ESOPs: What They Are, How They Work, and Their Advantages

by Alina Khan

Published On July 26, 2023

In this article

In today's competitive business landscape, companies are continually seeking innovative ways to attract and retain talented employees. One such employee benefit that has gained significant popularity is the Employee Stock Option Plan (ESOP). ESOPs offer employees a unique opportunity to become stakeholders in the company they work for, aligning their interests with the company's growth and success. In this article, we will delve into the world of ESOPs, exploring what they are, how they work, their benefits, different types, and providing a real-life example to illustrate their impact. Let's unlock the secrets of ESOPs and discover how they can be a win-win for both employees and companies.

What is an Employee Stock Option Plan (ESOP)?

An Employee Stock Option Plan (ESOP) is a company-sponsored employee benefit program that grants eligible employees the right to purchase company shares at a predetermined price during a specified time frame. ESOPs are primarily designed to incentivize and reward employees for their dedication and contributions to the company's growth. By offering employees the chance to own a piece of the company they work for, ESOPs foster a sense of ownership and loyalty among the workforce.

ESOP and Other Forms of Employee Ownership

Employee ownership plans come in various forms, presenting additional benefits to employees while reflecting the corporate culture that companies seek to maintain. Beyond Employee Stock Ownership Plans (ESOPs), there are several other versions of employee ownership, each tailored to cater to diverse objectives and preferences. Let's explore the array of employee ownership options, ranging from direct stock purchase plans to stock options and phantom stock.

Direct Stock Purchase Plans (DSPP)

Direct Stock Purchase Plans allow employees to purchase shares of their respective companies using their personal after-tax funds. Some countries offer special tax-qualified plans that enable employees to buy company stock at discounted prices, making it an attractive option for those seeking to invest in the company they work for.

Restricted Stock

Restricted Stock grants employees the right to receive company shares either as a gift or a purchased item once they fulfill specific restrictions. These restrictions may include working for the company for a specified period or achieving particular performance targets. Restricted stock motivates employees to stay committed to the organization and strive for exceptional performance.

Stock Options

Stock Options provide employees with the opportunity to buy company shares at a predetermined fixed price within a set timeframe. This form of ownership enables employees to benefit from potential increases in the company's stock value, making it a rewarding incentive for long-term dedication and loyalty.

Phantom Stock

Phantom Stock, also known as Shadow Stock, offers cash bonuses to employees based on their exceptional performance. The value of these bonuses is equivalent to a certain number of hypothetical company shares. Though employees do not actually own the shares, they receive financial rewards akin to stock ownership, aligning their interests with the company's prosperity.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights grant employees the right to benefit from the appreciation in the value of a specified number of shares. Unlike stock options, companies settle these rights by paying employees in cash, allowing them to enjoy the financial gains without owning the actual shares.

These diverse forms of employee ownership go beyond the traditional ESOP model, offering companies flexibility in structuring their incentive programs. Each plan has its unique advantages, allowing organizations to design customized ownership structures that resonate with their corporate values and employee aspirations. By extending the opportunity for ownership, companies nurture a culture of dedication, collaboration, and shared success, ultimately fostering a cohesive and motivated workforce that drives the organization's growth and prosperity.

How Does ESOP Work?

Here's a step-by-step breakdown of how ESOPs work:

  1. Granting of Options: The company's board of directors approves the ESOP, determining the number of shares to be allocated to eligible employees. These shares are offered to employees in the form of stock options.

  1. Vesting Period: Employees typically need to complete a specific period, known as the vesting period, before they can exercise their stock options. This period can range from a few months to several years, encouraging long-term commitment and retention of valuable talent.

  1. Exercise Price: The exercise price, also known as the strike price, is the predetermined price at which employees can purchase the company shares when they exercise their options. This price is usually set at the fair market value of the company's stock at the time the options are granted.

  1. Exercise Window: Once the vesting period is over, employees have a specified exercise window during which they can choose to exercise their stock options. This window is usually limited to a certain timeframe to prevent indefinite delays in decision-making.

  1. Tax Implications: When employees exercise their stock options, they may be subject to taxation based on the difference between the exercise price and the current market value of the shares. Tax regulations may vary based on the country and local laws.

Benefits of ESOPs

ESOPs offer several advantages to both employees and companies:

  1. Employee Motivation and Loyalty: ESOPs create a sense of ownership and pride among employees, leading to increased motivation, loyalty, and commitment to the company's success.

  1. Retention of Talent: By providing a long-term incentive through the vesting period, ESOPs encourage employees to stay with the company, reducing turnover and retaining valuable talent.

  1. Alignment of Interests: When employees become shareholders, their interests align with those of the company, fostering a culture of teamwork and shared goals.

  1. Wealth Creation for Employees: As the company's value grows, employees have the opportunity to share in the company's success, potentially reaping financial benefits through the appreciation of their stock options.

Types of ESOPs

ESOPs come in various forms, catering to different company structures and objectives. The most common types include:

Broad-Based ESOPs:

Broad-based ESOPs are designed to cover a significant portion of the company's workforce. They extend stock ownership to a wide range of employees, ensuring that even those at lower levels can participate and benefit from the program.

Selective ESOPs:

Selective ESOPs target specific groups of employees, such as executives, managers, or key contributors. These plans are often used to retain and reward top talent critical to the company's success.

Leveraged ESOPs:

Leveraged ESOPs are funded through debt, allowing the company to borrow funds to purchase shares for the employees. As the company repays the debt, employees' shares become fully vested.

What is an Example of an ESOP?

A prominent example of an ESOP can be found in the Indian startup ecosystem with Flipkart, one of India's largest e-commerce platforms. In 2018, following the acquisition of Flipkart by Walmart, the company initiated a buyback of $100 million worth of ESOPs, marking one of the largest liquidity events for employee shares in the Indian startup landscape. The ESOP buyback not only provided substantial financial rewards to employees but also demonstrated the potential of ESOPs in contributing to wealth creation in startups. The event underlined the importance of ESOPs in the broader employee incentive and reward strategy and highlighted how such schemes could foster employee loyalty and dedication.


Employee Stock Option Plans (ESOPs) are powerful tools that can transform the way employees perceive and engage with their workplaces. By granting employees ownership in the company, ESOPs foster a culture of dedication, loyalty, and shared success. Employees are motivated to contribute to the company's growth, and in return, they have the opportunity to reap financial rewards as the company prospers. Companies that embrace ESOPs often find that they not only attract and retain talented individuals but also build a committed and unified workforce, driving the organization toward greater heights. As businesses worldwide recognize the immense advantages of ESOPs, these employee benefit programs are undoubtedly here to stay, revolutionizing the way companies and employees collaborate to build brighter futures together.


  1. What is the purpose of an Employee Stock Option Plan?

The purpose of an Employee Stock Option Plan (ESOP) is to incentivize and reward employees by offering them the opportunity to purchase company shares at a predetermined price, aligning their interests with the company's success.

  1. How are stock options granted to employees?

Stock options are granted to employees through the ESOP, where the company's board of directors approves the number of shares an employee can purchase at a specific exercise price during a set timeframe.

  1. What is vesting, and why is it important in an ESOP?

Vesting in an ESOP refers to the period an employee must work for the company before they can exercise their stock options. It is essential to retain employees and motivate them to contribute to the company's growth over the long term.

  1. How can employees exercise their stock options?

Employees can exercise their stock options once they have completed the vesting period. They can buy the shares at the predetermined exercise price and become shareholders in the company.

  1. Are there any restrictions on selling the shares acquired through an ESOP?

Yes, there are often restrictions on selling the shares acquired through an ESOP. Employees may need to hold the shares for a specified period or meet certain conditions before they can sell them to maintain alignment with the company's interests.

  1. Are there any tax advantages associated with ESOPs?

Yes, there can be tax advantages associated with ESOPs, although the specific benefits depend on local regulations and tax laws. In India, the taxation on ESOPs occurs at two stages - first, when the employee exercises the option to purchase shares, and second, when the employee sells those shares. The difference between the fair market value at the time of exercise and the exercise price is considered as 'perquisite' and is taxable as part of the employee's salary income. The second stage of taxation occurs when the employee sells the shares. Any gain from this transaction is considered as capital gains and is taxed accordingly. However, tax implications can be complex, and employees should consult with a tax advisor or professional to fully understand the implications based on their personal circumstances.

  1. How can leveraged ESOPs be advantageous for companies?

Leveraged ESOPs can be advantageous for companies as they allow them to borrow funds to purchase shares for employees. The company repays the debt using future cash flows generated by the company's operations, making it a tax-efficient method to fund employee ownership without diluting existing shareholders' equity.

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