Employee stock ownership plan: A guide to ESOPS

Sep 07, 2022

While working in a corporate company employees are entitled to numerous benefits apart from their salaries.

Personalized perks like career development opportunities, health insurance schemes, and mental health counseling are some of the most significant ones and along with these, another important employee benefit is ESOPs (Employee Stock Ownership Plans).

All these are important elements of building an attractive talent recruiting plan. Basically, an Employee Stock Option Plan gives employees an opportunity to purchase and own a part of the company and take advantage of the business’s growth over time

ESOPs are an effective and attractive technique used by startups to allure and engage excellently skilled employees.

What is Employee stock ownership plan (ESOP)?

An Employee Stock Ownership Plan or more specifically an ESOP structure lays down certain rules and policies according to which employees are allowed to purchase shares of their business in the future at a suitable price.

This can be as a simple contract between the employee and company stating that the employee can buy some shares of the company on a particular future date at a fixed amount.

Although to maintain fairness among all the shareholders, to ensure that the options are allocated without any bias, and to make the best profit out of all of them, an ESOP is made up of the most superior options that a company can offer. 

A company’s ESOP holds great potential to affect the long-term structure of ownership of the business — however when an ESOP is signed no monetary exchange is made at the time.

The ESOP rules contain everything from the timeline to even the minute circumstances which could have a possible impact on the purchase in the coming time.

How do Employee stock ownership plans (ESOPs) work?

While ESOP planning, using their trust funds, employees are allotted certain company stocks and the employer is the decision-maker for which stocks will be open for purchase by employees.

Once the employee successfully concludes their vesting period (the duration of which is decided before the contract is drawn), they can use their ESOPs for stock ownership in the company. 

To be eligible to exercise an ESOP, employees are required to work for a specific predefined period of vesting time.

But, if an employee quits or leaves the company before the completion of the vesting period, there will no more be an ESOP to exercise, they would lose any right to purchase the company stock and those shares ultimately turn back into the company stock. 

While ESOP planning, there are three crucial things to carefully consider: 

Number of shares that can be fairly allocated for employee purchase

Price/cost at which the employees will be given the company stocks

The time period after the completion of which the company employee shares can be purchased (vesting period)

Example to understand Employee stock ownership plans (ESOPs)

Example 1:

A company offers the below-mentioned ESOP rules: 

100 shares at Rs 100 each

5-year vesting period 

Hence, if an employee still works in the company after these 5 years, they are eligible to purchase 100 shares at Rs 100 each. No matter what the company stock is valued at in the market, the employee would get it at the above-stated price. 

*Some startups and ESOP companies offer a shorter vesting period, this means, for example, 100 shares that can be earned over 5 years correlatively. According to this, the employee would be able to get 20 ESOPs per year.

Example 2:

An employee is offered 10,000 options (a legal contract granted to the buyer presenting the right to buy a certain amount of shares, but not an obligation). The present time price of each share is Rs 1. After some time, the company grows and its share value increases to Rs 2. 

However, when the employee avails of the ESOPs, they will have to pay Rs 1 per share. So, for 10,000 shares the employee would have to pay Rs 100. Hence, the employee made a profit of Rs 9,900 along with the salary.

Features of Employee stock ownership plan (ESOPs)

ESOPs are generally included in an employee’s CTC structure. This means these are basically given to the employees for free.

There are two dates related to ESOP structure, Vesting Date and Grant Date. The date when an employee is set to exercise their ESOP and buy the company stock is called the vesting date. On the other side, the grant date is when an ESOP agreement is actually formally signed between the employee and the company.

Employees are given the option to exercise their options either completely or partially.

It is in the hands of the company to decide which employees will be given ESOPs or will all the employees be granted ESOPs, all depending upon their hiring plan/strategy.

Some companies also allow ESOPs to be exercised in installments or specific period intervals or phases.

Grant price or Exercise price is the rate at which the company employees are offered to purchase the company shares using ESOPs.

Employees which have ESOPs are legally bound to exercise them after the vesting period.

Types of Employee stock ownership plans (ESOPs)

1. Employees Stock Option Schemes (ESOS)

The most customary ownership plan offered by the majority of the companies is an ESOS. Employee Stock Option Schemes offer the employees to purchase company stocks once the vesting period is completed but at a given price.

Under this plan, the employees are not obligated to invest in or purchase the shares of the company.

2. Employee Stock Purchase Plans (ESPP)

Under an ESPP, employees are given the opportunity to buy the shares of the company at a value lesser than the market price. This term and conditions of this plan include a predetermined price and vesting period.

An employee becomes company shareholder once they exercise their ESOPs.

3. Restricted Stock Award (RSA)

A Restricted Stock Award is a scheme where employees are required to fulfill a set of conditions and requirements after the completion of which they can enjoy being the shareholder of the company by being awarded a certain amount of the company stock.

This number is of course predefined. The award stock obligation can be renounced if the conditions are not fulfilled by the employees. This plan is unique because the employee becomes a shareholder as and when the stock is awarded.

4. Restricted Stock Unit (RSU)

RSU is a similar scheme to RSA. This scheme is different as the employee does not officially become a shareholder in the company until and unless the conditions mentioned and agreed upon in the ESOPs contract are not fulfilled.

It is only after the requirements are met that the employee actually gets the stocks.

5. Phantom Equity Plan

Under a Phantom Equity Plan, at a predefined rate employees are given notional company shares. The books of the company record the grant or exercise price, however, the employee is not actually paid that amount.

On the decided vesting date, the profits that the employee earns are paid after they exercise their ESOPs. This basically means that the employee doesn’t exactly get to be the possessor of the company stock but earns the profit amount of the notional buying.

Benefits of Employee stock ownership plans (ESOPs)

1. Enhanced productivity

ESOP is seen as a major employee benefit in industries with strong employee loyalty but their retirement fund participation is very poor.

The reason is pretty simple — by exercising ESOPs employees get the chance to benefit directly from the development of the company and also have some share in the ownership of the company

Companies with an Employee Stock Ownership Plan witness enhanced productivity and an immense upliftment in the overall performance of all employees

This basically gives employees a financial share in the organization, which automatically boosts their trust and morale to work towards the growth of the company.

2. Safety of ownership for aging owners

The tradition of inheriting businesses or passing the business to the next generation is a declining one. Along with this, mergers and acquisitions have both become less common, especially after COVID-19.

This means that aging business owners aren’t left with many trustable options to retire and give their business to someone who would take it forward. Here is where ESOPs entail a huge benefit

Instead of selling their company to a third party, business owners can just accurately distribute their company shares among the people who have honestly worked for the company, i.e., its employees.

To avoid conflict of interest, the identities of the employees can be kept confidential, which means they won’t be shared with prospective buyers of the company.

Owners of the company also possess the option to give away only a few shares at a time, instead of just giving them all up at once.

3. Tax benefits

ESOP structures bring along various ESOP taxation benefits. ESOPs contributions to C-corporations are tax-deductible and the ESOP part in S-corporations is tax-exempted. Basically, employees are not supposed to pay any tax on their contributions.

Similar to this, in a standard retirement account, employees are obligated to only pay tax on the ESOP when they ultimately retire and withdraw that money. Along with this, as stock contributions are used as ESOP loan repayment, those are also tax-deductible.

4. Hiring the best talent and employee retention

In a situation when an employee works for less than two years in a company, their shares can be forfeited.

However, employees who work for four or more years depending on the decided vesting period by the company get a chance to earn up to 40 percent of their share value when they leave the company.

ESOPs basically motivate the employees to stay longer in the company and get the maximum payout possible. The opportunity of being a shareholder in a company is an attractive offer for all the best-talented people looking for job opportunities.

How to structure Employee stock ownership plan?

1. ESOP Agreement and committee

ESOP planning includes meticulously creating an ESOP Agreement structure where a separate Employee Stock Ownership Pool is made.

An ESOP Pool means that a certain percentage of the company shares are kept aside for the employees only. So, employees basically become financial shareholders of the company by getting a share from this pool.

Along with this, an ESOP Agreement also clearly lays down the names of all the people who will be the ESOP committee members. This committee consists of all the senior executive members of the company.

They are responsible for everything related to the ESOP Pool and also suggest some encouraging business moves that the Board of Directors of the company should contemplate and implement.

2. Cliff and vest period

Every ESOP consists of a Vest or Cliff period. A Vesting schedule shows how much would the employee get over the year and will also state that all the shares won't be granted at once.

However, a vesting “Cliff” means that there is a ‘no vesting’ period but still the employee would acquire the benefit once the Cliff time is complete. A Vest period is the time frame before the ESOP is actually exercised.

This is the period where the employee has to work for the company in order to exercise their ESOP. Employees who resign before the Vesting period is over but the Cliff period is completed are facilitated with pro-rated stocks according to their duration of work in the company.

3. Selling curtailment

Every company mentions in their ESOP rules, some selling restrictions or defines a specific time frame within which the employee cannot sell the shares from their portion.

How does an employer benefit from ESOPs?

1. Recruiting top talent

Whenever reserves are certainly low during the organization's underlying years, ESOPs plan to overcome any issues in remunerating the employees.

Assuming the employees have confidence in the capability of the organization's development, they acknowledge ESOPs as a feature of their pay bundle to secure the organization's stocks at decreased rates.

This aids in securing great ability at a decreased beginning expense.

2. Increment employee proprietorship

Whenever employees have a stake in the organization's proprietorship, they are self-persuaded to invest their best amounts of energy for the most extreme efficiency

All things considered, the more the benefit, the more the organization's stock is worth and the higher the benefits that the employees can procure.

3. Employees maintenance

ESOPs help in employee maintenance. Since employees are permitted to trade out their investment opportunities solely after the vesting time frame, they will quite often remain with the organization to encash their stocks.

This increases maintenance and chops down steady loss rates, particularly in tech, where weakening can be alarmingly high.

How do employees profit from ESOPs?

1. Higher benefits at diminished rates

They assist employees with procuring great stocks at a decreased rate. Employees can, then, at that point, clutch these stocks for long-haul returns or auction them at a higher market worth to acquire benefits on their stockholding.

2. Extra income source

By becoming investors, employees get voting rights in the organization's administration. They likewise get to acquire a profit on their stockholding which fills in as extra pay.

3. Work Stability

Because of the vesting time frame, employees additionally land position dependability which, thus, drives up employee fulfillment.

4. Taxability of ESOPs

There are no expense ramifications in assigning ESOPs to forthcoming ability. Notwithstanding, assuming that you bring about costs on ESOPs, such costs would be permitted as an assessment deductible cost from your business pay.

At the point when the representative activities ESOPs, they are available according to the employee's expense section.

Assuming there's a benefit after the employees sell the offers, it is considered as capital additions. Assuming that the offers are sold somewhere around a year, a 15% capital increase charge should be paid, very much like with some other buy or offer of stock.

What is it that businesses need to be aware of before settling on ESOPs?

However ESOPs can assist bosses in withdrawing in great ability, particularly in a desperate economy, there's a ton to consider before offering it to the employees.

Right off the bat, there are explicit legitimate standards and guidelines overseeing the working of ESOPs. Organizations need to conform to every one of the standards to run ESOPs legitimately.

Besides, re-evaluating ESOP administration and checking it inside brings about extra expenses. Managers, in this way, need to remember the expense structure while presenting the idea of ESOPs in their association.

6 Reasons to think about ESOPs for your business

1. If you are planning to sell portions of your business

One benefit of an ESOP is the adaptability an ESOP structure gives. In contrast to a sale to a private equity firm or an essential purchaser, a sale to an ESOP doesn't need to be an "all or nothing" recommendation.

An ESOP can be utilized for a fractional exit - a choice that might be extremely valuable in an assortment of circumstances including:

Giving minority investors a vehicle through which they can sell their portions.

Separating from couples who are joint entrepreneurs.

The need to make liquidity to repay proprietors who are prepared to leave the business, while not sabotaging the groundworks of the organization or constraining a sale by the people who wish to stay included.

Permitting proprietors to some extent to adapt their possession for broadening purposes.

2. Safeguard your legacy

Certain individuals close the entryway on a business and that is the finish of it for them. Get the most ideal cost, and head out toward the distant horizon, anticipating partaking in all the

things they didn't time for while building their business.

For the people who see that change unexpectedly, an ESOP can be a more alluring arrangement. An ESOP empowers your representatives to turn out to be essential for your inheritance.

It permits you to keep your name on the entryway and keep on taking an interest in and guide the running of your organization.

For instance, assuming you are a significant manager in your local area and give financial essentialness, occupations, and opportunities to the area, there could be no "pariah" who could choose to move the activity to another city. 

Or, on the other hand, assuming you were a trendsetter in further developing the work conditions in your office or plant, an ESOP might bear the cost of you the potential chance to keep up with and perhaps extend those advancements.

Assuming you're hoping to make more space in your life for non-work exercises, yet at the same time need to capitalize on your energy and mastery concerning your business, an ESOP can be organized to permit you to do precisely that.

3. Enlist and retain the best workers

Enlisting and holding individuals is one of the greatest secret expenses for any organization, particularly in exceptionally serious business sectors.

Having the option to offer possible employees a piece of the business can be a strong selecting device, making up for a badly designed drive or area, or contrasts in health advantages.

Besides, ESOPs are less difficult to set up than different choices, like laborer cooperatives however can give comparative advantages as far as giving monetary strengthening to employees.

As indicated by analysts at Rutgers University, ESOPs can help minimize laborers' fabrication resources notwithstanding their salary.

This, thus, makes it simpler for them to draw from different wellsprings of financing when they need to pay forever's costs.

The plans have certifiable advantages for low-abundance and low-pay families when a family part can take an interest: that's what the investigation discovered ESOPs in these cases can represent over 25% of a family's lengthy-term investment funds.

ESOPs likewise emphatically affect retirement investment fund plans also — especially for minorities.

Genuinely talking, these groups make more modest commitments to retirement plans, for example, government retirement plans because of lower compensation than their white, male partners.

ESOPs, dissimilar to those, are not attached to income, which can make it simpler for a more extensive area of employees to collect offers.

An ESOP could be organized to incorporate contractors, giving the business a genuine advantage in viewing for ability.

Having a genuine stake in the business is an advantage that isn't accessible in all organizations, and surely is only occasionally accessible to contract workers.

Similarly, progressing to an ESOP can assist you with holding important employees, giving a monetary advantage to the proprietor past the expanded liquidity furthermore, charge benefits.

4. To maintain a sense of control

Another way an ESOP can end up being a more adaptable option in contrast to an outsider sale is that it permits the proprietor to keep overseeing and directing the organization

The liquidity given by the deal to workers permits you to enhance your possessions while proceeding to partake in the administration of the business.

You can remain effectively associated with your organization's future inside the limits of good corporate administration and Employee Retirement Income Security Act (ERISA) guardian rules.

5. Safeguard business information from competitors

One of the top worries of entrepreneurs while selling their businesses is privacy. The dread that private data gets spilled, or even that there is a deal cycle for the business, is a real concern.

Having monetary data, client records, exclusive cycles, or methodology plans spilled can hurt a business. And keeping in mind that privacy arrangements attempt to put a fence around this issue when the pony has left the stable, the harm is finished.

By offering an ESOP, the gamble that touchy data gets out is significantly diminished.

No worries about sharing monetary data; no stresses over having your best clients appropriated; no issues with your merchants becoming apprehensive about who they'll manage assuming the organization sells.

Offering an ESOP lessens the nervousness of these issues.

6. Enduring potential economic downturns

ESOP-possessed organizations have shown astounding strength in any event, when the economy all in all is dealing with issues.

A recent report led by Phil Swagel and Robert Carroll of the McDonough School of Business at Georgetown University followed the execution of ESOP-possessed organizations and showed that in any event, during the main year of the 2008 downturn, they were adding employees and seeing twofold digit development.

As per research by the Rutgers Institute for the Study of Employee Ownership also, Profit Sharing supported by the Employee Ownership Foundation, representatives at ESOP-possessed organizations experienced cutbacks multiple times less frequently than those without employee possession, with turnover rates however much multiple times lower than in customary organizations.

They likewise have greater retirement reserve funds, seriously preparing and contributing to the business and more benefit-sharing.

Way forward for ESOPs in the startup environment

There have been numerous examples of overcoming adversity by employees creating appealing gains through their ESOPs. ESOPs have, in this manner, become very well known lately when new companies are driving business patterns in India.

New companies are especially frustrated with adequate capital in their foundation stage. Accordingly, ESOPs have shown to be the ideal pay plot for recruiting and holding capable employees.

For entrepreneurs who are keen on continuing, yet have felt obstructed by any of the above contemplations, an ESOP gives an adaptable option in contrast to a deal to a monetary or key purchaser.

Similarly, as with any undertaking of this sort, such progress requires a lot of arrangement and a group of experts with skill in the making of ESOPs. It's a trifecta — monetary liquidity, charge benefits, and getting off your vision for your organization.