Investments can overwhelm you with complex terms and concepts, especially when trying to understand the nuances of employee benefits like Employee Stock Ownership Plans (ESOPs) and equity shares.
As an investor or even as an employee of a company offering these benefits, it’s crucial to comprehend these financial instruments. This post will demystify ESOPs and equity shares, highlighting their unique features, benefits, drawbacks, and key differences.
Definition and Basics
Employee Stock Ownership Plan (ESOP)
An ESOP scheme allows employees to own a part (or shares) of their company. It’s a common tool companies use to retain and incentivise their employees. Companies grant ESOPs to their employees, which can be converted into equity shares after a specific vesting period.
In simple terms, equity represents ownership in a company. If you own equity shares in a company, you technically own a part of that company. Equity is often purchased with the help of an online Demat account and can yield dividends or capital gains.
How ESOPs Work
Providing ESOPs is a strategic move by companies to keep their valued employees invested in their growth. The process of granting ESOPs involves several steps:
- The company extends an offer to the employee with specific terms and conditions.
- These ESOPs come with a ‘vesting’ period, during which the employee cannot sell the shares.
- After the vesting period, the employee can ‘exercise’ the options, meaning they can buy the shares at the predetermined ‘exercise price’.
- ESOPs in India come with certain tax implications. When the employee exercises the options, the difference between the fair market value and the exercise price is treated as a perquisite and is taxable. The income is considered capital gains and subject to taxes accordingly.
Equity shares represent a slice of the company’s assets and earnings. There are two primary types of equity shares – common and preferred.
- Common Shares: These are the most common equity shares investors buy through their online Demat account. Common shareholders have voting rights in the company but are last in line to receive any remaining assets if the company is liquidated.
- Preferred Shares: Preferred shareholders have a higher claim on the company’s assets and earnings. They receive dividends before common shareholders. However, they usually don’t have voting rights.
- Just like ESOPs, equity shares also have tax implications in India. The profit earned from selling equity shares is considered as capital gains and is taxed based on the holding period of the shares.
Key Differences Between ESOPs and Equity
ESOPs and equity shares may seem similar on the surface, but they have some fundamental differences.
- Ownership and Control: While ESOPs and equity shares represent ownership in a company, the key difference lies in their accessibility. ESOPs are only available to company employees, while any investor can purchase equity shares.
- Risk and Rewards: ESOPs are generally less risky as they are offered at a discounted price. However, they may lack diversification since they are tied to the employer. On the other hand, investing in equity shares offers the potential for higher returns but also comes with higher risk.
- Tax Implications: The taxation of ESOPs and equity shares is different. The exercise of ESOPs is taxed as a perquisite, while the sale of shares (both from ESOPs and equity) is taxed as capital gains.
Pros and Cons of ESOPs
ESOPs come with their own set of advantages and disadvantages:
- Benefits: ESOPs can be a powerful tool for employee retention and motivation. They allow employees to share in the company’s growth and success. As they are generally offered at a discounted price, they present a potentially profitable opportunity for employees.
- Drawbacks: ESOPs lack liquidity as they come with a vesting period during which the options cannot be sold. Additionally, since they are tied to one company, they lack diversification, which could be risky if the company doesn’t perform well.
Pros and Cons of Equity
Equity shares also have their own set of pros and cons:
- Advantages: Equity shares offer the potential for high returns, especially in the long run. They provide voting rights, giving shareholders a say in the company’s important decisions. Plus, they offer liquidity as they can be easily bought and sold through an online Demat account.
- Disadvantages: Investing in equity shares comes with risks. The stock market is unpredictable, and there’s always a chance that the share price may go down, leading to potential losses.
Both ESOPs and equity shares offer unique opportunities and challenges. By understanding their key differences, benefits, and drawbacks, you can make a more informed decision about which one aligns better with your financial goals.
Always remember diversification is key in investing, and it’s essential to maintain a balanced portfolio. Read more blogs on our website.