What is ESOP? Meaning, Taxation, Benefits

Employee Stock Option Plan, also known as ESOP, is a method used by companies to give employees a chance to own a part of the company. An ESOP allows employees to buy company shares at a predetermined price after a certain period. This makes employees feel like owners and encourages them to contribute to the growth of the company.

ESOP is not only beneficial for employees but also for companies, especially startups, as it helps attract and retain talented employees without using too much cash. Below, we’ve explained the ESOP meaning, the ESOP process, the ESOP buyback process, the ESOP implementation process, taxation, and benefits.

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What is ESOP?

ESOP, meaning refers to a benefit plan offered by companies to their employees, directors, or officers, giving them the right to buy shares of the company at a fixed price in the future. ESOP can be understood as a way to reward employees for their work and loyalty without immediate cash payment.

The ESOP is also connected with employee ownership. When employees have shares in the company, they are motivated to work harder because they directly benefit from the company’s growth. Companies use ESOP as a tool to retain skilled employees and ensure long-term commitment.

The main idea behind ESOP is to give employees a sense of ownership while keeping company finances stable. ESOP also provides employees with the potential to earn profits when the company’s value increases over time.

Types of ESOP

ESOP can be categorized into different types based on how and when employees receive the shares. Below, we’ve mentioned the main types:

1. Grant ESOP: Grant is the stage where the company informs the employee that they are eligible for ESOP. At this stage, the company also determines the exercise price of the shares. The grant helps employees know their entitlement in advance.

2. Vesting ESOP: Vesting is the period after which employees can earn the right to exercise the options. Usually, the minimum period between the grant and vesting is one year. Vesting ensures that employees stay with the company for a longer time before they can buy the shares.

3. Exercise ESOP: Exercise is when employees actually buy the shares of the company at the predetermined price. Once the shares are exercised, employees become shareholders and may receive dividends and voting rights.

4. Cliff Vesting: Some companies offer ESOP with cliff vesting, where employees must wait for a fixed period before any options vest. This helps ensure long-term retention.

5. Performance-based ESOP: In some cases, an ESOP may be linked to performance. Employees receive options only when they achieve specific targets or milestones set by the company.

6. Early Exercise ESOP: Certain ESOP plans allow employees to exercise their options before they are fully vested. This is less common but may be offered in startups to encourage early investment by employees.

How Does ESOP Work?

Below, we’ve mentioned that the ESOP works in a simple three-step process:

1. Grant: The company gives the option to employees, letting them know the number of shares they can buy and the price.

2. Vesting: Employees wait for a fixed period called the vesting period to become eligible to exercise their options.

3. Exercise: Employees buy the shares at the fixed price and become shareholders.

This system motivates employees to stay with the company and contribute to its growth. ESOP meaning also aligns employees’ interests with the company’s long-term goals.

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ESOP Implementation Process

Implementing an ESOP involves a formal procedure to comply with legal requirements. The ESOP implementation process includes:

Step 1: Drafting the ESOP plan in accordance with the Companies Act, 2013.

Step 2: Send a notice and draft resolution for the board meeting to all directors at least seven days in advance.

Step 3: Passing the board resolution and approving the issuance of ESOP, and calling a general meeting for shareholder approval.

Step 4: Filing the necessary forms (MGT-14) with the Registrar of Companies after the board and the shareholder approval.

Step 5: Sending options to eligible employees and maintaining a ‘Register of Employee Stock Options’ in Form SH-6.

Step 6: Ensure the Articles of Association allow ESOP issuance for the private companies, or alter the AoA from an extraordinary general meeting if it required.

ESOP Buyback Process

The ESOP buyback process is the procedure followed when the company decides to buy back shares from employees. The ESOP buyback process ensures proper legal compliance and record-keeping. Below, we’ve mentioned the steps in the ESOP buyback process:

1. Decide Buyback Details: The company decides the number of shares to buy and the price.

2. Board Approval: The board of directors approves the buyback and ensures it complies with regulations.

3. Shareholder Approval: In some cases, shareholders must approve the buyback.

4. Transfer of Shares: Employees transfer the shares to the company, and records in the ESOP register are updated.

Taxation of ESOP

ESOP is subject to taxation at two points, at the time of exercising the option and at the time of selling the shares.

1. Tax at Exercise: When employees exercise ESOP and buy shares, the difference between the exercise price and market price is treated as salary income. It is taxable under the income tax rules.

2. Tax at Sale: When employees sell the shares, capital gains tax applies. Short-term or long-term capital gains tax depends on the duration the employee holds the shares.

Benefits of ESOP

ESOP offers several advantages for both employees and companies. Below, we’ve mentioned some of the main benefits:

1. Motivates Employees: ESOP makes employees feel like owners, and it encourages them to work harder.

2. Retains Talent: Employees are more likely to stay with the company until their shares vest.

3. Supports Cash Flow: Companies can reward employees without paying extra cash, which is useful for startups.

4. Attracts Talent: Startups can attract skilled employees by offering ESOP as a long-term incentive.

5. Wealth Creation: Employees can earn profits if the company grows and the share value increases.

6. Aligns Interests: ESOP aligns employees’ goals with company performance, improving overall productivity.

ESOP is a simple yet effective way to reward employees, retain talent, and encourage ownership in a company. Understanding ESOP meaning, ESOP process, ESOP buyback process, ESOP implementation process, taxation, and benefits helps both employees and companies make informed decisions. By implementing ESOP carefully, companies can create a motivated workforce, and employees can enjoy the financial advantages of being a shareholder.