What is the Employee Stock Ownership Plan (ESOP)? Why is it important? How do they work?

What is the Employee Stock Ownership Plan (ESOP)? Why is it important? How do they work? | Vrid
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In the past, employees were often treated as mere workers, receiving only a salary for their services. However, in today’s startup era, companies have transformed how they value their employees.

Alongside salary, they now offer a range of welfare benefits. They even provide opportunities for ownership through Employee Stock Ownership Plans (ESOPs).

ESOPs are a unique way for employees to own a slice of the company they work for, and they can be a powerful tool for building wealth and fostering a sense of ownership. Let’s understand ESOPs, their importance, and how they work.

Estimated read time: 4 minutes and 11 seconds

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What is an ESOP?

An ESOP, or Employee Stock Ownership Plan, is a benefit plan that enables employees to own shares in the company they work for. It is a way for companies to distribute ownership among their employees, aligning their interests with the success and growth of the business.

When you join a company that has an ESOP, they may allow you to own a part of the company. They do this by giving you shares of the company’s stock. Think of these shares as a portion or piece of the company itself.

However, you don’t get ownership of all the shares right away. Instead, there is a process called vesting. 

Vesting means that over time, usually several years, you gradually earn ownership of more shares. They usually do this to encourage you to stay with the company for a longer period.

The value of the shares you receive can change over time. It depends on how well the company performs in the market and how the business is doing. If the company does well and its stock value increases, the shares you own will also become more valuable.

ESOPs offer various benefits to employees. For example, you might receive dividends from the company – a portion of the profits distributed to shareholders. Additionally, some companies allow you to buy more shares at a discounted price through an Employee Stock Purchase Plan (ESPP).

And, if you decide to leave the company, retire, or meet specific criteria outlined in the ESOP, you can sell your shares and receive money for them. This can provide you with additional income.

Why is ESOP important?

ESOPs play a significant role for both employees and companies. 

ESOPs are crucial because they empower employees by giving them a stake in the company’s success. It also provides a means for wealth creation.

Providing a sense of ownership and pride in the company’s success is really important. When you own a piece of the company, you are more likely to feel invested in its success and to work hard to help it grow, right?

For companies, ESOPs help to reward performance, attract and retain talent, offer tax benefits, facilitate succession planning, and promote corporate governance and employee voice.

ESOPs can be a powerful tool in promoting a positive work environment. It helps to align employee interests with company goals and build a more sustainable organisation.

How does an ESOP work?

Every ESOP plan is unique. Because each company has different rules and structures for their plans. 

Generally, an ESOP plan comprises a vesting and exercise schedule that outlines the number or percentage of shares allocated to an employee over a specific period. It also specifies the timing and price at which employees can exercise their vested shares.

Imagine you started working for a company with an ESOP program in place.

The company explains after completing one year of service, you become eligible to take part in the ESOP program. 

Once you enrol in the ESOP program, the company grants you ESOP units as a form of ownership in the company. These units represent a certain number of shares or a percentage of the company’s equity. 

The number of units granted to you depends on various factors, such as your position, performance, years of service, and others.

Remember, the ESOP units you receive are subject to a vesting schedule.

Let’s say the company offers you 1,000 units of the company in the ESOP plan, and the vesting period is four years, with a one-year cliff and monthly vesting thereafter. 

This means that after completing one year of service (the cliff), you become vested in 25% of the granted units – 250 of the 1,000 units. From that point onwards, additional units vest gradually every month until the end of the fourth year.

Usually, your employer will maintain an ESOP account. This account tracks the number of vested ESOP units you own and their current value. The company provides regular statements or online access to your ESOP account, allowing you to monitor the value of your vested units.

And once your ESOP units are vested, you have the option to exercise them.

Exercising means converting the vested units into actual shares of the company. The exercise price, which is predetermined, is the amount you need to pay to acquire the shares. 

Sometimes the exercise price may be lower than the prevailing market price, providing you with a potential financial benefit.

Remember, while exercising the vested units, you have some tax obligations associated with ESOPs. We discussed the tax implications here

If you decide to leave the company, different exit options are available. You may have a specified period within which you can exercise your vested units after leaving the company. 

Alternatively, if the company undergoes an acquisition or IPO (Initial Public Offering). You might sell your vested units to the acquiring company or on the stock market.

Please note that the specific details and rules of ESOPs can vary from one company to another. It’s important to carefully review the ESOP plan details and consult with the HR department or ESOP administrator to fully understand your company’s ESOP program.

ESOPs have a lot of components. And understanding their benefits, drawbacks and tax implications in one post is not viable. We have covered other elements in other post here.

Don’t forget to share these insights with your buddies.

Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

Groww – What is ESOP?

Warikoo – ESOP – Employee Stock Option Plan EXPLAINED

Slidebean – Stock Options explained: basics for startup employees and founders

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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