According to recent reports on the Indian startup ecosystem, startups are said to be mushrooming at an annual growth rate of 10-12%. This demands efficient planning of resources, right from getting the right assets and tools to putting together a powerful team in place.
The fierce competition in the startup fraternity makes onboarding employees and retaining them very important. And this is only possible by rewarding them for their contributions. One such reward that startups give out these days are Employee Stock Options (ESOP).
Usually, startups roll out this scheme for selected employees, based on their position and ability to impact the company. ESOPs enable employees to buy the company’s shares at a discounted price.
Typically, this is a part of the retirement and employee benefit plan giving the ownership of interest to employees. This ownership comes in the form of company shares, which is assured upon fulfilling predefined conditions. But most often, ESOPs become a part of their compensation offering in startups, to motivate employees to give their best at work.
How an Employee Stock Ownership Plan (ESOP) Work?
An ESOP is a plan that allows employees to own shares of their company’s stock. The company contributes stock to the plan, and the plan uses the funds to buy shares of stock on behalf of the employees. This gives employees ownership in the company, which can grow in value over time. When they retire or leave the company, they can sell their shares back to the ESOP, the company, or on the open market. It’s a way for employees to invest in their company and potentially benefit financially from its success.
ESOPs as per the Company Law
ESOPs are offered as an option to employees, officers and directors of the company or its subsidiary or holding companies. This option gives the right to directors, officers and employees of the company to subscribe to the company share at a future date at a predetermined rate.
Note that the companies registered as private limited can benefit from this by following the Companies Act, 2013 and rules made thereon. This means that the employees and executives of a private limited company can become the company’s shareholders through ESOPs. For a company whose equity shares are listed, the ESOPs shall be issued as per SEBI regulations.
Usually, the right to buy the company’s shares at a future date price is lower than the anticipated market rates. The option gets converted into the share on any given date in the future after paying the price for it. Employees in the startup prefer to get the portion equivalent to the share price deducted from their salary itself. The ESOP agreement will have all the terms & conditions for that purpose.
Usually, it is preferred that the company undergo a feasibility study before rolling out the ESOP options. This is to conclude whether or not the ESOP is possible financially. Such an evaluation will involve gauging the financial position that helps establish share prices. And if the feasibility turns out positive, here is what the company should do:
- Draft an ESOP scheme and propose the same in a shareholders’ meeting to get approval
- If approved, employees should be granted the stock options in a ‘Letter of Grant’. This will have all the written information about the options like several granted options, exercise period, vesting exercise period, etc
- After the vesting period is over, the employees can translate this option to shares and thereby becomes the company’s shareholders
Quick tips to follow when opting for ESOP
- Carefully read the ESOP agreement and watch out for clauses like extending ownership after a long employment period and regaining partial ownership when the minimum vesting period is over
- Key employees can leverage their position and push for negotiations on factors like lower exercise price and faster vesting
- It is always recommended to exercise the ESOP by setting the expiry date reminder
- It is better to discuss agreement clauses by consulting your financial planner enabling or selling ESOP shares
Benefits of ESOP
- Employees can be a part of a company’s success by owning the shares directly
- Can avail wealth benefits by selling profitable shares that were acquired at a lower rate
- Motivates the employees to give their best
For the company
- Leverage employee’s morale urging them to perform better in their day-to-day tasks
- Boosts employee retention and thereby lowers turnover rate
- Savings on director remuneration for a private limited company as a part of salary by offering a certain portion of ESOPs
Understanding ESOP Taxation for Employees
All the employees who opt to convert the ESOP to shares will have those shares taxable under the Income Tax Act, 1961. The shares allotted under ESOP brings up the tax liability in two different stages:
- When exercising an ESOP option: Employees are charged with income tax when they exercise their option to convert ESOPs into equity once the vesting period is over. This tax is charged at the perquisite value under ‘Income from salary’.
The company can calculate the perquisite ESOP value offered to the employee and can deduct the tax from that amount. The onus of showing the ESOP value and deducting tax is on the employer. The information on tax deducted from ESOP is mentioned in Form 16.
The computation of taxable value is as follows:
- The fair market value of shares (on the date of exercise of the option)
- Less: Amount recovered from employees for such shares (exercise price)
- When the employee sells the shares: When the employees sell the shares allotted to them under ESOP at a higher price, then it leads to capital gains. Selling such shares at higher prices is calculated either as short-term or long-term capital gains. The tax rate varies depending on the type of capital gain.
The computation of capital gain is as follows:
- The sale price of shares
- Less: Fair Market Value of Shares (on the date of exercise of the option)
Making ESOP a part of offerings to employees is the best way to get the team working better and longer. There is a subtle sense of pride that employees may feel when you make them a part of business success. Also, it is a great way to retain worthy personnel by offering them a higher stake.
Frequently asked questions
What is an ESOP and how does it work?
An ESOP is a plan that allows employees to own shares of their company’s stock. It’s a way for employees to invest in their company and potentially benefit financially from its success. The company contributes stock to the plan, and the plan uses the funds to buy shares of stock on behalf of the employees. This gives them ownership in the company, and their shares can grow in value over time. When they retire or leave the company, they can sell their shares back to the ESOP, the company, or on the open market. It’s a win-win for both the company and its employees.
Is an ESOP good for employees?
Yes, an ESOP can be good for employees as it allows them to have ownership in the company they work for and potentially benefit financially from its success.
How long do ESOPs last?
ESOPs can last indefinitely, as long as the company sponsoring the plan continues to exist and the plan is maintained according to its rules and regulations.
What are the disadvantages of an ESOP?
Disadvantages of an ESOP can include lack of diversification for employees, potential for reduced wages or benefits to fund the plan, and potential for conflict of interest between management and employees.