How ESOPs Works
By: Rishabh Chandel
Tags: Esop, Taxes, Employees, Wealth, Startup

If you are working in a start-up or want to work with one, the biggest attraction is ESOPs. Employee Stock Option Plan. There are so many conversations going on about ESOPs. Someone got lakhs or crores of ESOPs, some start-ups are going public, some are on an ESOPs buyback spree. I love the fact that in India, wealth creation as a start-up employee is possible. And that is fascinating because until now we heard stories of Google or Uber employees becoming millionaires. But now, things are changing in India, and through this blog, I want to tell you about everything important for ESOPs. Understanding the basics of ESOPs is immensely critical. ESOPs are not simple. Sometimes, employees do not bother to understand how their ‘options’ will work. Failure to understand the intricacies is likely to leave you disappointed later on.

What are ESOPs? Think about the stock market when you see Reliance, HDFC, or any other companies shares going up and down, what is that? That is a price for a single share or stock of the company, correct? There will be stocks or share in a company. And to buy them one has to pay the price. ESOPS are not stocks but are stock options. There is a huge difference. This means that if you are an employee, the company is giving you options that sometime in the future you can buy the stocks of this company at a predetermined price(exercise price), which is usually negligible or very low price. This is great because if the company is doing well, they are getting a lot of funding, a lot of valuation has been done, then each and every stock is immensely valuable, right. Simply based on these ESOPs, you can earn a lot of wealth over a period of time. However, there are a lot of nuances, which one must know.

Five basic things:

Value of ESOPs: how many ESOPS are you getting, and what is the worth. Vesting period: how long will it take you to get these ESOPs. Cliff: the minimum time you will have to be in the company to get these ESOPs. Exercise period: which is after leaving the company what will be the time you will get to exercise these options. Taxation: how tax is calculated on ESOPs.

Let’s understand each point in detail.

Value of ESOPs

The first one, most fundamental, right, and that is how many ESOPs am I getting? Usually, ESOPs will be determined in value. Suppose there is a company whose value is 1,00,000 rupees, for simplicity’s sake. And the company has 10,000 shares. This means that every share’s value is 10 rupees(valuation/no. of shares). Now, if the company tells you that they are giving you 1000 rupees worth of shares, then this means that they are giving you 100 ESOPs. That is how the value of ESOPs is determined. However, at the point when your ESOPs are granted to you, that is the value for those ESOPs at that point. And then your hope is this company will be doing well in the future, because of which the valuation will increase, the price per stock will increase, and because of that the stocks units or ESOPS that I have got their prices will increase as well. Now, what does that mean in the current example? You got 100 ESOPs and each ESOPs value is ₹ 10. Say, after 6 months, there is new funding and now the value of each stock is not ₹ 10 but is ₹ 15. So, now suddenly, you did get ₹1000 worth of ESOPs, but their notional value is now ₹1500. That is how your ESOPs value keeps increasing. However, this is just a fundamental basis, what are the other nuances?

Vesting period

At what point or by what time period will you get these ESOPs? One company will never want to a person who has recently joined, give 100 ESOPs, then after one month you say, it is not working out and you leave. You leave, and you take away these 100 EOSPs with you. The company doesn’t stand to benefit at all, right? So, what do they do? They put these ESOPs in a vesting period. This means that you will not get ESOPs right away, you will get them over a period of time. What does it do for the company? It ensures that, for that period of time, if these ESOPS are important for you, you will remain associated with the company. It also helps them spread the ESOPs over a period of time. It is interesting for you as well because per year as you spend time in the company, you will keep getting more ESOPs, which is great. How does it usually work? Mostly it is yearly vesting. This means that every year there will be equal vesting and typically in India, there are 4 years of vesting. Meaning, if you have received 100 ESOPS, then every year, you will get 25 ESOPs. There is one more approach to it where aggressive companies want you to stay with them for four years and don’t leave them before that, then they backload these ESOPs. So they over four years don’t give you 25% each, they over four years give you the first 10%, then 20%, then 30% and finally 40%. A lot of employee-friendly companies, reverse it completely. They say we won’t do 10, 20, 30, 40, we will do 40, 30, 20, 10. Not many companies do this, but if you are associated with them, you know that they care about you and its employee a lot. A lot of companies say that one year is kind of unfair. Why? Let say you have spent 18 months in the company, so suddenly it may happen oho! IF I leave the company now, then I will get only one year of ESOPs, because the second year is yet to get completed. And companies don’t what that if an employee is checked-out or not contributing and only there because of the ESOPs. So, what do they do? Instead of yearly vesting, they make it quarterly vesting. So, every three months, you will get ESOPs. So, if you get the same 100 ESOPs, you won’t get 25 ESOPs every year, instead, you will get 6 ESOPS after the third month, again 6 ESOPSs after the sixth month, again 6 ESOPs after the ninth month, and finally in the 12th month 7 ESOPs(6+6+6+7 = 25). There is nothing called 6.25 ESOPs, it will always be a round figure. That is called the vesting period. Following this is the third thing called the cliff — the same logic.

Cliff

The company doesn’t want you to work for just 6 months. And if there is quarterly vesting, then you take 2 quarters vesting and leave. They want you to at least spend a minimum of time in the company. And that is called the cliff. This means how much will you have to climb and only after will you start getting ESOPs. Cliff! Most companies have a cliff of one year. This means before one year, if you leave the company you will not get any ESOPs. Only after completing one year, you will get the first allotment. And that means if you have got 100 ESOPs, then for the first year, you don’t get anything. At the end of the first year, you will get 25 ESOPs. And if there is quarterly vesting, then after every 3 months, after the first year, you get “6,6,6,7”, “6,6,6,7” and it continues. The fourth point and this I think is the most misunderstood. I won’t even say it is misunderstood, instead, it is an unknown point.

Exercise period

This is called the exercise period. What does this mean? You haven’t received the company’s stocks yet. All you have is the company’s stock options. This means that you have the option to buy the company’s stocks. That doesn’t mean you still have it. To convert this stock option into stock, you will get a time, and that is called the exercise period. A lot of companies, in India, have allotted three months as an exercise period. This means, at any point in time if you leave the company, then in three months, you will have to convert your ESOPs into stocks. If you don’t do that, then ESOPs will vanish. They are not there anymore. A lot of companies are booming that is thankfully employee-friendly, and they are saying that three months is not fair, we want to give them more time. So, there are many companies which give 5 years, even 10 years as an exercise period. Now the question that arises is “how does it matter?” If I want to convert these ESOPs into stocks. I will do it quickly. It’s not that easy. As per the income tax laws, ESOP is one of your incomes. Because you haven’t spent any money on that. Then whatever you get is an income. So, when you convert your stock options into stocks, then you will generate an income for yourself. And that means you will have to pay Income Tax. And that is not a great feeling. Why? Because you haven’t received any money for these stocks. You have only become the owner of these stocks. But you still have to pay the money to the government. So, if you have, let’s assume received 100 ESOPs, and you have resigned and you want to convert these 100 ESOPs into 100 stocks, and each stock price is ₹ 10, then the government will tell you that you have received ₹ 1000 income. And on this ₹ 1000, you will have to pay tax, which is, let’s say you fall under 30% tax slab, then Rs. 300. Now you haven’t received ₹ 1000. The only thing you have got are stocks. But you will have to pay ₹ 300 to the government from your pocket. And that’s why most people don’t do that. What do they wait for? They wait for a point when they can convert these stocks into money. That can be new funding round, that can be an IPO, that can be sales, that can be a secondary purchase. The basic thing is to convert stock into money. There will be an event and at that event, people exercise their ESOPs. Because they say that if I convert 100 ESOPs into stocks, and I will get ₹ 1000 and even if I have to pay ₹ 300 to the Government, then also there won’t be an issue, at least I have received ₹ 700. And that is a better situation. Exercise period is a very, very important part, and as I said an unknown part of ESOPs. If you know about these four things, then you will have clarity about your ESOP grant.

Taxation

Interestingly, ESOPs are taxed at 2 instances. First, when you exercise your options, and second when you sell your stocks. Let’s understand both scenarios in brief. When the employee has exercised the option, the difference between the FMV(Fair Market Value, which is the value of the stock on the exercise date) and the exercise price is taxed as perquisite. So, if a stock value is ₹ 15 on the exercise date and let say the exercise amount was ₹ 1 and you have 100 options, then you will be taxed on ₹ 1400((FMV — exercise price) X number of stocks). And the tax will be according to your salary bracket. If the employee sells these shares, another tax event happens. The difference between the sale price and FMV on the exercise date is taxed as capital gains. So assume you sell your stocks for ₹ 30. Then capital gain tax will be deducted on ₹ 1500((sell price — FMV) X number of stocks). And this can be long-term or short-term capital gain tax according to the time you hold your stocks for after the exercise date. So, to summarize:

Exercise price < FMV < sell price ESOP will be taxed on (FMV — exercise price) at the time of exercise, as a prerequisite. And again on (Sell price — FMV) at the time of sale by the employee, as a capital gain.

One important fact I would like to stress here is that your income tax will usually be more than your capital gain tax. So, to optimize for tax, you can exercise your options immediately after the vesting(FMV will be low compare to the future), instead of waiting for liquidation(FMV will be high compared to the past) to happen. But in this case, you are paying from your pocket for something which may not value anything in the future. That is a call which you have to take. Here’s ClearTax’s complete blog on it if you want to nerd out.

To conclude companies are leveraging ESOPs as a retention tool and growth multiplier, at the same time employees also benefit in the overall process, since monetization of ESOPs (if the startup has a considerable valuation) will far exceed the employee’s standard remuneration. If you already have ESOPs, check out how good is your startup’s ESOP policy.