Deepak Abbot, a former senior VP at Paytm says in a webinar,
While companies are leveraging ESOPs as a retention tool and growth-multiplier, employees are benefitting in the overall process. To summarise, ESOPs pave a way for employees to:
- Boost personal wealth (through equity ownership)
- Grow professionally (as primary contributors)
- Improve job security and satisfaction
- Actively participate in decision making
As companies grow multi-fold, they understand the value of loyal team members. By offering ESOPs as a reward scheme, companies are able to retain employees whose performance is stellar and at the same time attract those who can be potential assets to the startups.
- ESOP: The word ESOP is generally used in two contexts:
- First, is the literal meaning which is the Employee Stock Option Plan, this is usually a plan or scheme under which options are given to the employees in a company
- The second meaning is the Employee Stock Options. It’s important to note that options are NOT shares themselves. Rather this signifies the ‘option or right’ of the employee to purchase the shares of the company. ESOP is given to the employee via a grant letter with grant date, vesting details, exercise price, etc clearly mentioned on it.
- ESOP Scheme: A ESOP Scheme holds certain agreed-upon terms and conditions based on which ESOPs are granted and exercised for all the employees in a company
- ESOP Pool: As part of the ESOP adoption in a Startup, certain number of shares are set aside for ESOP grants to employees. This set of shares is called ESOP pool and is part of the ESOP scheme document approved by shareholders.
- Grant Date: The date on which ESOPs are issued to the employee
- Grant Letter: The letter given by the company through which ESOPs are issued to the employee
- Vesting: In very simple and general terms, vesting refers to the amount of time an employee must work before acquiring a certain benefit. Vesting is, therefore, the process by which an employee becomes eligible to exercise his/her stock options and become a shareholder in the company. Typically the first vesting happens after 12 months and thereafter periodically maybe every year for 4 years altogether
- Vesting Period: The period between the grant date and the date on which all the specified vesting conditions of ESOP grant are satisfied. A very common vesting period is 4 years with a one year cliff
- Accelerated Vesting: This allows an employee to quicken the schedule by which his/her ESOP vesting happens. Accelerated vesting generally occurs at the time of mergers & acquisitions
- Vested Options: Number of options for which vesting date has been completed (in the past)
- Unvested Options: Number of options for which vesting date has NOT yet arrived (still in the future)
- Cliff Period: This is the minimum period after the grant date when the first options get vested. In India, it is mandatory to have a minimum of 12 months cliff period
- Exercise: Literally this is about the employee exercising the right to purchase shares of the company. Note that the employee can exercise (or purchase shares) only after his options have got vested, not before.
- Exercise Period: After vesting, the employee earns the right to buy the shares of the company. However, the employee can buy those shares within a certain period of time. This is called the exercise period
- Exercise Date: The date on which the employee exercises (his right to purchase shares) and receive shares of the company.
- Exercise Price: The price at which the employee buys the shares. This price is, in most cases, lower than the prevailing share price
- Exercise Tax: At the time of exercise (purchase of shares), not only does the employee need to pay the exercise price, he/she also needs to pay an income tax. The notional income is calculated as the difference between the fair market value (FMV) of the shares and the exercise price at the time of exercise. The employee needs to pay income tax on this notional income based on his tax bracket
- FMV: Fair Market Value of shares is usually obtained by the company to calculate its income tax liability at the time of exercise. Note that the company gets the FMV through a valuation certificate obtained from a merchant banker
How do ESOPs work?
Roshan has been granted 1500 ESOPs via this grant letter on Feb 14, 2018 (grant date). The exercise price is INR 500 per option. The options will vest annually over 4 years (vesting period) after a 12 month cliff period. The complete vesting table and dates are as follows:
|Vesting Date||Total Options Vested (till date)|
|Feb 14, 2019||375|
|Feb 14, 2020||750|
|Feb 14, 2021||1125|
|Feb 14, 2022||1500|
After the cliff period, he can exercise his vested options first on Feb 14, 2019, and then on the same date in subsequent years. If he chooses to exercise on the same date (see the attached exercise letter), he will pay 375 X 500 = INR 1,87,500 as the exercise price
Roshan will also have to pay the exercise tax
Let’s assume that the FMV of the shares is INR 8,500 per share. So, he will pay a tax on his notional income. The notional income can be calculated as
375 X (8500-500) = INR 30 lakh
On this notional income of INR 30 lakh, Roshan has to pay tax as per his tax slab. If the tax rate for his slab is 33%, he needs to pay about INR 10 lakh as income tax in that year.
Now, let’s assume that Roshan decides not to exercise his vested options annually. He leaves the company on Feb 28, 2021, after his third vesting schedule. As of now, he has 1125 vested options. His unvested options (1500-1125 = 375) lapsed the moment he resigned.
But, the company has a policy of allowing employees to exercise within six months of leaving the company. If he doesn’t exercise in this time frame, all of his 1125 vested ESOPs will lapse. If he chooses to exercise, he has to pay a lot of exercise tax (apart from his exercise price), Roshan is thinking hard about what to do 🙂
After a few years, as part of the Series C round, the company is providing ESOP liquidity to select employees including Roshan for 20% of his vested ESOP. Roshan decides to take part and he exercises his vested options, he submits the exercise letter to HR and pays the company 1125*500*20% = Rs 1,12,500. He also has to pay the income tax amount to the company. The company will allot 1125*20% = 225 Equity shares to Roshan and he will receive the duly signed share certificates. Then these shares will be transferred to the investor and Roshan will in-turn receives the sale amount.
How does ESOP Liquidity work?
#1 | ESOP Buyback
Under an ESOP buyback, employees holding vested ESOPs are eligible to sell their ESOPs to their company or employer. Startup companies may choose to buy back the ESOPs at a premium under specific instances.
Bangalore-based online freight aggregator BlackBuck bought back some ESOP shares from employees. 35 employees sold back their stock options at a price much higher than the FMV. The company’s senior HR management mentioned in a public release that BlackBuck bought back the shares to restructure its ESOP pool.
#2 | Secondaries
A secondary sale is a sale by an existing stockholder of shares in a private company to a third party that does not occur in connection with an acquisition of the company. Secondaries are considered the most effective liquidity rounds.
Policybazaar saw a secondary purchase in 2018 worth $30 M during a fund infusion up to $236 M Series F round led by SoftBank.
In one of the largest secondary sales, by Temasek, investors and employees of Ola liquidated shares worth $255 M.
#3 | IPO
Initial public offering or stock market launch is a type of public offering in which shares of a company are sold to institutional investors and usually also retail investors. An IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges.
The IPO of IndiaMART in July 2019 resulted in its ESOP-privileged employees earning millions. The company offered 4.89 million shares (at a face value of INR 10 each) on the NSE & BSE, and the issue price of each share was listed at INR 970-973. 10,000 shares were reserved for employees at a discount of INR 97 per share. The stock shot up 40% on listing and today the stock is trading above INR 2000 per share. A similar trend was observed when JustDial, QuickHeal, Info Edge, and Matrimony.com went public.
Satheesh KV, ex-HR Director at Flipkart, says in a webinar,
Deepak Abbot, former VP of Paytm says in another webinar,
Questions that employees should ask during offer-stage discussion
- Valuation of the company
Not all companies are the same. While some will become unicorns, others won’t. Asking the current valuation of your potential employer is necessary. Understand this number and ask about the roadmap. This is when you should evaluate their logic and see if they are really going in the right direction. Can you actually generate a good profit out of your granted options?
- What percentage of the company do your ESOPs represent?
A large ESOP grant is attractive, but what percentage is that number of the total valuation? Suppose you get offers from 2 companies. While the first company offers you 1000 options out of 1,00,000, the second offers 500 out of 10,000. In this case, the offer of the second company is worth going for. You have more skin in the game here. Also, you need to have clear visibility into the ESOP pool. What is the present size of the ESOP pool and will it be diluted further in the future? These questions will help you better understand the founder’s vision.
- Comparison between offered ESOPs and the market average
Some companies offer a cash component that is higher than the market average. They do this to offer less ESOPs. And some companies do the exact opposite. It is important for you to know this. The answer will help you understand if the company has aggressive cash or ESOP policies. The more successful the company the fewer options it generally offers. This comparison will help you evaluate your potential employer’s outlook and policies on team, culture, and rewards.
- Exercising the ESOPs
When can you exercise your options? Yes, the grant letter and offer letter will have all the formal information, but ask these questions to the founders directly. Most companies have a policy according to which employees are required to exercise their options within 90 days of their departure from the company. If you don’t, your options will lapse and you can’t claim them. Know the ESOP policy well and be prepared for exercising your options beforehand!
The other questions you must ask regarding exercise are: What if you decide to leave the company before all your options have vested? Is there a policy for accelerated vesting in the time of a merger? Can you exercise your ESOPs early? Is there a possibility of a potential buyback in the upcoming years?
- Existing fundraises
Employees should know all about the funds that the company has raised. Ask the founders directly. Ask them about the existing funding and the time until the next fundraising round. Not just do the value of your ESOPs depend on subsequent fund raíses but also this is a good way to evaluate the core value and strength of the business and understand the metrics that you might be working towards.
- Roadmap and expansion plans
If you are joining a company at the CXO level, you become a key driver of the business. Knowing the roadmap and expansion plans is very important. Not only will you be able to align closely with the vision of the founder, but also help you understand the trajectory of your own growth in the organization.
What should you check before signing your grant letter?
- Is the exercise price nominal or linked to the fair market value (FMV)?
- What’s the vesting schedule? Is it uniform or front-loaded?
- Is the vesting of your ESOPs linked to performance?
- What happens to your ESOPs when you leave the organisation?
- What are the transfer restrictions once you exercise your options?
- How does the company facilitate ESOP liquidity for employees?
- Is there a tool like MyStartupEquity that enables employees to look into the equity stack?
Generating liquidity is not easy. A plethora of ESOP tax implications surround both startups & employees, and understanding all of them may prove to be tricky. In this blog, we bring to you all you need to know about ESOP-related tax implications.
Tax implication at the time of exercise of shares
Tax incidence arises only when the employee exercises ESOPs; there is no tax implication during the vesting period. Recently, in #Budget2020, the Finance Minister proposed the deferral of exercise tax to the time of sale of shares, 5 years, or when the employee quits the company, whichever is earlier.
(For more insights on how #Budget2020 will affect ESOPs in startups, click here!)
Upon exercise, if the Fair Market Value (FMV) of the share is more than the exercise price then it becomes a gain for employees and such a gain is treated as a ‘Perquisite’ in the hands of employees as per Section 17 of the Income Tax Act, 1961. As a result, the employer (i.e. startup) is liable to deduct TDS on such a perquisite depending on the tax bracket in which the employee falls, and deposit the same with the government before the 7th of the next month. This amount appears in the employee’s Form 16 and is included as a part of his total salary.
Cess & Surcharge are charged as per the employee’s income bracket
- TDS is deducted only on those shares that are exercised
- Companies are liable to deduct TDS on exercised ESOPs
Tax implications on the sale of ‘exercised shares’ – Capital Gain
In the eventuality that the employee sells his ‘exercised shares,’ he will have to pay capital gains tax on the profit that he makes from the share sale.
Capital gains are of two types:
- Short Term Capital Gain (STCG)
- Long Term Capital Gain (LTCG)
Calculating Taxation on Capital Gains
Tax implication on STCG:
STCG arises when shares are sold within 24 months of exercising
Cess & Surcharge are charged as per the employee’s income bracket
Tax implication on LTCG:
LTCG arises when shares are sold after 24 months of exercising.
Rate of tax = 20% (after indexation of cost)
Indexation cost is basically factoring in the Cost Inflation Index (CII)
Cess & Surcharge are charged as per the employee’s income bracket
- Tax Residential Status: As a general rule, the income tax rate of an employee is decided based on his/her tax residential status (‘TRS’). TRS is governed by Section 6 of the Income Tax Act. If an employee is the tax-paying resident of India at the time of exercise then the TDS would be calculated based on the normal Indian tax slab but if he is treated as a non-resident then tax rate might differ. Double Tax Avoidance Treaty benefit is also available in such cases.
- Advance tax: Since capital gains will add on to the total income, advance taxes are calculated accordingly.
Understanding ESOP Tax – An Example
Imagine a Senior Product Manager, Rahul joined a startup ‘Fix-It Solutions’ as one of the early employees in 2014. Upon joining, Rahul was granted 100 ESOPs at an exercise price of INR 1000 per share, the valuation of the company at the time was INR 20 lakh. The vesting period according to the ESOP policy of the startup was 4 years.
In 2019, Fix-It Solutions raised its Series D round and the company’s valuation went up to INR 6000 cr. At this point in time, Rahul’s vesting period is already over, and he decides to exercise all of his 100 options. The FMV of each share on the date of exercise is INR 1,94,000.
Total exercise price = INR (100 X 1000) = INR 1 lakh
Assume, he falls in the 30% tax bracket.
Perquisite = INR (1,94,000 – 1000) X 1000 = INR 1.93 cr
TDS = 30% X Perquisite = INR 57.9 lakhs (applicable cess & surcharge will be extra)
Total selling price = INR (1,94,000 X 100) = INR 1.94 cr
At the time of sale,
Short Term Capital Gain = zero (as the sale is done at the same time of exercise)
Tax on capital gain = zero
Amount the employee gains (after taking care of taxes) = 1.94 cr – 57.9 lakh = INR 1.36 cr
Deepak Abbot has proved his mettle in the startup world as an all-rounder who is capable of doing anything from product management & web development to analytics & marketing. Deepak joined the early product team in Paytm in 2013 and in a five-year run drove engagement & created marketing impact to become a Senior Vice President. Now, Deepak has taken the entrepreneurial plunge and is building his own startup.
In this webinar with MyStartupEquity, Deepak talks about how employees should approach ESOPs. He explains ESOPs from an employee’s perspective – what must you negotiate for at different levels and stages. Listen in to this webinar if you want to understand the entire ESOP lifecycle from entry to exit. Deepak has been honest and candid and provided “real actionable” insights on how to approach various situations from entry to exit.