How an Employee Stock Ownership Plan (ESOP) Works

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There are many ways for a company’s management to reward and recognize their employees for all their contributions and hard work that led them to forge a company that stands tall amongst others today.

Once a business achieves complete maturity and financial independence, the company must take over more significant decisions such as managing the equity or capital. Most companies list themselves in the stock market once they have achieved maturation, and decide how the stocks will be divided.

There are ESOP shares, Preferential Shares, Equity Shares, and so many other types of shares that need to be accounted for and distributed amongst the various stakeholders such as the owners of the company, the board of directors, the investors, the consultants, or agents, the employees and finally the public. Knowing the right strategy to go about this process is essential for any significant business.

How an Employee Stock Ownership Plan (ESOP) Works
How an Employee Stock Ownership Plan (ESOP) Works

ESOP and its Working Principle

ESOP or Employee Stock Ownership program is a stock option distribution plan that major companies adopt. In this method, a trust is set up that helps evaluate the stocks and shares and then devises a plan based on stock options or grants that can be provided to the employees. Preferential shares and equity shares are first pooled and accounted for.

Once they are assigned and distributed, the rest of the shares can be pooled in an ESOP pool – a dedicated and allotted set of shares that will be distributed to employees based on criterions such as length of service in the company, seniority, sales turnover achieved, etc.

It is to be noted that the employee stock option plan does not distribute shares of the company as such; it is only an Option or a Grant. The difference between a share and an option is that an option is only a right provided to an employee, access to a share but not the share as such.

The employee may or may not convert their option into stock. When a company or a business wants to reward its employees for their excellent work or to compensate senior employees who have been part of the company’s journey for the longest, the company provides such employees with a Grant letter that allocates a share option under the employee stock option scheme.

ESOP Share Price

It also contains information on criteria that must be met to convert these options into shares, the ESOP share price is the strike price at a discounted value. It is up to the employee to convert these grants or options into stocks.

They may either redeem these options and purchase the ESOP shares at the strike price (which is much lower than the market price, therefore, enabling the employee with an edge over the general public), or they may sell the options (not shares) back to the company at fair market value when the company calls for buybacks.

An employee may also use these shares to sell them outside of the company, sell to a replacement employee when they are exiting the said company, or sell to the company itself at buyback options. If a share right is exercised or sold back to the company as an option, the employee is bound to benefit from this system and monetize the share value.

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