What is ESOP? How employee stock option plans work, tax implications and benefits for employees

What are ESOPs?

The employee stock option plan (ESOP) is an incentivising tool that was developed by Louis Kelso, an American economist and lawyer, in 1956. It was conceptualised as a scheme to attract and retain talented employees by offering them the company’s shares at a predetermined, discounted price after a specified period. ESOPs became popular in the 1990s in India during the tech boom.

Employees can purchase the stocks after working with the company for a certain period, known as vesting period, and for this duration, the stocks remain in a trust fund. Employees need to remain with the company during the vesting period, after which they can purchase the stocks at a discounted price and have the option of selling them immediately or retaining them.

The tax implication for employees occurs twice—once when they the exercise the option of buying the shares and, again, when they decide to sell them.

Benefits of ESOPs

For employers

Attracting talent: This additional component in the pay package offered by a company acts as a lure for hiring talented staff.
High retention: The vesting period enables companies to hold on to their employees and reduce attrition rates because the former can exercise their option to buy shares only after the end of this period.
Improves performance: ESOPs help motivate employees to engage at a deeper level and become invested in the company’s growth because they have a skin in the game and stand to gain as stakeholders in the company.

For employees

Discounted shares: Employees can purchase shares at nominal rates, which are typically lower than the stock’s fair market value.
Wealth creation or income source: If employees decide to retain their company’s shares, they can create an additional source of income through dividends. If the company sees a growth surge, it can create significant wealth for the employees when they decide to sell the shares at a later date.
Career stability: Longer period of employment and company ownership translate to stable career growth and better retirement security for the employees.