“Under an ESOP, you treat employees with the same respect you would accord a partner. Then they start behaving like owners. That’s the real magic of an ESOP,” explained Don Way, chief-executive officer (CEO) of a California-based commercial insurance firm, in Nation’s Business. A more textbook definition of an employee stock option plan (ESOP) is this – a right that permits you, as an employee, to purchase a certain number of shares of the company at a pre-established price. The favorable tax benefits for the holder of such a right are:

(1) delays his or her personal taxable event until the stock is actually sold by the holder (instead of at the exercise of the option) and

(2) receive long-term capital gains treatment for gain at the point of sale of stock (instead of ordinary income tax rates)

Why ESOP?

An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. The company incentivises an employee to think of ‘continuous employment’ as typically, the plan will state a period from the date of the grant of options until say, two years before the date of exercise of the stock option. Experts believe that turning employees into shareholders increases their loyalty to the company and leads to improved performance. Internationally, ESOPs are used for granting retirement benefits to employees and as a succession plan for owners.

How is it set up?

The options are granted pursuant to a written stock option plan that is required to be adopted or approved by the shareholders of the company. They are mostly nontransferable and can only be exercised by the employee. However, if the employee dies, the employee’s heirs or beneficiaries can exercise them.

In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some other formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting.

How does it work?

The company grants to an employee the right (option) to buy a certain number of shares in the company at a fixed price for a certain number of years (option period).

The fixed price is called the ‘grant’ or ‘strike’ or ‘exercise’ price and is usually the market value / fair value of the shares on the date of grant.

Since the grant price remains fixed over the term of the option, the employee expects that the share price would increase and he would gain by exercising his option at a lower price and if it falls he is insulated from the risk of having to buy it, since he only holds a right not an obligation.

Before the employee can exercise the option he usually must complete the vesting period (or fulfill other vesting restrictions) which typically, require that he continue to work for the company for a minimum number of years before part or all of the options can be exercised. Sometimes, certain performance targets are set before the options can be exercised.

What is a vesting Period?

Vesting period is the period of time involved in attaining the entire set of rights or privileges associated with an ESOP scheme. The overall vesting period is normally divided into a number of incremental periods, with each period reflecting an additional amount of time that the company continually employs the employee.

Vesting periods may begin with the original date of employment, once the employee completes probation or after he successfully completes the company-required criteria based on performance.  The person usually has to be considered a ‘permanent employee’ to participate.

Two terms to be understood here are– vesting percentage and vesting period. Vesting percentage refers to that portion of options that an employee is eligible to exercise. Vesting period is the period on the completion of which the said portion can be exercised.

The following table presents an example of an employee who is granted 120 options on January 1, 2011 with a vesting schedule of 25 per cent and 75  per cent at the end of one and two years from the date of grant respectively.

What is exercise?

The act of converting the options granted by paying the price is called the exercise of the option. The price that you pay in order to convert the option to shares is the exercise price and the period over which you exercise the option is the exercise period, it begins from the day of vesting, as you can exercise any day from thereon. Once your options are vested the decision to exercise is solely yours.

The basics of ESOPs will now let us work through the following series on when you should issue ESOPs and how to negotiate the sale of the ESOP in a sale of business or in a capital-raise scenario.