Did you know that buying shares from the open market or through an Initial Public Offering aren’t the only ways to acquire shares of a company? There’s another, more intimate way as well – via the Employee Stock Option Plan route. Why intimate, you ask? Well, because, as the name suggests, ESOPs are only provided to employees of the company.
What exactly are ESOPs?
Stock options are a type of alternative compensation that some companies offer as part of their salary package for employees. This compensation is often over and above the regular remuneration in the form of salaries, reimbursements, perks or any other form of cost to the employer. Sometimes, particularly in the case of newly launched startups, employees may come on board at a lower-than-normal salary in exchange for the possibility of a big payday later on.
I’ll get to how this payday comes about, but before that, let’s go over the most important terms in connection with ESOPs.
The 7 Most Important Terms
- Stock – Stock or shares are YOUR piece of the pie. It is, in literal sense, your share in the company. The terms are often used interchangeably.
- Options – Options are NOT shares. They simply provide you with an option to buy the shares at an agreed price at a time in the future or sometimes immediately.
- Fair Market Value (aka FMV) – In its simplest sense, fair market value (FMV) is the price that a share would sell for in the open market. It is basically what the share is worth.
- Exercise – The act of materializing your options to convert them into shares is technically known as “exercising your options”.
- Exercise Price (aka Strike Price) – The exercise price is the price at which an option can be purchased from the company. It is a predetermined price.
- Exercise Date – The date from when you can exercise your options in the company. You can not exercise before this date.
- Vesting Period – Vesting means to give someone the legal power over something. Simply put, vesting period for ESOPs is the waiting period after which you will earn the right to buy the shares.
Let’s take a hypothetical scenario…
When Riya joined her current company, she was offered stock options as part of her compensation package. As per the terms, she could exercise these options after a vesting period of 2 years, at an exercise price of ₹100. Two years later, Riya saw that the FMV of the stock is ₹200, so she decided to exercise her options. This means that she bought the allotted number of shares at ₹100 each.
What happens on the taxation front?
Here, the difference of ₹100 is treated as a salary perquisite and Riya would have to pay tax on it. Let’s say, a few months later, the price went up to ₹250, and Riya decided to sell these shares in the open market. The difference between the FMV at the time of exercising the options, and FMV at the time of selling the shares, i.e. ₹50, is treated as capital gains and taxed accordingly.
Taking from this example, let’s go into a bit more detail.
How do ESOPs work?
Through ESOPs, companies allow their employees to be part owners in the company. This is done through offering shares of the company, usually at a discounted price, with certain terms and conditions. The condition is to wait for a certain period of time to be able to buy these shares. Once the employees buy these shares, they can choose to hold it for as long as they want or sell it.
The process of selling shares is different for listed and unlisted companies. If the company is listed, the shares can directly be sold on the stock market. However, if it is not listed, the employees can exit only when the company announces a buy back or brings an IPO i.e. when it gets listed.
Why Do Companies Offer ESOPs?
Usually ESOPs are given out over and above the cash remuneration. Some companies offer shares instead of a bonus. Other companies offer them mainly because they want employees to be a part of the company’s success story, which in turn transforms their attitude towards work. Since there is a vesting period to exercise the option, it encourages employees to be with the company for the long term and not leave soon.
Benefits from an Employee Perspective
Employees of companies that offer ESOPs feel a sense of ownership and loyalty towards the company. Their jobs feel like more than just jobs. They are filled with a heightened sense of purpose because they are rooting for the overall growth of the company.
On a more tangible note, there is a huge benefit in terms of wealth creation. Since the shares are usually offered at a discounted price, ESOP investments often give higher returns in the long run.
All in all, for companies with potential, ESOPs are a win-win for both the employer as well as the employees.
If you’ve received ESOPs and have any questions about it, feel free to reach out to us anytime.
