ESOP – Employee Stock Option Plan
What is ESOP?
Employee Stock Option Plan (ESOP) is a type of employee benefit plan which gives you an ownership interest in the company. In this, you can acquire the shares of the company at a concessional rate at a predetermined price, as compared to the market rate.
It is one of the most popular ways to encourage you to work for a longer time in the company. Many startups also offer ESOPs as part of the package as they cannot afford to pay you huge salaries.
In ESOP, the stocks are not allotted to you immediately. You are given an ‘option’ to purchase the stocks at a future date at a predetermined price. This price will be usually less than the prevailing market price. You can choose to ‘exercise your option’ i.e you can buy your company’s stocks at the agreed price or let it lapse. There is no obligation for you to buy the stock option.
Also read about – What is ESPP – Employee Stock Purchase Plan?
How does ESOP work?
ESOPs are granted by the company as part of your CTC (Cost-to-Company). When it is allotted to you, you do not become the owner of the shares of the company immediately. You are only given an option to purchase the company’s stock at a later date at a price determined now.
The date on which such an option is given to you is called the ‘grant date’, the date on which you are eligible to exercise the option is known as the ‘exercise date’ and the predetermined price of the stock at which you can buy on that exercise date is called ‘exercise price’.
Stocks purchased under ESOP also have time restrictions, after which it can be sold. Every year, a certain percentage of the stocks (also known as tranches) vest. On vesting, you can either continue to hold the stocks or sell it.
In case the shares are not listed on a stock exchange, you may not be able to sell your stocks immediately on vesting. You have to wait until the shares get listed or when the promoters offer you an exit option.
E.g. Assume you join a company on 10th April 2018, your company gives you an option to purchase 50 stocks on 10th April 2019, at a price of Rs.200.
So on 10th April 2019, you have the option to buy the stock at a committed price of Rs.200. You may choose to exercise your option and buy the stock or you may let it lapse.
Also read about – What are Restricted Stock Units (RSUs)?
Taxability of ESOP
Since there is a cost incurred in buying the stock options, the difference between the price at which you exercise your stock option, and the prevailing market price on that day, is considered as an income.
Tax on the income: The income derived from ESOPs are considered as perquisites and taxed accordingly.
Tax on the capital gains: The gain in ESOP is calculated as the difference between the sale price and the exercise price. However, the holding period is calculated from the vesting date of the stocks. If you sell your stocks within one year of vesting, it is treated as a short-term capital gain (STCG) and tax is calculated at the applicable STCG tax rate. If you sell your stocks after one year of vesting, it is treated as a long-term capital gain (LTCG) and LTCG tax rates are applicable.
With ESOP, you can buy the stocks of the company at a lower price than the market price. There is a potential to create wealth in the long-term.
To buy ESOP on the exercise date, you should have the cash ready. In case, you are not able to buy the stocks on the exercise date, you will lose the benefit. Also, the time duration between the vesting date and grant date is longer due to which you may not be able to liquidate the stocks in times of need.