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What Is Employee Stock Option Plan? 4 Types Of ESOPs, Benefits & Its Process In Private Companies

What is Employee Stock Option Plan?

There exist various mechanisms through which an employer can reward their employees and encourage them to work hard for their company. Monetary rewards and benefits, incentives, and bonuses are some of the most popular means to recognize and appreciate employees for their contribution to the organization.

But what if the employee deserves more? What if the employees have performed so well that it creates a new benchmark for the entire workforce?

Employee Stock Option Plan or ESOP is one such employee benefits scheme to reward them for their exceptional work and to keep them motivated. The biggest USP of the Employee Stock Option Plan is that employees can own a share of the company, which is the highest form of motivation for any employee.

Monetary rewards such as incentives and bonuses are one-time and short-term employee benefit plans, but ESOP is long-term and makes the employees part of the organization by providing them equity shares.

In this blog, we will cover what is Employee Stock Option Plan, its benefits and what are the different types of Employee Stock Option Plans in India. Besides, we will explore the characteristics of the ESOP scheme for private companies, and how ESOP in Indian companies is actually implemented and executed.

So, without much ado, let’s dive into the exciting practice of the Employee Stock Option Plan!

What is Employee Stock Option Plan?

Employee Stock Option Plan or ESOP is an opportunity for employees to own equity shares of their organization, and own a part of the company for which they are working.

By providing the employees with a portion of the company shares, the employers aim to motivate and inspire the employees to give their 100% for the company’s growth.

The logic is simple: When the employees own a part of the company via equity shares, then they will be more engaged, focussed, and keen to make the company succeed.

In case ESOPs are provided to the employees, then the company’s success literally becomes their success.

Generally, one of the critical terms for granting ESOPs to employees is fulfilling a condition: say, X number of sales, or launch of a major product. In case that condition is fulfilled, employees are provided with ESOP, and thus, they own a part of the company.

ESOP Scheme for Private Companies in India

The concept and the idea of the ESOP Scheme for private companies in India was first introduced in the Company’s Act 1956, which explains what is Employee Stock Option Plan or ESOP.

The definition of ESOPs as per Company’s Act 1956: “the option given to the whole-time directors, officers or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a pre-determined price”.

In the amended Companies Act 2013, one aspect of holding company was added to this definition. Under the amendment, holding or subsidiary companies of the parent organization can also allocate securities and equity shares to the employees as a reward.

Employee Stock Option Plan in Indian Companies – How Does It Work?

As per the latest rules, ESOPs in India are governed by Companies (Share Capital and Debenture) Rules, 2014.

Here is the process which employers must follow for rolling out ESOPs to their employees:

  1. In the 1st step, the company should draft an ESOP plan, and take the approval of all shareholders. Earlier, the ESOP scheme should have been passed via ‘special resolution’, and then filed with the Registrar of Companies. But after 2015, this lengthy procedure was removed.
  2. In step 2, at the time of ESOP allocation to the employees, a ‘Letter of Grant’ is issued to the employees stating the number of shares allocated, vesting period, finding out the exercise price, and more. Note here, that options are not shares, but the right to own the shares.
  3. In case the employee wishes to exercise the options granted under the Letter of Grant, they will need to make an ‘Exercise Application’. Once this is done, the options are converted into shares.
  4. Once the vesting period ends, the employees can encash the shares at the current market rate.

*Follow here (.pdf) for ESOP guidelines by SEBI.

Types of Employee Stock Option Plan

There are mainly 4 types of employee stock option plans, are mentioned below:

1. Employee Stock Purchase Plan (ESPP)

In this, the company offers shares to the employees at a much lower rate than the fair market value. It needs a minimum service period from the employee.

2. Employee Stock Option Scheme (ESOS)

In this, the employee is granted options on a pre-defined valuation, constrained by vesting period and performance metrics. Once the vesting period is over, the employee can exercise options to own shares, by paying the pre-defined exercise price.

3. Restricted Stock Units (RSU)

In this, the employee is granted shares of the company only after the occurrence of an event. There is generally no vesting period or exercise price in RSU.

4. Stock Appreciation Rights (SARs)

Technically, this is not ESOP because, in this type, the company offers cash in exchange of the shares if a condition is met. But several companies use SARs as the ESOP model.

Benefits of ESOP

  • The employee gets financial benefits which is much more than bonuses and incentives
  • Employees become part of the decision-making process of the company and feel more responsible
  • ESOPs provide more job satisfaction and job security to the employees

There are several more aspects to ESOPs and the practice of allocating shares to the employees for their performance and loyalty. Besides, the tax angle also needs to be understood before offering ESOPs to the employees.

If you are seeking more clarity on ESOPs and trying to find the right balance of ESOPs in HRM, then business coaches and mentors at MSMEx can help you out. MSMEx is an ed-tech platform for MSMEs and Small business owners in India.

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