ESOP (Employee Stock Option Plan) is a benefit plan drawn up for employees. The plan offers the employees a right to own shares in the ownership of the company. ESOPs provide an incentive for the employees to contribute to the future progress of the employer (company). Employees receive their rewards in terms of future appreciation in the stock price of the company.
ESOPs are granted by start-up companies as well as by established companies. Start-ups grant ESOPs to attract talented employees whom they cannot pay high salaries in their initial years. Established companies grant stock options to employees as a reward for their long-term commitment to the company. The company determines the criteria for granting ESOPs.
The ESOP scheme provides for specific rules for the vesting and exercise of stock options. For example, a company may provide for a vesting period of four years with a cliff period of one year. The exercise price for an option is Rs 100. The company grants an employee 100 options on 1 January 2020 with a vesting period of four years staggered at 10%, 25%, 30% and 35%. The cliff period of one year means the vesting will commence after the expiry of a year from 1 January 2021. The vesting will happen as follows:
- 10% on 1 January 2021
- 25% on 1 January 2022
- 30% on 1 January 2023
- 35% on 1 January 2024
Upon vesting, the company will prescribe a time within which an employee can exercise their options. In the example mentioned above, if the vesting period is five years, then the options vested can be exercised and converted into stock/shares on the following dates:
- 10% on or before 1 January 2026
- 25% on or before 1 January 2027
- 30% on or before 1 January 2028
- 35% on or before 1 January 2030
Most companies generally have a cliff period of one year to ensure employees stay committed to the company. When an employee wants to exercise the options, they have to make an application to the company. The options would convert to stock at the exercise price in the ESOP scheme. In the example mentioned above, the first tranche of 10% would convert by paying Rs 100*10 shares equalling to Rs 1,000. The company will allot 10 equity shares to the employee.
In case an employee resigns, the options which are yet to be vested will lapse. In case options which vest with the employee before the resignation, their treatment would be as per the ESOP scheme. Employees with ESOPs should read the terms of the ESOP scheme and calculate their vesting and exercise dates. They should also evaluate the effects of their resignation on the options vested or exercised by them.
In general, ESOPs are rewarding for employees who stay committed for the long-term in the company. Employees would need to understand the ESOP scheme from a legal and financial perspective. Last but not least, employees should calculate their tax outgo at the time of exercise of options and at the time of the subsequent sale of the stock.
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I am a Chartered Accountant by profession. I specialise in personal taxes and corporate income tax matters. I am an avid reader and track developments in financial markets, economy and other market developments.