Employee Stock Ownership Plans (ESOPs) are increasingly used by Indian companies to attract and retain talent while aligning employees with long-term company performance. Particularly in startup and growth-driven sectors, ESOPs act as both a compensation strategy and an ownership model.
Selecting the right ESOP type and financing method can significantly impact how effectively a company grows while keeping its workforce engaged. This article explores the key types of ESOPs, their financing methods, and how to align both with your business goals.
What is an ESOP
An ESOP is a structured scheme that gives employees ownership interest in the company. It is commonly used to reward employees through equity-linked incentives that vest over a defined period.
These plans are widely implemented by private and public companies, including startups, as part of compensation packages. They are governed by specific tax and regulatory frameworks under Indian corporate and income tax laws.
Why ESOPs help businesses grow
Well-designed ESOPs offer mutual benefits to companies and employees:
- Enhanced productivity: Employees with equity tend to show greater commitment and accountability.
- Talent acquisition: ESOPs attract skilled professionals, especially where salary budgets are tight.
- Retention: Multi-year vesting structures encourage long-term employment.
- Cost-effective growth: Companies can preserve cash by offering equity-based rewards.
However, the design and funding of these schemes determine how effective they are in delivering these benefits.
Types of ESOP
There are multiple ESOP types suited to different business stages, ownership structures, and talent needs.
Employee stock option plan (ESOP)
Employees receive options to buy shares at a fixed price (exercise price) after a vesting period. If the share value rises, they gain from the price difference.
Use case: Suitable for startups and private companies seeking to retain high performers without immediate cash outflow.
Stock appreciation rights (SARs)
SARs provide the monetary value of stock price appreciation, paid in cash or shares. No share purchase is required.
Use case: Ideal for companies that want to avoid equity dilution.
Restricted stock units (RSUs)
Employees are awarded shares upon meeting certain conditions such as tenure or performance. There is no exercise price involved.
Use case: Effective in mature companies with defined performance evaluation systems.
Phantom stocks
These are not real shares but mirror the value of company shares. Upon a trigger event (like IPO or acquisition), the employee receives a cash payout.
Use case: Favoured by unlisted companies that prefer to avoid equity dilution.
Employee share purchase plan (ESPP)
Employees purchase company shares—often at a discount—through salary deductions.
Use case: Typically adopted by listed companies to promote broad-based ownership.
ESOP financing: What it means
To gain from ESOPs, employees must exercise their options by paying the exercise price. For many, this cost can be significant, especially if the company’s valuation has risen sharply. ESOP financing allows employees to obtain funds to exercise these options.
It bridges the gap between grant and ownership, enabling employees to participate in equity without an immediate financial burden.
Types of ESOP financing
Loan-based financing
Employees borrow from banks or non-banking financial companies (NBFCs) to pay the exercise price. Repayments are often tied to future share sale proceeds.
Pros: Immediate ownership
Cons: Interest costs and financial risk if shares decline in value
Loan against fixed deposit is another option where employees can borrow funds by pledging their fixed deposits as collateral. This method typically offers lower interest rates compared to unsecured loans, but it carries the risk of losing the deposit if the loan is not repaid on time.
Non-recourse loans
The lender only recovers the ESOP shares upon default, not any other personal assets of the employee.
Pros: Lower personal liability
Cons: Often comes with higher interest or stricter terms
Employer-assisted buyback
The company agrees to repurchase shares at a future date, allowing employees to repay loans or monetise gains. This is common during funding rounds or before an IPO.
Pros: Easier liquidity for employees
Cons: Requires company commitment and financial planning
Payroll deduction
Employees repay the ESOP exercise amount through structured monthly deductions from their salaries.
Pros: No need for lump sum payments
Cons: Works best with low exercise prices and long deduction periods
How to choose the right ESOP and funding mix
Aligning the ESOP structure with business needs requires a balanced view of financial, legal, and human resource considerations.
- For startups: Plain ESOPs with flexible vesting and non-recourse funding are easier to manage.
- For established companies: RSUs or SARs may offer better control, especially when market value is high.
- For employees: Plans must be understandable, with manageable tax and cash flow outcomes.
- For finance teams: Dilution, tax liability, and funding costs must be evaluated before finalising the structure.
Taxation of ESOPs
Tax treatment of ESOPs involves two stages:
-
At exercise: The difference between the fair market value and the exercise price is treated as a perquisite and taxed as salary income.
-
At sale: Capital gains tax is applied on the profit from selling shares, depending on holding period.
For many employees, tax on exercise becomes a significant cost even before selling the shares. ESOP financing can also help manage this burden by including tax funding within the loan.
Common mistakes to avoid
- Overcomplicating ESOP terms: Complex legal language or conditions can confuse employees and reduce participation.
- Ignoring liquidity planning: Offering ESOPs without clear exit options can frustrate employees.
- No financing support: Without access to funding, many employees may let their options lapse.
- Poor tax planning: Failing to guide employees on tax liabilities can reduce net benefits and lead to dissatisfaction.
Companies should ensure ESOPs are treated not just as a reward tool but as a strategic investment in human capital.
Conclusion
ESOPs, when designed and funded correctly, can transform employee ownership into a driver of business growth. They align workforce interests with long-term company performance, reduce attrition, and attract top-tier talent.
By choosing the right ESOP structure—whether options, RSUs, or SARs—and implementing employee-friendly financing models, companies can maximise value for both employees and shareholders. With regulatory compliance, tax planning, and employee communication in place, ESOPs can serve as both a talent strategy and a financial catalyst.
If you are looking to scale your business with a motivated and invested team, investing in the right ESOP type and funding model may be the next logical step.
