ESOPs: Meaning of employee stock options, its benefits and demerits
Companies today provide a bunch of benefits, besides a salary, to attract and retain talent. ESOP is one such benefit. So, what does ESOP mean? The full form of ESOP is Employee Stock Option Plan.
What is ESOP?
ESOP is a benefit granted to employees that entitles them to a fixed number of shares in the company at a predetermined price after a predetermined period. This predetermined price is called the exercise price and the period is called the vesting period. ESOP is not an obligation and employees can exercise this option only if they wish to. After the vesting period is over, employees have a window called the exercise period when they can exercise this option.
ESOP is mostly granted as a part of the remuneration package. Employers distribute these fixed percentages of shares to different employees based on their salary, performance, tenure with the company or other criteria as negotiated in terms of employment.
ESOP shares are held in a trust unit for security and growth throughout the vesting period for the respective employee. If the employee exits the firm before the vesting period ends, they lose their option to exercise the ESOPs. The shares are then bought back by the company at fair market value and put back into the ESOP distribution system.
Example of ESOP
For instance, let's assume Mr Kapoor has worked in ABC Ltd for 5 years and is now eligible to enrol in its ESOP program. The market value of the share is Rs 110, and the exercise price is Rs 60. Suppose Mr Kapoor is entitled to 5,000 shares; the perquisite value of the ESOP is the difference between the exercise price and the stock's fair market value.
Perquisite value of ESOP = (Market value of a share - Exercise price) x No of shares
= (110-60) x 5000
= 50 x 5000
= Rs. 2,50,000
Benefits of ESOP
Let us understand the benefits of ESOP to employees and employers -
1. A means to earn additional income
2. If employees time it right, ESOP also helps them create substantial wealth and own a part of the company’s success
3. Makes employees feel incentivised and appreciated
1. Improves the company’s performance as employees are motivated to do well since they are also part owners of the company
2. Increases employee retention, leading to low turnover rates.
3. Companies can avoid cash compensation, saving immediate outward cash flows.
Demerits of ESOP
There are certain demerits associated with ESOP and issuing them to employees. These points must be kept in mind before issuance; the gravity of these mustn’t be ignored.
Limited benefits to new employees - ESOP is usually provided to most employees, but employees that enrol in them earlier stand a higher chance to benefit, unlike employees who join in later stages of the company’s growth.
Dilutes the company’s share value - ESOP issuance dilutes the ownership of each shareholder as new stocks are granted
Lack of investment diversification - Employees lock their savings in the same company and risk losses if the company collapses. This is against the principle of investment theory.
If used correctly, ESOPs are a great tool for organisations and employees. Hence, the importance of ESOP mustn’t be ignored. They are associated with greater employee effort and commitment in exchange for ownership of shares. Meanwhile, employees tend to gain a part of the company’s success.