ESOPs are coveted perks and there are many stories floating around of ESOPs making people rich. Got some? Then, you can be wealthy too.
Did you hear about the software professional who made crores through ESOPs? Impressed? You might also want to consider ESOPs if they are offered to you. It could be one way to pay off your outstanding Credit Card bills in one swoop.
But, you should first understand what ESOPs are and how you should handle them. Here’s what you need to know.
Additional Reading: Know About ESOPs!
It all started here…
San Francisco lawyer Louis O Kelso founded the Employee Stock Option Plan (ESOP) in the year 1956 to transfer ownership of a company called Peninsula Newspapers to its successors and employees. The employees who got laid off due to acquisitions by large newspaper companies were retained using these ESOPs. Since then, the ESOP has evolved as a motivational tool.
It’s popular!
Ernst & Young conducts a yearly survey on ESOP market trends. The results for 2018 were pretty interesting. The survey conducted across Indian and Multinational companies found that 94% of the organizations surveyed
have a share-based incentive plan in place. This is significantly supported by the fact that most organizations
(87% of them) have positive feedback on the share-based incentive plans that they have implemented. The survey also found that 92% of organizations prefer to cover select employees in the plan. Most organizations use employee grade and performance as key considerations for determining the grant size.
Capital committed by Indian organizations and multinational organizations vary – 53% of multinational
organizations and 45% of Indian organizations allocated up to 3% of their paid up share capital towards share-based incentive plans.
Given that ESOPs are such a popular way to reward employees, here’s all you need to know about them.
Additional Reading: How To Start Investing In The Stock Market
What are ESOPs?
ESOPs are the options to buy your company’s shares at a future date, at a pre-determined price (most often discounted from the market price of the share). The price is determined at the time the ESOP is granted. There are ESOPs that give employees the right to buy warrants or bonds too. Equity shares are the most popular route.
According to the 2018 EY survey, the most preferred source of benefit is a fresh issue of shares as 87% of the respondents issued fresh shares.
Why is it called an option?
You can choose whether you want to use ESOPs or not. That’s why they are called options. You have the right but not the obligation to buy the shares.
What is a vesting period?
A vesting period is a period you need to wait to exercise the option. The EY survey found that over half the respondents prefered uniform vesting, with the vesting period ranging from three to
five years.
For example, suppose you get 100 options on 1st January 2019 with a schedule of 50%, 30% and 20% at the end of one, two, and three years from the grant date, you would be able to exercise your option and buy 50 shares on 1st January 2020, 30 shares on 1st January 2021 and 20 shares on 1st January 2022 respectively.
Additional Reading: What Really Affects The Stock Market
What is exercising the ESOP?
Exercising your options is the process of converting your options into shares by paying the pre-determined price. Suppose you get 100 options at Rs. 50 each, you would need to pay Rs. 5,000 (100 x 50). The EY survey says the range of exercise period can vary mostly between one year to five years, with 59% of the
respondents operating with this exercise period.
Why are ESOPs valuable?
ESOPs are mostly issued at a discount to the market price. So, you can buy the shares and sell them for a profit in the market. Also, if prices fall in the future, you have the choice of not exercising the ESOP. Taking the above example into consideration, if prices fall to Rs. 40 in the market on 1st January 2020, you wouldn’t need to exercise the ESOPs. In other words, you wouldn’t need to buy them at the pre-determined price of Rs.50.
How are ESOPs taxed?
ESOPs are perquisites and you will need to pay taxes on them. This perk is usually valued as the difference between the market price and the exercise price as on the date of exercise. If you sell those shares for a profit in the market, you may have to pay capital gains tax.
Additional Reading: How To Calculate Long Term Capital Gains (LTCG)
Given today’s volatile market, what should you do with your ESOPs?
You shouldn’t make decisions to exercise your ESOPs based on market conditions. There are two critical points to note before exercising ESOPs. One is the quality of management, its capabilities and strategies that the management devises. This will tell you whether the management is running the business in the right way. Another is the industry’s performance. If you believe that the management will be able to perform as expected in the 3-5 year time frame, ESOPs make perfect sense. Note that there is no numeric formula to find out whether the price offered for an ESOP is profitable. A lot depends on your judgement of the management and industry.
If you have exercised your ESOPs, should you be selling the shares now? No! Always analyse the company and long-term trends before you sell. A market crash shouldn’t prompt you to sell your ESOPs as they might give you best returns only in the long-run.
No funds to exercise your ESOP?
You can try a Personal Loan. You can repay the loan in full once you have made those profits on your ESOPs. Look for loans that come with no/low foreclosure fee. You also have to check the waiting period for foreclosure. The lower the waiting period, the better it is. After paying the interest on your loan, you will still be left with profits if your capital gains are much higher than the interest paid on the loan. The earlier you close the loan, better will be your profits.
Lastly, one should remember that cash compensations are always better than equity compensations as there is no risk involved. You never know what the future holds. Keep this in mind before going in for ESOPs. But if you are really interested in getting those ESOPs, check out these amazing offers on Personal Loans.