Decoding ESOPs

ESOP (Employee Stock Option Plan) as a term has been widely heard and used by Corporates, Professionals and Employees, but hardly understood well as a concept.  Here, we intend to explain the basic concept and break down the wide term of ESOP.

Going by the nomenclature – it is evident that it is an Employee benefits program which is linked to the Stocks of the company granting it, giving us a broad idea about the concept. ESOP is a method of compensation -linked to Equity Shares of the company, along with other components of Compensation like Salary, Variable pay, Bonus, Pension, Gratuity etc.

ESOP works as additional compensation, where the ultimate benefit accruing to employees depends upon the company’s growth, i.e. increase in value of Equity shares. It’s a reward to Employees as wealth created due their efforts, is shared with them. The interest of the Employees is aligned with the interest of Company and Shareholders, resulting in lesser Organisational conflicts. ESOPs also gives Employees, an opportunity be part owners of the company by exercising their options and becoming a Shareholder.

ESOP has also been used as an effective motivation and retention tool for the Employees, as it promises due benefits over a span of time and can be linked to certain performance goals.

Stock Option is a kind of Derivative, i.e., an instrument which derives its value from another underlying asset i.e., Equity Shares of the Company granting it. The term “Option” in ESOP stands for the Right given to Employees without any obligation to buy Equity Shares of the Company on a future date (Exercise date) at a predetermined price (exercise price).

Terms of Grant (Number of Options), Vesting (Conditions and Period), and Exercise (Period and Price) of the “Rights, “i.e. Stock options are communicated and known by the Employees on the date of Grant, thus making it easier for Employees to take a decision regarding the Rights conferred to them.

ESOP plans are meant to be for the benefit of Employees, and therefore terms are generally favourable, also to make it attractive for Employees.

ESOP is a generic term used for a wide range of Equity-linked instruments, e.g., ESPS (Employee Stock Purchase Scheme), RSU (Restricted Stock Units), SAR (Stock Appreciation Rights), Phantom Options (Equity linked Cash Plans), etc.

Equity Linked plans, including ESOPs, are generally divided into four stages i.e.

Grant – Employees get a certain number of Stock Options with a predetermined Exercise price and other definitive conditions

Vesting – Employees need to fulfill the conditions attached to Options granted to earn the Rights granted over a period.

Exercise– Employees can convert their Vested Options or “Earned Rights” into actual Equity shares by paying the Exercise Price within the Exercise Period defined.

Sale– Employees can sell off their Equity Shares at the prevailing Market Price to realize actual gains.

ESOPs have been used over the years to the advantage of both Employers and Employees. In order to optimize the advantages from the implementation of ESOPs, Organisations need to understand the instrument in-depth and analyze the modalities from all angles.

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