What is inflation?
The economy is opening up to newer shifts in professional practices, which works best in favor of employees of an organization, especially those who have a higher net worth. The growth of a firm is a collaborative effort of the entire workforce, starting from subordinates at the bottom of the hierarchy funnel to the high-ranking individuals who have a more profound interest in the larger picture and the firm’s scope to grow in the market.
Larger-scale organizations and startups are introducing the better alternative of ESOP or Employee Stock Option Plan. With a steady increase in small businesses and startups, there has also been a rise in the hiring workforce. That’s why from an Employer’s perspective, ESOPs came out as a savior to attract or retain highly-talented personnel and offer inclusive growth to its employees.
Established and recently incorporated startups seek funding and investment for sustainable growth in the company to invest in working capital and assets that flourish the profits. For such organization retaining their talent and ensuring reduced attrition rates is essential for the organizations growth. Offering a stake in the profits of the organization is the best way to bridge the gap.
ESOPs & The recent Updates
In a recent event, the big tech organization Infosys allotted 2,95,727 equity shares to all its deserving employees under the 2015 Stock Incentive Compensation Plan. As part of another recent event, the B2B E-commerce platform Udaan made it more accessible for its employees to avail ESOP quarterly by removing the one year ‘Cliff Vesting’ period. More and more businesses are understanding the concept of an ESOP and how they can use it to improve their valuation and reward or retain skilled employees.
While so much has been said and done, it is time to understand ESOPs and how they can work in favor of an organization and the employees sitting at executive positions.
What are ESOPs?
Employee Stock Option Plan is a benefit offered by a firm to its employees where they are granted an ownership interest in the company’s profits. The ESOP benefit plan enables an employee of the company to purchase shares at a relatively lesser price than the Fair Market Value (FMV). ESOPs are part of direct-stock or bonuses offered to eligible employees, and the employer has the right to decide who would receive the benefit of the ESOP plan and how many shares they can buy. ESOPs are typically presented to competent staff upon recruitment, assessments, or as part of a rewards and recognition programs. These working professionals stimulate growth and expansion in the near future. Hence, offering ownership in the company and profits seems like a suitable compensation.
Things you should know about ESOPs
- ESOPs are offered to employees at no additional costs, it is considered a component of the employees Cost To Company (CTC)
- The company’s choice to establish the qualifying criteria for workers to whom ESOP would be provided is referred to as the ‘grant of option’.
- Cliff Vesting is defined as the period after which the employee becomes completely vested. Common industry practice is to have employees wait for 1 year for their ESOPs to vest.
- The vesting date is the day on which the employee may exercise their ESOP and convert it into company stock.
- The grant date, is the day on which the ESOP is awarded in accordance with a written agreement between the employer and the employee.
- ESOPs can be exercised in full or in part, and in some situations, ESOPs can be exercised in instalments over a predetermined period.
- Employees have the right to choose whether or not to exercise their ESOPs.
How Does ESOP work in favor of employees?
Offering shares and ownership to an employee worth higher-valuation works like a charm for companies, especially when it comes to choosing a long-term financial strategy for the firm. But the question is, why must an Employee think about getting the accessibility of profit-sharing in the firm?
The answer brings forward these benefits:
- Being granted the power to obtain a share of a company’s profit, you have vested your time in increasing the revenue, works on top of usual salary compensation.
- Employees get an advantage with the power vested to buy shares at a lesser cost than the public, who would buy it at the actual market value.
- Employers have the advantage of offering a piece of ownership to new talent in the company as part of their CTC, so there is no immediate cash flow. The perks come evidently for the long term.
The Taxation Implication of ESOPs
When it comes to taxation policy and implication in ESOP, two instances are majorly followed:
- Since the employees buy the shares at a nominal fare, the difference between FMV and the exercised rate is a perquisite (a privilege enjoyed by the employee because he has been vested the power in that company). Hence, the difference becomes taxable.
- After selling the share, the profit made by the employee comes under tax gain. Like most assets, shares sold in less than 12 months fall under the Short-Term Capital Gain tax(STCG) and under Long Term Capital Gain (LTCG) for periods over a year. The timelines may differ for listed and unlisted organizations.
Having said that before opting to accept the offered ESOPs an individual should keep in mind these crucial points:
1. The legality in offering and holding ESOPs includes complicated rules that need to be followed. Any oversight or violations by the firm could lead to further risks in holding.
2. Organizations that are cash strapped require significant capital, in such cases employees should avoid accepting ESOPs as it further leads to a reduction in cash flow for the organization.
3. Holding a considerable amount of ESOPs could lead to the risk of concentration and lack of diversification due to investments in a single stock.
Employees with vested interest in their organization along with a considerable holding of ESOPs can be susceptible to risks of concentration of assets in a single company or sector. Other potential risks involve staying invested even in underperforming organizations due to familiarity bias.
For a business, ESOPs may enhance the employer-employee relationship and aid in the long-term hiring and retention of better talent. While, from the standpoint of an employee, being a shareholder in a developing organization may foster a sense of ownership as well as offer inclusive growth where they can have a growth trajectory in tandem with the founders or promoters. Nonetheless, investors must be mindful of the concentration risk associated with staying invested in a single business, and they must ensure that the asset aligns with their financial goals and investment strategy.