Understanding Employee Stock Option Plans (ESOP's)

Tuesday February 19, 2013 , 5 min Read

ESOP’s are Employee Stock Option Plans under which employees receive the right to purchase a certain number of shares in the company at a predetermined price, as a reward for their performance and also as motivation for employees to keep increasing their performance. Employees typically have to wait for a certain duration known as vesting period before they can exercise the right to purchase the shares.

The main aim of giving such a plan to its employees is to give shares of the company to its employees at a discounted price to the market price at the time of exercise. Many companies (especially in the startup phase) have now started giving Employee Stock Options as this is beneficial to both the employer as well as the employee.

Benefits of ESOP’s

The major benefits of awarding Employee Stock Options are mentioned below:

Lock-in Period:

ESOP’s come with a lock-in period known as vesting period and employees can exercise the options only after this period. If the employee leaves the organisation before completing the specified period – these ESOP’s get lapsed and the employee will not get any benefit.

A ‘Sense of Ownerhip’ for the employees:

When the employees are given shares of the same company in which they are working, it gives them a sense of feeling that now they are not employees of this organisation but are the owners. As they are now they owners, they also have a share in the profits of the company. In fact, since employees directly benefit from the increase in the share price, they focus on overall value creation for the company.

Kind instead of Cash

ESOP’s are a way of awarding the employees in kind instead of cash. In the initial days of ESOP’s in India, small organisations who were cash strapped used to give ESOP’s to their employees to increase the overall pay package. In this manner, they were able to compensate the employees in kind without affecting their cash reserves (if a organisation issues ESOP’s- its cash reserves are not affected).

Case Study

Many companies like Infosys in their early days used to award employees and even clerical staff with ESOP’s. This way, there were able to manage their direct costs. Moreover, giving ESOP’s to employees was also a way of motivating the employees to work harder by creating the sense of ownership and directly rewarding employees for increase in the company’s valuation.

Infosys grew very fast; many employees who got ESOP’s of Infosys in the early days and preferred to keep these shares have today turned millionaires. Infosys used to even award Drivers, Office Assistants and Secretaries with ESOP’s and many of them have also turned millionaires.

Many small companies which are growing fast but are in need of cash have started replicating the ESOP’s model which was implemented by Infosys. This model not only helps the organisations preserve cash but also keeps the employees motivated. In fact, Narayan Murthy went on record saying that “Every Indian employee at every level who joined the company on or before March 2010 is a stakeholder of Infosys”.

Word of Caution: Infosys earlier used to award ESOP’s to almost all its employees but has now started awarding ESOP’s judicially as awarding too many ESOP’s may dilute the promoters’ & investors’ stake.

Taxation of ESOP’s in India

There have been various changes in the taxation of ESOP’s in the past 20 years. The Government finally seems to have found a logical way of taxing ESOP’s. The manner of computation of Tax of ESOP’s in the hands of the employee has been explained hereunder:-

At the time of giving ESOP’s:The benefits arising on ESOP’s are taxed as Perquisites in the hands of the employee and form a part of the employee’s salary income. The employer is also required to deduct TDS in respect of such perquisite. The perquisite value is computed as the difference between the fair market value of the share and the Exercise price.

At the time of sale of such ESOP’s by the employee: The gains arising on the sale of ESOP’s are considered to be Capital Gains; Capital Gains Tax is levied on the such gains and tax is liable to be paid in the year in which such ESOP’s are sold. The Capital Gain is computed as the difference between the sale price and the price at which it was awarded by the Employer.

The Capital Gains treatment further depends on the holding period of the ESOP’s i.e. if the shares are held for less than 12 months – Short Term Capital Gains Tax@ 15% is levied and if the shares are held for more than 12 months- Long Term Capital Gains Tax is levied (this is currently NIL). Thus, if such ESOP’s are held by the employee for more than 12 months, the gains arising on the sale of such ESOP’s is effectively exempt from Tax.