ESOPs: Why stock compensation can be great for both employers and employees

Employee stock ownership plans (ESOPs) are a form of compensation often offered as incentives or rewards by employers to their employees.

ESOPs: Why stock compensation can be great for both employers and employees
Employee stock ownership plans (ESOPs) are a form of compensation often offered as incentives or rewards by employers to their employees.

In July, one of India’s largest technology firms, Infosys, announced its intention to offer stock compensation plans in order to hire and retain high-level talents. Stock compensation is often a hard-to-grasp concept to lay persons.

In this article, we will take a look at the subject from various angles: why stock compensation can be great for both employers and employees, how an employee’s stock compensation can grow in a manner his salary can never, and the tax implications of receiving stocks.

The Basics
Employee stock ownership plans (ESOPs) are a form of compensation often offered as incentives or rewards by employers to their employees. This compensation is over and above the regular remunerations in the form of salaries, reimbursements, perks or any other form of cost to the employer.

Companies often use ESOPs as a tool to attract and retain high-quality employees. They disburse stocks in a structured manner. For example, a company may grant stocks at the end of a financial year, thereby giving employees an incentive to remain with the company in order to receive that grant.

Then there’s the absolute value of the grant itself. The value of stocks rise or fall in conjunction with their companies’ revenues. Employees with ESOPs of a growing company can earn huge monetary benefits and find their compensation growing faster than their base pay. This gives them an incentive to remain with their employers to accumulate more stocks and benefit monetarily.

How ESOPs Work
ESOPs allow a company’s employees to be the part of its growth, making employees stakeholders in the company. Typically, a company would offer a definite number of shares to the employees at a discounted cost – or at no cost – as per its predetermined policy.

There is usually a lock-in period on the ESOPs. They are transferred to employees at fixed intervals: monthly, annually, biennially, and so on, as decided by the company. For example, a company could offer you 10,000 shares to be distributed in a vesting period of five years. In the first two years, you may receive 2000 shares. In the next two years, you could receive 3000 more. And in the final year, you may receive the remaining 5000 shares.

As an employee eligible to receive these shares, you will have to agree to the conditions of the offer within the exercise period, failing which the offer may lapse.

Remember, there are different types of stock compensation plans. It is a company’s prerogative to pick one according to its requirements. Employee stock purchase plan (ESPP), share appreciation right (SAR), restricted stock units (RSUs) etc. are all different forms of stock compensation.

Why employers offer ESOPs
There are long-term objectives of companies offering ESOPs. Not only do they want the long-term retention of employees, but also to make them stakeholders of the company. Many IT companies have high attrition rates, and an offer of ESOPs could curtail attrition to a degree. IT companies have also used stock compensation as a pull for high-quality talent.

Start-ups often offer stocks to attract talent. Often such companies are cash-strapped and thus unable to pay handsome salaries. But providing a stake in the company makes their job offers competitive.

ESOPs From Employee’s Perspective
Before accepting a job offer containing ESOPs, you must analyse how the long-term value of the ESOPs compares to earning opportunities available elsewhere in the job industry. This means you must assess how many stocks you can accumulate in your stint with the company, and how much the value of those stocks could appreciate in the medium to long term. If you find that there may be considerable appreciation in the stock value, it may make sense to have a long stint with such a company.

There are plenty of success stories of employees raking in the riches along with the founders of their companies. When Google went public, its founders Larry Page and Sergey Brin became two of the richest people in the world, but its stock-holder employees became millionaires too. A great example of this was Google’s executive chef Charlie Ayers, who received stock reportedly worth $26 million, a sum that employees can ordinarily not make through a salary income. In Google’s case, around 900 employees became millionaires with the company’s IPO in 2004.

Ayers, who was employee No. 53 at Google, may have assessed the company’s future correctly. Not all companies will achieve Google’s success and therefore it is up to you to try and understand the full value of any stock grants being offered to you on the job. The value of the stocks will appreciate or erode depending on how well the company performs.

Tax Implication
ESOPs are considered as a perquisite when it comes to taxation. Companies are not liable to pay any tax when they give ESOPs. Employees are taxed on the difference of a stock’s purchase price and the selling value. Such difference in the two amounts is taxed as per the employee’s corresponding tax bracket.

At the time of liquidating his ESOPs, an employee is required to pay short term capital gain on his profit if sold within one year of purchase. If the ESOP is sold after one year, then it is treated as long term capital gain and therefore no tax needs to be paid.

Bear In Mind…
Remember that there is typically a waiting period before ESOPs can be exercised. During the waiting period, the stock value could erode and fail to meet your expectations, thus eroding your overall compensation.
If you are looking for liquidity, ESOPs may not be a great option. They are suitable for risk takers – employees who don’t mind gambling with a portion of their compensation.

The ESOPs evaluations are different in case of unlisted companies in comparison to the listed one. The value of listed companies can be easily derived from market data. But for unlisted companies, you must understand the ESOP value and exit clause clearly before accepting the offer.

In an ideal world, stock options are a win-win deal for the employers and the employees both. Employers can rest assured that the employee would stay loyal to the company while the employees get to be the company’s stakeholders and directly contribute to its growth, thereby having a leverage on the growth of their own compensation.

The author is CEO

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First published on: 26-07-2016 at 11:33:22 am