shares are sold after two years or less, they are taxed as short-term gains/losses, and if sold after two years, they are taxed as long-term gains/losses. At the time of sale, the following income tax rates apply to capital gains:
| Holding period | Tax Rate |
| Short-term capital gain/loss
(Two years or below) |
Tax as per the income slab rates applicable |
| Long-term capital gain/loss
(Above two years) |
20% with Indexation Benefit |
Taxation on IPO/Pre-IPO Shares:
Several exceptions apply to the rule that STT must be paid at the time of purchase, such as if shares were acquired through an IPO, were unlisted, or no STT was applicable at the time of purchase (STT came into effect on 1 October 2004). As a result, STT must be paid on the sale of such shares after they are listed on any recognized stock exchange. For shares held for 12 months, the following tax treatment would apply:
| Long Term Capital Gain(LTCG) | Taxed at 10%
(Above INR 1 Lakh) |
| Short Term Capital Gain(STCG) | Taxed at 15% |
Loss on Sale of Unlisted shares:
- Short Term Capital Loss(STCL) can be carried forward for up to eight years and be adjusted against both STCG and LTCG.
- Long Term Capital Loss(LTCL) can be carried forward for up to eight years and adjusted against LTCG only.
Advantages of ESOP Shares:
- As the employees become the company’s stakeholders, the overall performance improves and, in turn, helps the company recognize and retain talented and competent individuals.
- Often, an employee might get better and more sustainable compensation due to ESOP application. This acts as a way for companies to appreciate the employees and encourage them to build the organization long-term.
- ESOP serves as an ultimate option for planning a healthy retirement. Even after leaving a company abruptly, the employee can continue to be a stakeholder to benefit from the company’s growth.
Disadvantages of ESOP Shares:
- The price of the company shares might decrease, due to which Employees can face serious losses under ESOP.
- In ESOP, there’s no guarantee that the selling price will align with the fair market value. Changing negotiations within an organization have a significant impact on this.
- An ESOP can demand a higher annual payment than your tax and cash flow savings. In such cases, searching for alternative options is the only solution.
Bottom line:
If you want to explore the Employee Stock Ownership Plan(ESOP), you can opt for it after going through certain studies and profiles of strong ESOP candidates. If you are looking for portfolio diversification, then ESOP is one of the most beneficial steps. Regardless, an ESOP requires intense preparation, powerful strategy, and sometimes expert assistance to be a source of profit for an employee.
Frequently Asked Questions(FAQs)
- What is ESOP in the share market?
Employee stock ownership plans (ESOPs) give employees an ownership interest in the organization. There are three types of employee stock ownership plans: direct share ownership, profit-sharing plans, and bonuses.
- What is the benefit of ESOP Shares?
In an ESOP, a company’s employees can acquire shares at low rates and sell them after a long period to gain profit. A few employees have raked in the riches along with the company’s founders with the help of ESOPs.
- Why do companies offer ESOP?
One of the most important forms of compensation for employees is the employee stock option plan. Employees and companies both benefit from ESOPs. This rewards employee loyalty, while a startup’s liquidity is maintained.
- Can I sell my ESOP shares at any time?
Your ESOP shares are converted into shares in your Demat account once the vesting period has been completed. Once the shares have been issued, you can sell them anytime.
- Does ESOP end if I leave the company early on?
When you terminate your employment under an ESOP, you do not lose ownership of the company shares. Owning the shares or selling them is your choice.
- Is it legal to buy ESOP when I am not working for the company?
No. You cannot buy the ESOP after leaving the company. An Employee Stock Ownership Plan(ESOP) is a benefit plan for the company’s employees only. To encourage employee ownership, the company makes it available to its employees.