What are ESOPs? What are some of their advantages and disadvantages?

What are ESOPs? What are some of their advantages and disadvantages?

June 4, 2021

What are ESOPs? What are some of their advantages and disadvantages?

Answer and ExplanationSolution by a verified expert


Employee stock ownership plan is a plan created by the company for the benefit of its employees. It is a retirement plan for the employee. The company contributes its stock to the scheme. The employees do not own the shares of the company directly when the employee is still employed with the company. The employee is entitled to the shares of the company on his retirement, termination or ceases to become an employee in any other way.
Advantages of ESOPS to the company are as follows:

Employees with ownership rights work for the ultimate benefit of the company to increase the shareholder's wealth. It makes employees realise that the harder they work, the larger will be the value of their retirement benefit. Thus it increases the value of the stock, which in turn helps in increasing their wealth in the company.
An attractive ESOP scheme deters the employee from leaving the company. The employee will not leave the company till the rights in the ESOPs are vested. Even if the employee switches the company, he may or may not be entitled to ESOPs.
The funds required by the company to contribute to ESOPs are available at a lower rate of interest. This is because the financial companies providing this funds are provided liberalised tax rates on the interest income they earn through ESOP funding.
ESOPs help to avoid takeover to a certain extent. When the ESOP owns substantial part of the company's share the employee representatives may oppose the management for takeover of the company. Takeovers usually lead to labour cutbacks which are not good for the employees. Moreover, takeovers affect the decision taking ability of the existing management.

Disadvantages of employee stock options are as follows:

A financial advisor or an expert needs to be hired for advising and creating policies related to employee stock options which increases cost to the firm.
Though ESOPs provide additional benefits to the employees, these benefits can be enhanced if the ESOPs were more diversified. Majority the ESOPs are contributed by the share of a single company. Thus, returns depend solely on the performance of one company.
There prevails a risk to the employees if the promoters sell their stake in the company. Promoters may have pledged the sales proceeds. This will adversely affect the company's future cash flows and will be used to repay the ESOP loans.
Although, investments in stock options are exempt from income tax but profits earned due to the difference in selling price and fair market value of shares at the time of selling are generally taxable under capital gains tax.

Verified Answer

Employee stock ownership plan (ESOP) is an employee benefit scheme where the company motivates its employees to acquire ownership in the form of shares at a price lower than the market price.
The company has following advantages of maintaining an ESOP:

Increase in productivity of employees.
Enables the retention of employees in the company.
Availability of funds for ESOP at lower cost, due to tax benefit to lending institutions.
Helps to avoid the takeovers.

Disadvantages of employee stock options are as follows:

Increased cost of hiring experts.
Lack of Diversification.
Risk of promoters selling their stake.
Profit earned by the holders from selling the options are taxable under capital gains.

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