In essence, Esop is a practice where companies give employees shares in the firm as part of their compensation structure. In some cases, Esop is generally referred to as an employee stock option plan. This is a trend we find across industries, but as of now it is more prevalent in the services sector such as information technology, financial services and pharmaceuticals.
What’s the benefit?
For the company, it is a deferred compensation plan, so the outflow in cash salary is restricted and takes shape in the form of equity. While there are many ways of doing this, the most popular is by issuing stock options. For the employee, this is an opportunity to make supernormal earnings by participating in the company’s overall growth rather than just drawing a salary based on the industry’s compensation standards.
How does it work?
At any time during a person’s employment, the company offers the opportunity to acquire shares at a reduced price over a period of time. Essentially, these are stock options given to the employee; the option relates to the choice that the employee has to buy the shares at a predetermined (often lower price as compared with the market value) price. This can be done after a fixed period of time, which means if an employee has been granted 10 stock options from his company, he will be able to convert it into tradable stocks only after a specified time has lapsed or once the stocks have “vested”, the period after which employees can exercise their right to buy the shares. After vesting the employee can convert the options into tradable shares by buying them from the company at the predetermined price.
How does it affect the company?
Employee productivity: It is believed that Esops help increase employee productivity by linking their efforts and commitment to ownership. If employees contribute to the betterment of the company by helping the business grow, it would lead to better earnings and hence better stock value and that in turn would increase the potential earnings of the employee. This is motivation enough to work sincerely.
Equity dilution: From time to time, any company needs capital for expansion; one of forms in which this comes in is institutional funding in exchange for shares. However, if there are lots of pending Esops, the equity base will expand and the earnings per share (EPS) will get diluted. This acts as a disincentive for institutional investors and can also affect share prices negatively. However, typically Esops are a very small portion of the overall equity of the firm and don’t affect EPS significantly.
Does it matter to you as an investor?
Quantitatively it does not significantly affect your investing decision, but you should consider the qualitative factor during stock selection. As mentioned above, Esops play a role in defining an employee’s motivation and productivity. This can lead to consistent growth in earnings, which bodes well for stock prices.