ESOPs: The Basics and the Benefits
An employee stock option plan is an employee benefit plan that is flexible enough to be utilised to incentivize employees via equity ownership. As a result, ESOPs, according to theory, increase production and profitability while also creating a market for the shares. This increases shareholder liquidity and offers a mechanism for ownership transfer, which can aid in the transition from an owner/management group to an employee-owned management team.
Although ESOPs have been in use for a number of years – and their fundamental structure and advantages have changed with each new tax legislation — their basic structure and benefits have survived the test of time.
Employee stock option plan, merit examination and consideration for prospective applicability. Here is a quick review of the esop plan, a simplified explanation of the two forms of ESOPs, and a synopsis of the benefits of employee ownership to employees, stockholders, and employers.
An ESOP Defined
An esop plan is a type of employee benefit plan that qualifies for certain tax breaks under the Internal Revenue Code (“Code”). To take advantage of these tax benefits, it must follow the Code’s participation, vesting, distribution, reporting, and disclosure requirements. These restrictions are intended to safeguard the employee owner’s interests. Employee stock option plans are also subject to the restrictions outlined in the Employee Retirement Income Security Act of 1974 (“ERISA”), which basically established a formal legal standing for ESOPs and requires them to fulfil the Department of Labor’s employee benefit plan standards.
Esop plan also known as equity-based pay, are commonly considered as variable non-cash remuneration in the Total Rewards philosophy. Variable because its value swings as business valuations rise. Non-cash because all equity-based instruments are encashed by default as a result of stock market activity. As a result, the employee gets paid by the instrument’s buyer rather than the employer. There is no financial outflow for the company.
Every company strives to strike a balance between fixed and variable remuneration. The preference would be to include a significant non-cash component in variable pay. It is common practise in various businesses to have a larger variable component across all grades and designations. In other cases, the Pay philosophy gradually evolves into that model. Several established industries’ pay structures (for example, building and commerce) remain relatively robust in terms of fixed remuneration.
Total Rewards Concept of Employee stock option plan
In general, the Total Rewards composition changes along the lines shown above for steady-state firms in several industries, the Fixed cash component is already smaller than the Variable and ESOP components in the early years. This amount has been lowered over time and has been replaced by the Cash component. In contrast to what the image above portrays,
While this is the desired progression, what will it take to get there? In other words, can a corporation lower fixed compensation while increasing variable pay, and may the non-cash variable element replace the cash variable? If so, what steps must be taken to get there? We are not discussing whether the firm should go on this path in this conversation. That is assumed to be true.
The first stage is to rebalance the variable pay allocation by raising the Non-Cash (ESOP) component while decreasing the Cash (Performance bonus) portion. At first glance, this should not be difficult to convince because, at the end of the day, both are tied to company performance. However, a closer examination reveals significant disparities between the two.
- Assuming that the performance standards are satisfied, the performance bonus is cash in hand for the employee, which is both physical and genuine. Whereas an employee stock option plan begins with an option, then a share, and finally cash. The employee must pay the exercise price in order for the option to become a share. The step from share to cash assumes that the shares have a market and are liquid. While permitting cashless exercise can solve the first obstacle of paying the exercise price, maintaining a liquid market for the shares (of unlisted firms) is required to release funds.
- The relationship between company success and stock price rise is not entirely linear. Though both tend to go in the same way most of the time, there may be external factors that influence stock markets and cause them to move in a different direction than corporate performance. A situation in which stock prices rise despite poor performance is also possible in some instances.
Employees have little or no control over either supplying liquidity to the shares or causing the market to act in accordance with performance in both of these cases. As a result, they are hesitant to take chances. However, given the disproportionate growth in business valuations (particularly in unlisted firms), employees prefer ESOPs over traditional performance incentives, which are capped as a percentage of fixed compensation.
The second phase of decreasing fixed pay and boosting variable pay (non-cash variable) is more challenging since it may affect employees’ monthly take home pay. This is probable only at senior levels, when the sensitivity to a lower monthly take home pay is not as strong, or if ESOPs are practically as certain as cash.
If companies can address the above-mentioned concerns, ESOPs can certainly help to reduce cash compensation. Providing or ensuring share liquidity is a prerequisite for implementing an ESOP Plan, particularly in unlisted companies. Liquidity can be given by stock buybacks by the company, purchases by current or new investors, an IPO, or the cash settlement of options. No one can guarantee that the absence of correlation between performance and stock price will move in one way. It is preferable that this danger be fully addressed to employees so that they are aware of its ramifications. It is feasible to offer a safety net method, however, this is a debatable approach.
Globally, the adoption of ESOPs has assisted corporations in reducing cash pay. This has also been done in India, where firms who have employed ESOPs for more than 7-10 years have seen employees get substantially larger cash in hand than regular performance incentives. As a result, there is no standard response to the question. It’s neither a categorical yes nor a categorical no – it’s more of a maybe, a possibility, and a goal.
The positive aspects of an employee stock ownership differ depending on whether you are an employee/participant, a current shareholder, or an employer.
An ESOP can reward an employee with considerable retirement assets if the person has been with the firm for a long time and the employer stock has increased in value prior to retirement. The ESOP is primarily intended to reward employees who have been with the company the longest and contribute the most to its success. Because stock is distributed to each employee’s account based on a contribution from the firm, there is no expense to the employee for this benefit.
- Employees are not taxed on employer contributions to the ESOP or income made in that account until they receive dividends. Even in such case, “rollovers” into an IRA or unique averaging procedures used in income computation might lessen or postpone the income tax effects of distribution.
- When the employee’s involvement in the ESOP ends, they are entitled to their portion of the “vested” benefit based on a schedule included in the ESOP deed. Distributions can be issued in the form of stock or cash. A “put” option, on the other hand, which requires the Plan or the firm to buy stock delivered to participants, may pay cash in exchange for their shares. This is especially useful for participants in privately owned enterprises if the company has no market.
ESOP Benefits To Shareholders
- An ESOP can create a market for a privately owned company’s stock. The ESOP offers a ready, current market for outside shareholders’ equity, providing liquidity that would not otherwise be available. Participants, beneficiaries, prominent shareholders, and estates of dead shareholders may utilise this function.
- The ESOP leveraging allows a selling shareholder to obtain cash instead of incurring the risk of a delayed payment agreement.
- The Code provides for exceptional tax breaks for certain stock transactions to an employee stock ownership, subject to certain restrictions and rules. This would allow a tightly held firm shareholder to sell shares to an ESOP, reinvest the profits in other qualifying securities, and delay taxes on any gain from the sale.
ESOP Benefits To The Employer
The legislation requires an employee stock ownership to invest contributions largely in employer shares. It is also the only qualifying employee benefit plan that can borrow money on company credit to buy employer stock. These distinctions give tremendous flexibility for a firm employing an ESOP as a corporate finance instrument, allowing it to achieve corporate goals that would otherwise be impossible to achieve.
The employee stock ownership can be used as a corporate financing tool to issue fresh equity to repay outstanding debt or to buy assets or outstanding shares by leveraging with third-party lenders. Because contributions to an ESOP are entirely tax-deductible, an employer can use pre-tax resources to make both the principal and interest payments on an ESOP’s debt service obligations. Dividends used to repay debt may also be tax-deductible.
Another significant ESOP benefit for both the employer and the shareholder is the beneficial impact that occurs when employees have equity ownership in the firm. As a result, productivity, profitability, and overall company performance increase.
An ESOP is a popular employee perk and business financing tool, with structures ranging from basic to sophisticated. Competent lawyers, accountants, and administrators should assess its viability to assure tax-deductibility compliance with Internal Revenue Service laws and to fulfil the Department of Labor’s employee benefit plan criteria.