How employee stock option plan or ESOP works

ESOP or Employee Stock Option Plan is a benefit plan for employees in which if employee wants then they can become owners of the company. Companies in India and abroad use this method to attract and retain talented employees within the organization. Many companies are also able to manage the employee turnover through this method.

In ESOP, an employee will be allotted stocks of the employer company at a particular price set on the grant day. The ESOP option will have a maturity period. Within that period employee can select to exercise the option at the predetermined price.

ESOP or employee stock option plans

Please remember, Employee Stock Option Plan or ESOP gives the employee a right to buy certain amount of shares in the employer’s company at a predetermined price, there is no obligation to buy.

However, if employee exercised his ESOP option then employer is obliged to sell the required number of shares to employee at the predetermined price. Predetermined price is also known as exercise price. This method is commonly known as call option, option to buy.

This means there will be a contract between the employer and employees to give the right to buy a specific number of employer’s shares to employees at a fixed price within a certain period of time.

If the company’s share market price rises above the predetermined call price then the employee could exercise the ESOP option, pay the exercise price and would be issued with ordinary shares in the employer’s company.

Benefit for the employee will be the difference between current market price and exercise price.

If stock’s market price falls below the exercise price at the time of near expiration then employee will not exercise the ESOP option as he is not obliged to do so. In this case the option to buy employer’s company share will lapse after the period over.

Another best reason why companies issue employee stock options or ESOs as part of employee’s compensation is to stop cash outflow which could have been spent by paying bonus or incentives.

After exercising the employee stock option plan, employee can either sell the shares in current market or hold on to it in the hope of further price appreciation.

In ESOP, employee can also avail the option in a phased manner.

In India, Employee Stock Option Plans or ESOP are popular in IT industry. Companies like Infosys have these schemes to retain employees within the organization. Infosys is the first company in India to issue ESOPs.

Employee stock option plans should not be confused with the term Employee Stock Ownership Plans, both are different. In our next article we will cover employee stock ownership plans.

ESOPs are taxable in the hands of employee. We will cover it later.

Example of Employee Stock Option Plan or ESOP

Let us assume that company XYZ limited on 1st April 2014 has granted you 100 shares under its employee stock option plan or ESOP at a predetermined price or exercise price of Rs 100 per share with a vesting period of 1 year. Current market price of the stock is also Rs 100.

Now you have the right to avail the option only after a year i.e. on or after 1st April 2015.If the current market price on or after 1st April 2015 is more than the predetermined price then you pay the predetermined price of Rs 100 and get the shares.

If the current market price on or after 1st April 2015 is more than the exercise price of Rs 100 then you have right to not to avail the option as open market price is lesser than the ESOP price.

If price has gone up after availing the option then employee can sell the shares and make profit.

Editorial Staff at Yourfinancebook is a team of finance professionals. The team has more than a decade experience in taxation and personal finance.