The multiple benefits of ESOPs you should know.

ESOPs are a great way for cash-strapped companies to hold on to their employees while allowing the latter to profit from the company’s growth. But, as an employee, is it better to simply opt for more cash in hand, or stay put in the company for the long run?

What is an ESOP?

Employee Stock Option Plans (ESOPs) aim to bridge the gap between owners and employees by offering employees the opportunity to purchase company stock, effectively making them stakeholders. An employee that also holds a stake in the company is likely to be more committed to the company’s cause, and is likely to stick around for longer, which benefits the company immensely.

Why ESOPs?

Historically, there has been a clear divide between the workers and the owners in the workplace. Companies quickly realised, however, that they could only pay a specific person up to a certain point before losing him or her or jeopardising their salary structure. That is how ESOPs came to be.

So, what are the benefits of ESOPs for employees?

Employees are offered a certain number of shares at a discounted price, which they can purchase after a brief period (called the vesting period). Once the options are vested, you get an exercise period wherein you can purchase company stock at the offered price. Now you can hold on to the stock, as you would with other market-related equity investments, and build long-term wealth, or sell the stock to book immediate profits.

While you may receive a reduced salary (i.e., cash in hand), you’ll have an opportunity to build long-term wealth, especially since most companies offer staggered stock options. For example, say you’re offered a total of 100 shares for Rs. 100 each over 3 years at 20, 30, and 50 per cent respectively, at the end of each year. That means you can acquire 20 shares for Rs. 100 at the end of the first vesting period (1 year), regardless of the share market's price. Similarly, in the second year, you can buy 30 shares for Rs. 100, when the stock is likely to have risen substantially. And finally, at the end of the third year, you can buy 50 shares for Rs. 100 each, when the market price would most likely be even higher.

If the market price is lower, you can choose to not exercise your options. After all, ESOPs are employee benefit plans designed to keep you longer at the company while also providing you with the opportunity to make long-term gains.

Also Read: All You Need To Know About ESOPs

While the benefits of ESOPs are undeniably mutual for the company and the employee, there is an important factor to keep in mind:

ESOPs are taxed twice.

• During the exercise stage

When you exercise your options, the difference in amount between the buying price and the market price of the shares is taxed as perquisite – under your salary. This is therefore taxed according to your income slab.

• During the sale of shares

Here there are two scenarios:

1. Unlisted company: For an unlisted company, if you sell your shares within 24 months, you’ll be taxed under your income tax slab rate on the gains. However, if you hold on to it for more than 24 months before selling the shares, then you’ll be taxed at 20 per cent on your indexed gains. Indexed gains take into account the cost of acquisition concerning inflation, thereby increasing your theoretical cost of acquiring the assets while reducing the capital gains – essential in reducing your tax liability.
2. Listed company: Here, in case of sale within a year, you’ll be taxed at 15 per cent on your gains. Whereas, for gains occurring after a year, you’ll be exempted from taxation if the gains do not amount to more than Rs. 1 lakh. But if you realise gains more than Rs. 1 lakh in a financial year, you will be taxed 10 per cent on those gains.

Also Read: Is Income From Shares Brought Under An ESOP Taxable?

When should you choose ESOPs?

The advantages of ESOPs can be maximised when you intend to stay at the company for long, and the grant price is significantly discounted, with tremendous potential for market price growth. Furthermore, share buybacks, IPOs, and funding rounds are critical in ensuring your liquidity needs are met when the time comes.

The potential to create long-term wealth is undeniable, especially if the company has strong business fundamentals. Sometimes you may not have the option of getting more cash in hand. ESOPs may be your only wealth-creating option for a company that's in recessionary times.