Author- Shailja Choudhary
Employee stock ownership plans, sometimes known as ESOPs, are a form of business programme that offers employees investment opportunities, pay, or incentives in the form of shares of the company’s stock. The main goal of an ESOP is to provide employees with the opportunity to become part-owners of their employer.
What is an ESOP?
Employee stock ownership plans (ESOPs) are a type of employee perk that allows workers to acquire a stake in their employer in exchange for monetary compensation. When someone purchases stock in a firm, they are essentially buying a fraction of the company’s profits and assets. Having shares in a firm means you have a stake in the business. Stock ownership schemes for employees are a great way to bring together the interests of workers and shareholders. An employee’s commitment to the company’s success may increase if he or she also owns a stake in it. It’s possible that ESOPs can function as an alternative to RRSPs (RRSP). ESOPs improve organisational dynamics by highlighting employees’ contributions to the business and incentivizing them to act in the best interests of their employer. Usually, this is part of a larger remuneration package, and the shares will “vest” over time. The goal of an ESOP is to unite the interests of the company’s workers with those of its shareholders. From the standpoint of management, ESOPs offer tax benefits and encourage staff to concentrate on the success of the business.
How does an Employee Stock Ownership Plan (ESOP) Work?
With an ESOP in place, employees of a closely held firm have the chance to purchase shares of the company at a discounted price.
ESOPs are trust funds that can be funded in a few different ways: by the company contributing freshly issued shares, by the company contributing cash to acquire existing shares, or by the company taking out a loan through the entity to buy existing shares. Several big, publicly listed organisations use employee stock ownership plans (ESOPs).
Companies that offer ESOPs have a duty to treat all employees fairly and must name a trustee to function as the plan’s fiduciary, despite popular belief to the contrary. Senior employees cannot be given a disproportionate percentage of the company’s stock, and ESOP participants cannot be denied the ability to vote.
ESOPs from an employee’s perspective
Employee stock ownership plans (ESOPs) allow workers to buy into a company at a discount and then sell their shares (after a specified period) for a profit. There are numerous examples of employees sharing in the company’s success with the company’s founders. Google’s IPO serves as an excellent case in point. Its co-founders, Sergey Brin and Larry Page, joined the ranks of the world’s wealthiest individuals, and the company’s stockholder workers also made millions[1].
Example of an ESOP
Take a worker who has been with a major IT company for the past five years. They are eligible for 20 shares in the first year and 100 after five years under the company’s ESOP. The value of the shares will be paid out to the retiree. Options on stocks, limited shares, and stock appreciation rights are all examples of the kinds of stock ownership plans that might be implemented.
The ESOP’s advantages for employees, vendors, and businesses are spelt out in the plan’s contribution structure. Employees who feel a sense of ownership over the company are more likely to contribute to its success by behaving and thinking like owners. A stock ownership plan can help a company in several ways, including:
- provide an advantageous trading environment for the shares of leaving shareholders
- Boost morale and encourage workers.
- Recognize and reward staff for hard work and success.
- Get resources through incentives.
- use pre-tax dollars
- borrow funds at a lower cost after taxes
- make contributions to employee
You can use an ESOP to purchase or obtain stock from the company and then hold it for employees at no expense to them. Fundamentally, employee stock ownership plans work by:
- Creating a trust: The trust is a type of legal entity used to hold the employee’s stock on their behalf.
- Contributing or borrowing money: An employer can contribute to an employee’s trust or obtain funds from a third party to do so. Leveraged ESOPs are utilised frequently by businesses and organisations and involve the borrowing of funds from a seller or bank.
- Purchasing company shares: With the funds raised, the trust will make an initial purchase of shares from the issuing firm. The value of these stocks is determined by an outside or contracted valuer.
- Distributing company shares: If an employee has a traditional account, shares are split evenly between them; if they have a leveraged account, shares are distributed in proportion to the principal repaid on any loans used to fund the account. After that, the worker is considered a shareholder in the business[2].
The benefits of adopting an ESOP are multi-pronged, being advantageous for both owners and employees. The following are advantages to consider:
Benefits of an ESOP
Whether you’re an employer, an existing shareholder, or an employee/participant, an ESOP offers a wide range of perks and advantages.
The Benefits to the employees
An ESOP can be a substantial source of wealth for a retiree if they have worked for the same company for a long time and the stock has increased in value. Employees who stay with the company the longest and make significant contributions to its success are the ones who stand to gain the most from an ESOP. Every employee receives an equal number of shares in their account, funded entirely by the corporation.
Employer contributions and earnings in an ESOP are not subject to taxation for employees until distributions are made. Income tax repercussions of distribution may still be mitigated or postponed, however, by “rollovers” into an IRA or through the use of unique averaging techniques for computing taxable income.
Following termination of employment, the employee is entitled to receive the “vested” portion of the benefit in accordance with the vesting schedule established in the ESOP agreement. Payments to shareholders may be made in cash or shares. Participants may receive money in exchange for their shares if the Plan or the company exercises its right to “put” and buy back the stock. This is especially helpful for people involved in privately owned companies whose stock is not traded publicly[3].
The Benefits to Shareholders
A privately held company’s shares may find buyers and sellers through an ESOP. There would be no other source of liquidity for outside shareholders’ equity if not for the ESOP. Participants, beneficiaries, large shareholders, and shareholder estates are all eligible to use this function.
A selling shareholder can avoid the uncertainty of a deferred payment arrangement by taking advantage of the ESOP’s leverage.
The Code provides for particular tax incentives for stock transactions to an ESOP, under specified criteria and limitations. By selling shares to an ESOP, a shareholder of a closely held corporation could reinvest the proceeds in other qualifying securities and postpone paying tax on the gain until later.
The Benefits to the employer
Contributions to an ESOP must, by law, be invested largely in employer stock. It’s also the only qualified employee benefit plan that can buy equity in the company using borrowed money. These distinctions give a business employing an ESOP as a corporate finance tool a great deal of leeway to pursue strategic goals that would be impossible with any other financing mechanism.
The Employee Stock Ownership Plan (ESOP) is a method of corporate financing that allows businesses to acquire assets or shares at a concession using borrowed capital. The principle and interest payments on an ESOP’s debt service obligations can be made by the employer with pre-tax cash due to the tax-deductible nature of contributions to an ESOP. If you use your dividends to pay off debt, you may be eligible for a tax break.
When employees have equity ownership in the company, it has a good effect on the employer and the shareholder. Because of this, productivity, profitability, and overall business performance are all enhanced[4].
Conclusion
An ESOP can be a straightforward or intricate method of employee benefit and corporate funding. To ensure tax deductibility in accordance with Internal Revenue Service laws and to meet the employee benefit plan criteria of the Department of Labour, its feasibility should be assessed by qualified lawyers, accountants, and administrators.
[1] https://economictimes.indiatimes.com/definition/esop
[2] https://www.esopinfo.org/how-esops-work/
[3] https://www.sebi.gov.in/sebi_data/attachdocs/1289549364138.pdf
[4] https://www.angelone.in/knowledge-center/share-market/esop
