The Debate: ESOPs vs. Profit Sharing for Business Growth

If you don't create a great, rewarding place for people to work, they won't do great work ~ Ari Weinzweig.

Profit sharing and equity ownership are both great ways to reward employees, but they work in different ways.

Employees get company shares with equity compensation, giving them a direct stake in the business. Profit sharing, on the other hand, gives employees a share of the company’s profits, usually in cash, based on a set formula.

While profit sharing can sometimes be in incentive or cash, it’s not quite the same as equity compensation.

Understanding ESOPs vs Profit-Sharing can help you choose the right way to reward and motivate your team.

Understanding ESOPs

Employee Stock Ownership Plans (ESOPs) give employees a real stake in the company’s success, offering both a way to share in the profits and a valuable retirement benefit.

When employees have ownership, they feel more personally connected to the company’s growth. As the company thrives and its stock value increases, so do its rewards, giving it an extra incentive to push towards shared goals. By becoming shareholders themselves, employees’ interests align with the company’s, turning them into partners in the company’s success.

Understanding Profit-Sharing Plan

A profit-sharing plan allows companies to share a part of their profits with their employees, to motivate them and give them a feeling of ownership in the company’s success.

When a company offers a profit-sharing plan, it’s a way of showing employees that their hard work directly contributes to the company’s growth. It’s a simple “thank you” gesture for their efforts, which can boost morale and productivity. Plus, the money shared in a profit-sharing plan comes with the added benefit of being tax-deductible, making it beneficial for everyone involved.

Benefits of ESOPs and Profit Sharing for Companies, and Employees

Employee Benefits

From an employee’s perspective, ESOPs have a different serving perspective than profit-sharing plans. The idea behind the profit-sharing plan is to provide employees with short-term rewards that motivate them to hit their monthly and yearly goals and share a portion of the company’s profits to encourage employees to work harder.

However, employees don’t see a clear connection between their efforts and the rewards because profits are often reinvested into broader company needs.

ESOPs, on the other hand, offer some ownership in the company. Employees become shareholders, which gives them a sense of pride and belonging. They feel more connected to the company’s success because as the company grows, so do their rewards. Unlike profit-sharing, where market conditions can influence the value regardless of employee performance, ESOPs tie employee efforts directly to benefits. This creates a stronger sense of purpose and motivation, turning employees into true partners in the company’s success.

Company Benefits

Profit sharing and ESOPs are great ways to attract talented people and keep them engaged for long work tenures. By offering employees a share of the company’s success, you show them that they’re more than just workers; they’re partners. This helps inspire people to work harder, knowing their efforts directly impact the company’s growth.

From a business perspective, profit-sharing contributions can bring tax benefits, and employees may also enjoy tax breaks, depending on how the plan is structured. It’s a great benefit for both sides financially.

But beyond the numbers, these plans create a sense of encouragement and enthusiasm for contributing new ideas. When employees know they’re part of something bigger and that their hard work is being recognized, they feel more connected to the company and are more likely to stick around for the long haul.

Would Your Employees Rather Receive Profit Sharing Payments or Equity Share Ownership?

It’s a tricky question, and the answer could be both but not equally for everyone, as the two approaches serve different purposes.

Can a business consider both options? Absolutely. But should it? That depends on the goals of the company. Many businesses can identify which team members have the potential to take on ownership responsibilities and actively contribute to growth.

If the aim is to build a more inclusive culture where everyone feels invested, equity plans aren’t the only way forward.

An Employee Stock Ownership Plan (ESOP) allows private companies to share company ownership more widely. It allows business owners to sell shares at full market value, which are then fairly distributed among employees creating a win-win for the company and its team.

Some notable Examples of Profit-sharing and ESOPs

An example of an Indian company that has successfully implemented a profit-sharing scheme is Tata Steel.

Tata Steel - Profit Sharing Plan

• Overview: Tata Steel, one of the largest steel manufacturing companies in India and part of the Tata Group, has a long-standing tradition of employee welfare and engagement. The company has implemented various profit-sharing initiatives as part of its employee compensation strategy .


• Profit-Sharing Plan: Tata Steel offers a profit-sharing scheme that allows employees to receive a share of the company's profits based on its annual performance. This scheme is designed to incentivize employees by directly linking their compensation to the company's financial success.


• Benefits to Employees: Through this profit-sharing plan, employees can benefit financially when the company performs well. This not only provides them with additional income but also promotes a sense of ownership and belonging within the organization. Employees feel more motivated to contribute to the company's success, knowing that their efforts can directly impact their earnings.


• Impact on Company Culture: The profit-sharing initiative at Tata Steel has contributed to a positive organizational culture, where employees are encouraged to work collaboratively towards common goals. This alignment between employee interests and company performance enhances overall productivity and job satisfaction.

Other Examples of Companies with Profit-Sharing Schemes in India

1. Hindustan Unilever Limited (HUL):

HUL has implemented profit-sharing plans that reward employees based on the company's performance, fostering a culture of shared success.

2. Infosys:

Infosys has introduced various profit-sharing mechanisms to align employee interests with company performance, enhancing motivation and retention.

3. Wipro:

Wipro offers profit-sharing plans as part of its compensation strategy, allowing employees to benefit from the company's profitability.

These examples illustrate how profit-sharing schemes can effectively engage employees , enhance motivation, and contribute to a positive corporate culture while aligning employee interests with organizational success.

A notable example of a startup in India that has successfully implemented an Employee Stock Ownership Plan (ESOP) is Zomato.

Zomato - Employee Stock Option Plan

• Overview: Zomato, founded in 2008, is a prominent food delivery and restaurant aggregator platform in India. It has grown rapidly and became one of the first Indian startups to be listed on the stock exchange.


• Implementation of ESOPs: Zomato has offered ESOPs to its employees as part of its compensation package. This initiative allows employees to acquire shares at a predetermined price after a specified vesting period, thereby aligning their interests with the company's long-term success.


• Impact on Company Culture: The introduction of ESOPs at Zomato has cultivated a culture of shared success, where employees are encouraged to work collaboratively towards common goals. This alignment between employee interests and company performance enhances overall productivity and job satisfaction.

Other Indian Startups Examples with ESOPs

1. Ola:

Ola, the ride-hailing service, offers ESOPs to its employees as part of their compensation package, allowing them to benefit from the company's growth.

2. Paytm:

Paytm has implemented an ESOP scheme that enables employees to acquire shares, fostering a sense of ownership and aligning their interests with the company’s performance.

3. Razorpay:

Razorpay has established an ESOP program that allows employees to own a portion of the company, enhancing their engagement and commitment.

These examples illustrate how startups in India are leveraging ESOPs not only as a tool for attracting talent but also as a means of strengthening loyalty and driving performance within their organizations.

Frequently Asked Questions.

1. How does ownership work in an ESOP vs Profit-Sharing plan?

Key Differences in Ownership

2. Can a company offer both ESOPs and a Profit-Sharing Plan simultaneously?

Yes, the company can offer both ESOPs and Profit-Sharing Plans. The company can combine the two and let the employees enjoy the perks.

Two Ways to Reward: ESOPs let employees feel like real partners in the company’s future, while profit-sharing provides immediate rewards for their hard work. Together, they create a balance that keeps teams motivated in the short and long term.

Something for Everyone: Some employees get excited about building wealth over time through ESOPs, while others appreciate the instant recognition of profit-sharing. Offering both ensures everyone feels valued.

Keeping Employees Invested: ESOPs help employees feel connected to the company’s growth, while profit-sharing gives them a reason to celebrate the here and now. It’s a great way to inspire loyalty and hard work across the board.

3. What are the tax implications of ESOPs and profit-sharing for employees?

Tax Implications of ESOPs for Employees

1. At the time of Grant:

There are no tax implications when the ESOPs are granted to employees.

2. At the time of Vesting:

Similar to the grant stage, there is no taxation when the shares vest. Employees do not pay taxes on the appreciation in share value during this time.

3. At the time of Exercise:

• When employees exercise their options (i.e., purchase shares), the difference between the market price (Fair Market Value or FMV) at the time of exercise and the exercise price is treated as a perquisite income and is subject to income tax.


• This amount is added to the employee's salary and taxed according to their applicable tax slab. For example, if an employee exercises options at an exercise price of ₹100 per share, and the FMV is ₹250, then ₹150 per share would be considered a taxable perquisite.

4. Tax Withholding by Employers:

Employers are responsible for withholding taxes on this perquisite income at the time shares are allotted. The tax is deducted from the employee’s salary in the month when shares are exercised.

5. At the Time of Sale:

When employees sell their shares after exercising options, they may incur capital gains tax. The nature of this tax depends on how long they held the shares:

• Short-Term Capital Gains (STCG): If shares are sold within 24 months of acquisition, gains are taxed at a flat rate of 15%.
• Long-Term Capital Gains (LTCG): If held for more than 24 months, gains exceeding ₹1 lakh in a financial year are taxed at 20% with indexation benefits.

Tax Implications of Profit-Sharing for Employees

1. Tax Treatment:

• Profit-sharing payments received by employees are generally treated as ordinary income and are subject to income tax as per their applicable tax slab.
• These payments are typically included in the employee’s salary for tax purposes.

2. Timing of Taxation:

• Employees must report profit-sharing payments in their income tax returns for the year they receive them, making it essential for accurate financial planning.

Conclusion

Picking between ESOPs vs Profit-Sharing Plans can be challenging for the company the question of which one will work for the business.

Profit sharing can help a company retain its best employees and keep their morale up. However, this plan is adopted by profitable companies with Cash in the Bank. Equity Sharing can be an excellent choice for startups or early-stage businesses that are not so profitable or require Cash in the bank to grow their company. It is a smart move and an initiative by the companies to incentivize their employees and let them grow with the company’s success.

Whichever option the company chooses for its employees, it’s very important to analyze the business needs and implement the plan so that the company achieves the expected goal.