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ESOP - explained

Just look on every business and just try to understand which is their strongest link for success, sure in most of the cases the answer will be employees. Employees will be happy if they feel they have a sense of belonging with the company and are able to identify them with the company. A well motivated employee force is inevitable for the success of every corporate in the long term.

When we look on to any successful start ups we can find that they have a strong workforce and they continue to motivate them. For example Paytm or Zerodha, companies which have made waves and continues to create waves, are still private companies with huge employee shareholding. It shows that even if a company is in starting stage and not making huge profits, if they treat their employees well they can create wonders.

What motivates employees?

Of course good salaries, incentives, bonuses and the like are very important, stock options given to employees also have a big role to play when to keep a motivated employee force.

There are situation where companies even offer big cars to motivate employees, HCL technologies can be a big example.

While the companies are growing from scratch, employees also put big efforts. Employee Stock Ownership Plan is one of such scheme wherein the employees obtain a right to invest in the shares of the company at a discounted price at any given future date. Schemes like ESOPs encourage employees to work harder and better. There are instances where startups offer ESOP packages to acquire talents from the market to augment growth.

Employee Stock Ownership Plan (ESOP)

It is an employee benefit plan that provides the employee with the right to purchase the shares of a company at a discounted price in the near future. The idea behind this is to better the performance of the company and aim at an increase in the value of the shares by involving the employees as stockholders, incentivising them to contribute to the company’s success, being personally vested in the company.

How Do ESOPs Work?

Employers decide the number of shares to be offered under ESOPs, their price, and the beneficiary employees. ESOPs are, then, granted to employees and a grant date is provided.

Once ESOPs are offered, they remain in a trust fund for a specific period, called the vesting period. Employees should stay with the organization for the vesting period to avail the ownership of stock by exercising the ESOP.

Once the vesting period expires, employees get the right to exercise their ESOPs. The date on which the vesting period expires is called the vesting date. Employees can exercise their ESOPs and buy the company shares at allotted prices, which are lower than the market value. Employees can also sell the shares that they have bought through ESOPs and make a gain on their holdings.

If the employee leaves the organization or retires before the vesting period, the company is required to buy back the ESOP at a fair market value within 60 days.

Benefits of ESOP to employees

Stock Ownership

Employees can enjoy ownership in the company that they work for as ESOPs give them the right to own a part of the company’s share capital.

Dividend Income

A part of the profit earned by the company is distributed among the shareholders in the form of dividends. Employees can, therefore, earn additional dividend income and also get the direct benefit from the efforts that they put toward the company’s profitability.

Buy Shares at a Discounted Rate

At the time of exercising the ESOPs, employees usually pay a nominal amount to buy the shares allotted to them. This, therefore, allows them to invest in the company at a preferential rate.

ESOPs normally have a vesting period, which refers to the time period for which the employee must work in order to exercise his right to purchase the shares under the ESOP.

Benefits of ESOPs for Employers

ESOPs are favorable for employers too. Here’s how:

Employee Retention

Since employees have to wait out the vesting period before they can exercise their ESOPs, it becomes easier to retain employees.

Better Productivity

Since employees themselves stand to gain from the profits earned by the company, ESOPs can boost employee productivity and make the company more profitable.

A Tool for Attracting Talent

ESOPs are additional compensation plans that help employers attract and retain talented employees. In fact, for start-ups, ESOPs help lure in good talent in the initial days when high pay packages are not feasible.

Tax Implication of ESOPs

There are dual tax implications of ESOPs.

  1. When the employee exercises his/her rights and buys the shares of the company

  2. When the employee sells the shares after buying them

Let’s understand these instances in detail:

  1. Tax Treatment at the Time of Buying the Shares

Employees can buy the shares after the vesting date at a rate lower than the Fair Market Value (FMV) of the share as of that date. As such, the difference between the FMV and the exercise price of the share is treated as a prerequisite in the hands of the employee and taxed at his income tax slab rate.

ESOP Calculation Example

In the case of start-ups, however, the government has relaxed the tax implications on ESOPs. Start-up employees would not have to pay the tax on the perquisite in the year when they exercise the ESOP. For them, TDS on ESOPs would be deferred to the following dates, whichever is earlier:

  1. Completion of five years from the ESOP grant date

  2. Date when the employee sells the ESOP

  3. Date of leaving the company

Tax Treatment at the Time of Selling the Shares

If the employee sells the shares, the difference between the selling price of the share and the FMV on the date when the share was exercised, would be subject to capital gains tax.

If the gains are earned from selling the shares after 12 months of buying them, 10% tax would be applicable on gains exceeding Rs. 1 lakh. If, however, the shares are sold within 12 months, the gains would be taxed @15%.

In the above example, if the employee sells the shares, here’s how the tax would be calculated:

What Happens to ESOPs When the Company is Listed?

For unlisted companies, selling shares bought through ESOPs is a challenge as there might be a few takers, and the FMV is determined by merchant bankers. Moreover, capital gains are taxed as per debt funds. This means that shares sold within 36 months of exercising them attract short-term capital gains wherein the gains are taxed at your income tax slab rates. Long-term gains, i.e., those earned from selling the stock after 36 months, are taxed @20% with indexation.

Once the company is listed, however, employees get more opportunities to cash out their shareholding. Moreover, the FMV is determined by market movements.


Therefore, understand what ESOPs are, how they work, their benefits, and tax implications. Remember what is the vesting period in ESOPs before you are allowed to exercise them. They might prove to be an attractive component of your pay package, but you should understand them completely to utilize the full potential that they have to offer. Further, use the ESOP tax calculator in India to find out your tax liability when you are exercising ESOPs or selling the shares so exercised.

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