ESOPs let employees own company stock, but understanding vesting, taxes, and capital gains is key to benefiting from them. Here’s everything you need to know.
As the startup ecosystem in India continues to grow and the corporate world evolves, an increasing number of employees are being offered Employee Stock Ownership Plans (ESOPs) as part of their compensation packages.
If you’re one of the recipients of ESOPs, you might be wondering what they are, how they work, and what it means for you financially in the future. This article aims to provide a thorough understanding of ESOPs, especially for first-time recipients.
What Are ESOPs?
An Employee Stock Ownership Plan (ESOP) is a programme that allows employees to acquire ownership in the company they work for, typically through the allocation of company shares. In simpler terms, ESOPs are essentially a way for employees to become partial owners of the company by giving them the right to buy or receive company shares at a future date, often at a discounted price or with other favourable conditions.
Unlike regular salaries or bonuses, ESOPs are a form of deferred compensation. While you might not immediately get cash or assets in hand, over time, as the company grows, your shares could increase in value, potentially leading to significant financial gains when sold.
A Brief History of ESOPs
The concept of ESOPs originated in the United States in the 1950s, but it wasn’t until the 1970s that they started to gain popularity, particularly with the passage of the Employee Retirement Income Security Act (ERISA) in 1974. This Act made it easier for companies to establish ESOPs as part of their employee benefits.
In India, ESOPs were introduced relatively recently, becoming common with the boom of startups in the 2000s. India’s Companies Act, 2013 and the Securities and Exchange Board of India (SEBI) regulations govern ESOPs for listed and unlisted companies, ensuring that employees’ interests are protected and that companies follow a clear set of guidelines.
Additional Reading: ESOPs Can Make You Rich: Here’s How
How Do ESOPs Work?
The mechanics of how ESOPs work can vary slightly from one company to another, but the overall structure remains the same. Here’s an overview of the key stages involved:
1. Granting of ESOPs: This is when a company allocates a certain number of stock options to an employee, typically as part of the hiring process or as a reward for performance. The employee is given the option, but not the obligation, to purchase shares at a later time.
2. Vesting Period: The vesting period is the duration over which the employee must stay with the company in order to earn the right to exercise (or buy) their stock options. Vesting schedules can vary, but common ones are 4-year vesting with a 1-year cliff, meaning you need to stay with the company for at least one year to receive any options, and after that, you earn a portion of your shares each month or year.
- Cliff Vesting: The employee becomes fully vested after a certain period. For example, a one-year cliff means the employee gets the full grant of ESOPs after the first year of employment.
- Graded Vesting: The options are gradually granted over time. For instance, 25% of the options might vest each year over four years.
3. Exercise Price (Grant Price): This is the price at which you can buy the shares when the options vest. The exercise price is usually set at the market price (or a discounted price) of the company’s stock at the time the option is granted. In the case of startups, this could be the price of the shares as determined by a valuation report from an independent valuer.
4. Exercising the Option: Once the stock options vest, you can exercise your right to purchase the shares at the pre-agreed price, known as the exercise price or strike price. If the company’s stock price has risen since the grant date, the difference between the exercise price and the market price is your potential profit. For example, if your exercise price is ₹100 per share and the current market price is ₹500 per share, you can buy the shares at ₹100, then potentially sell them for ₹500, making a profit of ₹400 per share.
5. Selling the Shares: After exercising your options, you may want to sell your shares. This can be done either in the public market (if the company is publicly traded) or through a private sale (if the company is private). For startups or private companies, liquidity might be limited, and you may need to wait for an event like an acquisition or IPO to sell your shares.
Key Terms in ESOPs
- Vesting Period: The time frame over which an employee earns the right to exercise their stock options.
- Grant Price: The price at which the employee can purchase the shares, which is often lower than the current market value.
- Exercise: The act of purchasing the shares at the grant price once they have vested.
- Strike Price: Another term for the exercise price, i.e., the price at which you can buy the stock.
- Liquidity Event: An event like an IPO or an acquisition, where employees can sell their shares for cash.
ESOPs in India: Taxation and Capital Gains Implications
When you receive ESOPs, it’s important to understand the tax implications involved at various stages of the process.
- Taxation at Grant: In India, there is no tax liability when the options are granted, as it is just an offer to buy shares at a later time. The actual tax liability arises when you exercise the options.
- Taxation at Exercise: When you exercise your ESOPs, the difference between the market price of the shares at the time of exercise and the exercise price is considered a perquisite (a benefit you’ve received in addition to your salary). This difference is taxed as Salary Income under Section 17 of the Income Tax Act and is subject to Income Tax as per the employee’s income tax slab. For example, if the exercise price is ₹100, and the market price is ₹500 at the time of exercise, the ₹400 difference is taxable as part of your salary.
- Taxation on Sale: Once you sell the shares, the profit you make is considered capital gains. If you hold the shares for more than 36 months, you will qualify for long-term capital gains (LTCG) tax, which is currently taxed at 10% without the benefit of indexation. If you sell the shares within 36 months, the profit will be taxed as short-term capital gains (STCG), which is taxed at 15%.
While many employees focus on the potential gains from ESOPs, it’s also important to be aware that there is a risk of capital loss. If you sell your shares at a price lower than the exercise price, the difference will be treated as a capital loss. This loss can be offset against any capital gains you have from other investments, reducing your overall tax liability. However, if you don’t have any capital gains to offset, the loss can only be carried forward for up to 8 years for set-off against future capital gains.
Additional Reading: How to Save on Long-Term Capital Gains
How to Redeem ESOPs
Redeeming your ESOPs means selling the shares you have exercised. However, the process of redemption largely depends on the liquidity of the company’s shares:
- Public Companies: If the company is listed on the stock market, you can sell your shares on the open market, either through a stock exchange or a broker.
- Private Companies: If the company is private, liquidity might be limited. You may need to wait for an acquisition, IPO, or another type of exit event to sell your shares. For employees of startups, exit events are usually the best opportunity to redeem ESOPs, as shares can become liquid only through an acquisition or IPO.
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Financing Options for Exercising ESOPs
When exercising ESOPs, employees often need to pay the exercise price to convert their options into actual shares. For employees who might not have the immediate funds to pay for the shares, there are several financing options available. Some companies offer cashless exercise programmes, where the company arranges to sell a portion of the shares to cover the exercise price, allowing employees to exercise without upfront payment.
Alternatively, employees can seek external financing, such as Personal Loans or margin loans from banks, or work with ESOP financing firms that specialise in helping employees finance the conversion of their options. These firms typically offer loans against the value of the shares, allowing employees to pay off the loan over time. However, it’s important to consider the associated risks and costs of borrowing before opting for this route, as selling or pledging the shares might limit your potential gains.
The Silver Lining
Receiving ESOPs is an exciting opportunity for many employees, particularly in high-growth companies like startups. If you believe in the company’s future success and its potential for growth, ESOPs can be a significant financial asset.
It’s important to understand the various complexities—such as the vesting period, tax implications, and the liquidity challenges—that come with ESOPs.
Before making any decisions, it’s advisable to seek financial or tax advice to ensure that you fully understand the potential tax impact and how to plan for the future. Additionally, always keep an eye on company developments, as the value of your ESOPs is directly linked to the company’s success.
In the end, ESOPs are a great way to incentivise employees, allowing them to share in the success of the company they help build. As long as you approach them with an understanding of how they work, they can prove to be a lucrative addition to your overall compensation package.