Different Types of ESOPs – Employee Stock Ownership Plans (ESOPs)

Employee Stock Ownership Plans (ESOPs) are a form of equity financing that allow employees to gain ownership in the company they work for. By becoming partial owners, employees are more motivated to contribute to the organization’s growth and success. ESOPs are powerful tools for enhancing employee engagement, improving productivity, boosting retention, and offering financial security, especially at the time of retirement.

Unlike cash-based incentives, ESOPs align the long-term interests of employees with those of the company. When employees benefit from the company’s performance, they are more likely to take initiative and stay committed to organizational goals.

However, not all ESOPs are the same. Companies may implement different types of ESOPs, each serving a specific strategic purpose. Some are designed for performance rewards, while others focus on retention or succession planning. In this article, we discuss six major types of ESOPs in detail, explaining their structure, purpose, and benefits for both employers and employees.

What are ESOPs?

Employee Stock Ownership Plans (ESOPs) are structured financial mechanisms that allow employees to become partial owners of the company they work for. ESOPs are not just tools for distributing shares—they are strategic instruments for building a strong sense of ownership, trust, and commitment among employees. Under these plans, companies allocate shares to eligible employees, often without requiring them to purchase the shares upfront. Over time, as employees vest into these shares, they begin to reap the financial benefits of company growth, especially during events like buyouts, public listings, or retirement.

The core idea of ESOPs is to align the interests of employees with those of the company’s shareholders and management. When employees own equity in the business, they are more motivated to perform well, contribute innovative ideas, and remain loyal to the organization. This creates a mutually beneficial relationship—businesses see higher retention and improved productivity, while employees gain long-term financial rewards.

ESOPs are often used by startups and established companies alike to attract and retain top talent. They are regulated to ensure fairness, mandating that all eligible employees should be given equitable access. Overall, ESOPs serve as a bridge between employee satisfaction and corporate success.

How ESOPs Work?

ESOPs function through a trust-based structure designed to hold company shares on behalf of employees. Typically, a company creates an ESOP trust fund, which acts as a legal entity managing the shares allocated for employees. These shares can be newly issued, purchased from existing shareholders, or acquired using borrowed funds (leveraged ESOPs). Once set up, the trust allocates shares to eligible employees, often based on factors like salary, designation, or years of service.

The plan follows a vesting schedule, meaning employees earn ownership of their allocated shares over a certain period. Until the shares are fully vested, they cannot be sold or transferred. A trustee is appointed to manage the ESOP trust, ensuring transparency, compliance with legal norms, and protecting employees' interests. This trustee oversees all ESOP-related activities, from share allocation to final distribution.

One of the standout features of ESOPs is non-discrimination—all eligible employees must be allowed to participate equally. This inclusivity promotes a unified culture of shared success and responsibility. Upon retirement, resignation, or a qualifying event, employees receive either the shares or the cash equivalent of their value.

Overall, ESOPs promote long-term engagement by making employees active contributors and beneficiaries of the company’s growth.

Types of ESOPs in India

The following are the different types of ESOPs in India:

Employee Stock Option Scheme (ESOS)

Employee Stock Option Scheme (ESOS) is a popular incentive tool used by companies to retain and motivate employees. Under ESOS, employees are granted options that give them the right—but not the obligation—to buy a certain number of company shares at a pre-determined price, called the exercise price, after a specific vesting period. The vesting period is usually based on time (e.g., 3 years) or performance milestones.

For example, if an employee receives 1,000 stock options at an exercise price of Rs.100 per share, and after 3 years the market price is Rs.250, the employee can purchase the shares at Rs.100 and sell at Rs.250, gaining Rs.150 per share. However, if the employee leaves before the options vest, the unvested options are typically forfeited.

ESOS is highly beneficial for startups and growing companies as it allows them to reward employees without immediate cash outflow. It also aligns employee interests with company performance. Companies must comply with SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, in India when offering ESOS. The plan boosts long-term commitment and ownership mentality among employees, making them stakeholders in the company’s success.

Employee Stock Purchase Plan (ESPP)

Employee Stock Purchase Plan (ESPP) is a program that enables employees to purchase company shares, often at a discount, either directly or through payroll deductions over a defined offering period. The discount is typically around 10% to 15% below the market price. This program encourages employees to become shareholders, aligning their interests with the company’s growth.

In most ESPPs, employees contribute a portion of their salary during the offering period, which is used to buy shares at the end of the term. The purchase price is often the lower of the price at the beginning or end of the offering period. For example, if the stock was Rs.100 at the start and Rs.120 at the end, with a 15% discount, employees would buy shares at Rs.85 (85% of Rs.100).

While many ESPPs are part of public companies, some private companies may also structure customized versions. Employees benefit from any increase in stock price, and companies benefit from increased employee loyalty and morale.

In India, ESPPs must comply with SEBI’s regulations if the company is listed. The plan is a low-risk way for employees to invest in the company they work for, while the discount provides an instant value advantage.

Restricted Stock Units (RSU)

Restricted Stock Units (RSUs) are a type of equity compensation where the company promises to give shares to employees upon the fulfillment of specific conditions, such as continued employment or performance targets. Unlike stock options, RSUs do not require the employee to pay an exercise price. Instead, the shares are granted outright once the conditions are met.

For example, a company may grant 1,000 RSUs to an employee with a 4-year vesting period. After each year, 25% of the RSUs vest, and the employee receives 250 shares annually. These shares typically come with restrictions on transfer or sale until full vesting or a liquidity event (such as an IPO).

RSUs are considered valuable because they guarantee the employee a certain number of shares if they meet the conditions, regardless of the share price at the time of vesting. However, taxes are levied at the time of vesting as perquisites under the Income Tax Act.

RSUs are especially favored in large tech and multinational firms, as they reduce the complexity of employee equity compensation. They provide direct ownership and can be a strong retention tool since employees must stay with the company to receive the full benefit.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) are performance-based incentives that provide employees with a cash or stock payout equal to the appreciation in the company’s stock price over a set period. Unlike ESOS, employees do not have to purchase the stock or pay any exercise price. Instead, they receive the monetary equivalent of the increase in stock value.

For instance, if an employee is granted 1,000 SARs at a base price of Rs.100, and the stock price rises to Rs.160, the employee gains Rs.60 per unit, totaling Rs.60,000. The payout can be in cash or equity, depending on company policy. However, there is no benefit if the stock price remains stagnant or falls.

SARs are particularly useful for companies that want to offer equity-linked rewards without diluting shareholding. It also protects employees from downside risk, as they are only rewarded if the share price appreciates.

In India, SARs are governed under SEBI (SBEB & SE) Regulations, 2021, and must follow specific disclosure and compliance norms. These rights help incentivize employees to work toward long-term value creation, as their rewards are directly tied to the company’s stock performance.

Phantom Stocks

Phantom Stocks are a type of deferred compensation plan that mimics real stock ownership without giving employees any actual equity. The company awards “phantom” shares that track the value of actual shares, and employees receive cash payouts based on the increase in share value over time. There is no physical issuance of shares or dilution of equity.

For example, if an employee is granted 1,000 phantom shares valued at Rs.100 each, and the share value increases to Rs.150 after 3 years, the employee receives Rs.50,000 as compensation (Rs.50 x 1,000). The payout may be made in a lump sum or over installments as defined in the plan.

Phantom stocks are ideal for private companies that want to share the company’s financial success without complicating ownership structures. It also avoids the compliance burden associated with issuing real shares.

These plans often have vesting conditions and may be linked to company milestones or individual performance. The value is taxed as income at the time of payout. Phantom stock plans are flexible and can be customized to meet organizational needs, making them an attractive option for rewarding senior executives and critical talent without actual equity transfer.

Conclusion

Knowing different types of ESOPs is important for both employers and employees to maximize the benefits of employee ownership. Each type serves a unique purpose—whether it’s enhancing performance, improving retention, or planning for succession. When implemented strategically, ESOPs can drive growth, loyalty, and create a culture of shared success. By choosing the right plan, companies can align employee interests with organizational goals and build a more motivated and committed workforce.

If you have any queries regarding ESOPs then you can book a consultation with Compliance Calendar experts through mail info@ccoffice.in or Call/Whatsapp at +91 9988424211.

FAQs

Q1. What is an ESOP?

Ans. An ESOP (Employee Stock Ownership Plan) is a program that allows employees to become partial owners of the company by allocating company shares to them. It aims to align employees' interests with company growth and success.

Q2. How do employees benefit from ESOPs?

Ans. Employees benefit from ESOPs through long-term wealth creation. As the company grows and its share value increases, employees gain financial rewards. They may also receive a payout when they retire, resign, or during company buyouts.

Q3. Are ESOPs only for senior-level employees?

Ans. No, ESOPs are designed to be inclusive. All eligible employees, regardless of position, must be given an equal opportunity to participate as per regulatory norms.

Q4. How are ESOPs taxed in India?

Ans. At the time of exercise, the difference between the market value and exercise price is taxed as a perquisite under the head ‘Salary’. Capital gains tax applies when shares are sold.

Q5. What is the vesting period in an ESOP?

Ans. The vesting period is the minimum time an employee must stay with the company before they can exercise their allocated ESOPs. It typically ranges from 1 to 4 years.

Q6. Can employees sell ESOP shares anytime?

Ans. No, employees can sell shares only after they are vested and exercised. For private companies, liquidity may depend on specific events like a buyback, merger, or IPO.

Q7. Who manages the ESOP?

Ans. An appointed trustee manages the ESOP trust. The trustee ensures compliance with legal requirements and acts in the best interest of the employees.