ESOP stands for Employee Stock Option Plan. An ESOP gives an employee an option to purchase  an equity share in the company that employees him or her. Colloquially, the option in an ESOP plan is called an ESOP.

ESOP policies are designed to reward key employees in case the company does well, and extra payouts are affordable by the company. Employees can also be incentivized with cash bonuses, but ESOPs are perfect instruments to align incentives with shareholders. This is because ESOPs also incentivize employees to maximize the share price of the company.

1. Key components and concepts associated with an ESOP policy

a. Grant Letter                                                                                                  

This document outlines the key terms with which ESOPs are granted to the employee.

b. Vesting of ESOPs

This refers to the ESOPs that are ready to be exercised by the employee. For example, consider an employee whose ESOP policy stipulates that after each year 5 ESOPs get vested. This means that after the year ends, the employee has the right to pay the exercise price for 5 ESOPs and get the shares allotted to him or her. that after Note that even though an ESOP may have vested, the ESOP policy may stipulate that the exercise must happen later.

c. Exercise Price of ESOPs

This is the amount an employee has to pay per ESOP option to get a share in the company. This price is lesser than the prevailing market price in order for it to be viable for the employee to exercise.

2. Structuring of ESOPs

a. Time linked ESOPs                                                                                                                                                                                                                            These ESOPs vest based on the time spent by the employee in the company. As an example, for each year that an employee stays with the company, some ESOPs vest each year. These are agreed and outlined in the Grant Letter.

b. Performance Linked ESOPs

These ESOPs vest only upon the achievement of certain targets laid out for the employee

3. Taxation of ESOPs

Taxation of ESOPs have two aspects:

a. Upon exercise:

Upon exercise, the difference between the prevailing market price and exercise price is usually taxable at the rate of the marginal rate of income tax

b. Upon sale of shares

This taxation is accrued when the employee sells the shares that have been received after exercising the ESOP. The taxation incurred will depend on the time period between the exercising of shares and when the shares are actually sold. This time period may lead to short term capital gains tax or long-term capital gains tax.

4. ESOP financing

In the case of publicly listed companies, employees are required to pay for exercising the ESOP and then sell the shares in the public market. This therefore requires the employee to have some capital in order to exercise the option. There are lenders who provide loans to employees for such cases.

5. Quantum of ESOPs                                                                                                                    

Structuring the number of ESOPs that are given to employees is a complex task. It is a function of the market compensation benchmarks and risk taken by the employee. Some considerations are below.                                                                                                                                                                                                                       

The total value of cash+ESOP components for an employee should match the industry compensation benchmarks. As an example, consider an employee who can receive a compensation of INR 10 lakhs per annum in the market. When an ESOP package is considered for that employee, then anticipated value from the ESOP along with the cash component being given should match INR 10 lakhs per annum and exceed it by at least a little so that the employee is compensated for the additional risk in relying on ESOPs. If the employee is paid AED 7 lakhs per annum in the cash component, the ESOP components should be valued in a manner such that the value obtained by the employee should be at least INR 3 lakhs per annum.

Performance linked ESOPs carry higher risk versus Time linked ESOPs from the employee’s perspective as targets have to be met. An ESOP package that relies on more performance linked components should offer a higher value to an employee versus a structure that relies primarily on time linked ESOPs.

In the end, the ESOP package is a negotiation item and retention of key management has no particular benchmarks.

For an employee, ESOPs based on unlisted shares carry higher risk versus those based on listed shares.

Higher exercise price aligns incentives between the management team and the shareholders, but it means higher ESOPs need to be issued. This is because the benefit that an employee per ESOP is the sale price minus the exercise price. An Exercise Price of zero would mean that per ESOP, the employee can get a higher value but then the employee can have a viable outcome with these shares even if they are sold at a lower price, perhaps even lower than the entry price of investors.

 

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