What is the difference between stock options and an employee stock ownership plan (esop)?

What Is Employee Stock Options Plan (ESOP)?

An Employee Stock Option Plan (ESOP) is a retirement or employee benefit scheme that allows employees to own shares of the company and have a financially stable post-retirement life. This provision helps strengthen the bond between employers and employees, encouraging the latter to stick with the former for a longer term.
Inhaltsverzeichnis Show

What Is Employee Stock Options Plan (ESOP)?
Employee Stock Option Plan (ESOP) Explained
Accounting For ESOP
Advantages & Disadvantages
Frequently Asked Questions (FAQs)
Recommended Articles
What is the difference between stock options and an employee stock ownership plan ESOP quizlet?
What is difference between ESOP and ESOS?
Is a stock option plan an ESOP?
What is an employee stock ownership plan quizlet?

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Any company can offer an ESOP at a discounted rate, which is considerably less than the market price. Hence, employees are willing to invest in these plans and buy shares of their company’s stocks, which gives them a feeling of ownership.

An employee stock option plan (ESOP) is an option granted to employees who carry the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as the exercise price).
These are complex call options granted by the companies as a part of the remuneration package.
Employee Stock Purchase Plan (ESPP), Employee Stock Option Scheme (ESOS), Restricted Stock Units (RSU), and Stock Appreciation Rights (SARs) are the types of ESOPs.
When stock options are exercised in large quantities, it can significantly impact the total number of outstanding shares, diluting the EPS and negatively affecting the firm’s valuations.

Employee Stock Option Plan (ESOP) Explained

An employee Stock Option Plan (ESOP) is a retirement plan that gives employees a sense of security and lets job seekers prefer getting employment in companies with ESOP provisions. ESOPs differ from exchange-traded options as they are not traded and don’t come with a put component. Though these options remain unlisted, they allow employees to invest and own the shares.

The employers issue stock options under the stock options compensation plan. Employees can exercise these options if the market price exceeds the exercise price or the strike priceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more, executing in-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more trade.

Once stock options are exercised, the company issues shares to the option holder. This, in turn, increases the total number of outstanding sharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more. As a result, earnings per shareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more (net profit/number of shares outstanding) decreases as the denominator increases.

Types

The employee stock option plan meaning becomes clearer as one explores its types. Employers can provide ownership of stocks in various forms – Employee Stock Purchase Plan (ESPP), Employee Stock Option Scheme (ESOS), Restricted Stock Units (RSU), and Stock Appreciation Rights (SARs).

ESPPs are schemes wherein companies offer shares to employees who complete a minimum service period. Then, they sell them at much lower than the market price. An ESOS, on the other hand, is a plan where employers offer options based on a pre-defined valuation. This works concerning the vesting period and the overall performance of employees. Employees can exercise the options at the pre-defined strike price as soon as they achieve the minimum vesting period.

The next is RSU, where employers grant company shares to employees with no particular vesting period or exercise price. Instead, the latter can exercise the right over the shares only when a local event occurs.

SARs, on the contrary, may or may not be considered an ESOP. This is because few companies prefer offering cash in exchange for shares to employees on meeting the specific criteria or conditions.

Accounting For ESOP

While allotting shares, companies calculate the difference between the fair market value at the exercise date and the price the employees pay at the time of subscription or at the time of exercise. This is the prerequisite value, eligible for tax deduction at the source.

On the other hand, the profit becomes a capital gain when an employee opts to sell their share. This is because taxes apply to capital gains – the difference between fair market value on the exercise date and the sale value of shares.

Example

Let us consider the following employee stock option plan example to understand how the concept works:

ESOP taxation – while exercising the option – The first condition for taxation

Prerequisite value of ESOP (at the time of allotment)
Market value = 120
Exercise price = 70
and the number of shares allotted under ESOP is 6000

Calculation of Prerequisite value of ESOP

Prerequisite value of ESOP = (fair market value- price at the time of exercise) * No of share

= (120-70) * 6000 =300,000

The above value of 300,000 is the prerequisite value of ESOP, which is a part of the employee’s salary. Therefore, it is taxable at the time of allotment of shares.

Advantages & Disadvantages

When companies offer Employee Stock Option Plan (ESOP), it builds motivation among employees. They own a share in the company’s stocks, which offers them a sense of belongingness, making them work even harder for the company’s progress. The ESOPs motivate employees and strengthen the relationship between employers and employees. In addition, these programs attract the best talents to join the company, which ultimately adds to its strength.

Besides the employee stock purchase plan benefits, there are a few disadvantages too that ESOPs are subject to. As the employees get a chance to own company shares, it dilutes the founders’ shareholding proportions. In addition, as the companies offering such schemes are unlisted, the shares’ liquidity is limited or non-existent. This, however, might lead to disputes between employers and employees.

Frequently Asked Questions (FAQs)

How to create Employee Stock Option Plan?

Based on the values and revenue of the company, the authorities design the ESOPs. Then, according to the plan, the company decides the criteria for the employees to fulfill to exercise the options granted. Next, the firms have a trust set up to purchase their stocks. The companies either make tax-deductible contributions to their shares or buy ESOP in exchange for cash. The trust then sorts the stocks and allocates a particular number of shares to individual employees’ accounts.

Are ESOPs qualified retirement plans?

Yes, these schemes are retirement benefit plans authorized and implemented by the federal government and other apply pension laws.

Do ESOPs pay taxes?

ESOPs are subject to taxes, and they are taxed twice. First, they are taxed for the first time when options are exercised and then as capital gains obtained from the shares.

What is the difference between stock options and an employee stock ownership plan ESOP quizlet?

Stock options are usually granted to company executives whereas ESOP's are provided to all employees.

What is difference between ESOP and ESOS?

Under ESOS, employees are given an option to purchase shares at a later date, i.e. after the vesting period. Under ESOPs, employees are given an option to purchase shares on the spot at a discounted price. The company may specify the lock-in period for the shares issued pursuant to the exercise of the option.

Is a stock option plan an ESOP?

An employee stock ownership plan (ESOP) is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan.

What is an employee stock ownership plan quizlet?

Employee Stock Ownership Plan. (ESOP) A plan whereby employees gain significant stock ownership in the organization for which they work. Advantages of ESOP. Favorable tax treatment for ESOP earnings. Employees motivated by their ownership stake in the firm.