What is an ESOP? And how come startups leverage ESOP for attracting top talent?

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What is an ESOP

Each business look forward to retain its executives and key employees, thanking them for their valuable contribution to the company’s growth. ESOP is a common way to reward these employees.

What’s “ESOP?”

‘ESOP’ is a business scheme / plan for the workers. Employee stock options are opportunities whereby a company entitles its employees to buy their shares at a discounted price. ESOP is a form of retirement and employee benefit plan that offer employees with the equity interest in the company’s stock under certain conditions.

Companies issue shares via ESOP to obtain certain benefits such as –

  • Boosting the financial well-being and motivational level of employees, thereby urging them to better serve the company;
  • Reducing employees turnaround rates;
  • Encouraging employees to help the company grow and succeed.

Employees get a chance to become the company’s owners and work for the company’s growth because they realize they will share the company’s profits.

Remember, only the businesses with private limited company registration in India can allow workers or executives to become members of the company by ESOP. This will do so by supplying them with equity options instead of shares.

Such options are in the form of stock options that give employees the right in the future to purchase shares of the company (usually lower than market price) at a specified price, i.e. they can turn them into shares after paying the price in the future. The criteria are laid down in the ESOP Agreement.

But before an organization plans to launch ESOP, a feasibility study should be carried out to determine whether or not an ESOP is financially feasible. It must also determine its financial position in order to set the prices of the company’s shares. When ESOP is feasible and efficient, the business will be able to move through the following steps.

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The process of issuing ESOP  

  1. The organization draws up an ESOP plan and brings it before the shareholders for approval.
  2. Once the approval is granted, it gives workers the stock options by sending them a ‘letter of approval.’ This letter contains all the specifics of stock options, such as multiple options issued, acceptance period, exercise time, exercise price, etc.
  3. The employees can turn the stock options into equity shares at the end of the vesting period and become shareholders in the company.

Things to consider while opting for ESOP

  1. Read carefully the ESOP agreement and see to it that provisions such as continuation of ownership after a long period of jobs and partial ownership are retrieved when the minimum time is over.
  2. Key workers will improve their position and press for concessions on factors such as a lower exercise price and a quicker transition.
  3. The ESOP should always be exercised by setting the expiration date record.
  4. It is easier to negotiate agreement provisions through consultation with your financial advisor to enable or sell ESOP shares.

Advantages of ESOP

  • For employees:

Employees can play a part in the success of a business by owning shares.

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May gain from wealth benefits by selling valuable shares acquired at a lower rate.

Motivates employees to offer their best to the company.

  • For Businesses:

Take advantage of workers’ moral values and encourage them to do better on their everyday tasks.

Increase employee productivity and thereby lower the turnover rate.

Save on the remuneration of directors as part of the salaries of private companies by providing some ESOPs.

Understanding ESOP Taxation for Employees

Any employee who wants to convert the ESOP into shares shall have these shares taxable in compliance with the 1961 Income Tax Act. The shares assigned under ESOP raise tax liability in two phases:

Phase 1

In the exercise of an ESOP option: workers are paid income tax when they are able to turn ESOPs into equities after the time limit ends. This tax is paid at the search amount under ‘salary profits.’

The organization will measure and work for income tax deduction from the preconditioned ESOP value given to the employee. The employer is responsible for displaying the ESOP benefit and the deduction of revenue. The tax information deducted from ESOP is given in Form 16. Form 16.

  • The fair market value of the stock (on the day that the right is exercised) is as follows.
  • Less: amount obtained for these shares from employees (exercise price).

Phase 2

If the employee sells the stock, it results in capital gains for employees selling the securities assigned to them under ESOP to a higher price. The selling of these securities is measured as short-term or long-term capital gains at higher rates. The tax rate depends on the amount of capital gain.

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The capital gain estimate is as follows:

  • Selling price of shares
  • Minus: fair market value of shares (date when the option is exercised)

Some businesses have an ESOP agreement provision that when workers leave the company, they must exercise their own options within a certain time frame, even if no liquidity event is scheduled.

However, this provision will lead to a cash burden on workers because of the tax implications while using the right. The taxable value is the difference between the fair market value of the stock (on the day the right was exercised) and the amount of the stock retained from the employees (exercise price).

Employees who leave also can opt out from getting the benefits. The businesses are therefore should be amending the provision so that workers can retain the transferred options after leaving the company and exercise them when the liquidity event occurs.

We have the right to pursue the same choices as the company’s existing staff. It is a fair tool for the retired workers who have represented the company for a long time. Nevertheless, the issue such as the proportion of options that ex-workers and current employees will exercise at the time of liquidity event should be taken into consideration and the clause should be integrated into the agreement accordingly.

Conclusion

ESOPs are provided to key workers by businesses to achieve the company’s long-term objectives. ESOPs require challenges and should therefore be handled by a professional team. The company management would know the costs involved in issuing shares through ESOP, which may be legal costs, administration costs, valuation costs, etc.

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