Start-ups offering ESOPs is seen as a retention strategy to incentivise employees early across different levels as a part of their growth and reward strategy. Conventionally, it was used for long-tenured senior management, but start-ups are recently actively deploying it as a hiring tactic to attract talent.
For the underserved, under the Companies Act, 2013, Employee Stock Option Plans (ESOPs), employees are offered stocks of the company at a low or no additional cost that they can encash after a specific period at a particular price.
Besides co-founders and backers, ambitious employees play a pivotal role in the success of any start-up as they believe in the company’s core values and are equally motivated toward achieving the organisation’s goal. For them, it transcends beyond cash as an incentive to join a start-up. ESOP comes as a win-win tool for both parties, talent and start-up.
For starters, ESOP can be issued to both non-permanent and permanent employees of the company working in India or outside India and a director of the company, including a whole-time or part-time director but not an independent director. The recent change in the new regulations is the inclusion of non-permanent employee as long as he/she works ‘exclusively’ for such a company. This means companies can now issue ESOPs to employees on fixed-term contracts, or those on probation, before confirmation of their employment.
How does it work? Employers decide the number of shares offered under ESOPs, their price and beneficiary employees. ESOPs are then granted to employees and a grant date is put forth. The date of the agreement between the employer and employee to give an option to own shares (at a later date) is the grant date.
These stocks remain in an ESOP trust fund for a specific period called the vesting period. Employees should stick around with the company during this vesting period to avail the ownership of stocks by exercising the ESOP. Once the vesting period expires, employees get the right to exercise the ESOPs. The date on which the vesting period expires is called the vesting date. Employees can exercise their ESOPs and buy company shares at allotted prices which are calculated on the current value. If the employee leaves the organisation or retires before vesting period, the company is required to buy back ESOP at fair market value.
Once stocks have ‘vested’, the employee now has a right to buy (but not an obligation) the shares within a certain period of time. This period is called the exercise period.
The date of agreement between the employer and employee to give an option to own shares (at a later date) is grant date.
But before getting excited, there are still a few things to keep in mind before you get lured by stock options offered by start-up:
1) ESOPs are not equity shares; they are options
When you get an ESOP, it’s just an option to buy a certain number of shares after the vesting period. You shouldn’t get excited about it as it’s just a piece of paper offering you the option to buy shares after the vesting period. This piece of writing is a letter issued to the employee after the company has created an ESOP policy, duly approved by board and shareholders. The letter indicates the exact number of ESOPs given to the employee and the terms. Until the formalities are completed, the company has only promised ESOPs to employees and not granted them.
Meanwhile, the employee has to bind himself/herself for the vesting period. Then also you will get allocated a certain percentage every year.
For instance, if the start-up has granted you 100 shares with a 5-year vesting period, you will receive 20 shares for every year of employment.
2) ESPOs are taxed twice under the current regime
ESOP is the only instrument where you have to bear the tax twice. First, when shares are allotted to you after you have exercised your option on completion of the vesting period.
When you have exercised the option, basically agreed to buy; the difference between the Fair Market Value (FMV) on exercise date and exercise price is taxed as perquisite. The employer deducts TDS on this perquisite. This amount is shown in the employee’s Form 16 and included as part of total income from salary in the tax return.
This can be very challenging as you are taxed before getting the money in hand.
During these times, the companies relax the exercise period to make sure the shares don’t get relapsed. But the moment you exercise it, irrespective of whether stocks get sold or not, you will have to bear it.
For instance, in July 2015, you were given the option under ESOP, to purchase 10,000 shares of your present company. As per the policy, the option can be exercised at the end of three years at an exercise price of Rs 30. After three years, you exercised this option sometime in July 2018. The fair market price of the shares at that time was Rs 70.
ESOPs would be taxed as perquisite, the value of which would be (on date of allotment) = (FMV per share – Exercise price per share) x number of shares allotted. (70-30) x 10,000 = 400,000 The amount calculated above as perquisite value of ESOP i.e. Rs. 4,00,000 shall form part of X’s salary and be taxable in the year of allotment of such shares. The employer is liable to deduct TDS on such amount.
Now the second level of taxation. This takes place when in January 2019, you decide to sell the shares at Rs 120 each. You would be liable to pay capital gain tax. It’s calculated like this:
Capital gains = Sale proceeds – FMV of shares at the time of allotment of shares (120 – 100) x 10,000 = Rs. 200,000
Since the holding period of shares in the hands of X is less than 12 months (will be counted from the date of allotment), gains will be classified as Short-term Capital Gains and will be taxable as per the standard slab rates applicable on you.
If capital gains are long term (two years), 20% tax will be levied with the benefit of indexation (LTCG).
3) Resign and lose your shares
You lose your money if you quit or get fired before your ESOPs get vested.
But when you resign after that vesting period, the company sometimes gives you 90 days to exercise the shares and pay the hefty perquisite tax to avoid the lapse of shares. You are betting on the rise of the company’s valuation. Once you pay the tax there’s no guarantee about its sale or valuation since risk of devaluation always exists. In fact, some start-ups may even have to shut shop, something that’s not uncommon.
The best way to go about it is to check if the company has gone through seed and Series A and B funding rounds. If the company has already been through B funding, it implies that it has accomplished certain milestones in developing the business and is past the initial start-up stage. The employee then should definitely consider its ESOPs.
4) Liquidity is a challenge
So, you have purchased ESOPs and even paid perquisite tax. But unless your start-up is VC funded or backed by a big investor, who will you sell it to since it’s not listed? There is no liquidity till it’s listed.
The other option is to sell the unlisted shares in the grey market, where liquidity and bid opportunities are limited.
There are chances of increased dependency on the start-up founder for secondary deal where strategic investors come and ask for a certain number of shares. The founder will liquidate by buying ESOPs from his employees who will get some cash. It’s a B2B, not an open deal.
There are still chances of monetising your ESOPs if your company gets acquired. For instance, when fashion e-commerce Myntra was acquired by Flipkart in May 2014, its employees, who had quit by the time of the acquisition but had vested ESOPs, could sell their shares. However, this may not be the case with all companies that get acquired.
5) ESOP Rules and Policy
The employee also has to keep in mind the backend rules of ESOP whose framework varies with every company. The laws governing ESOPs in India are different for listed and unlisted companies.
When it comes to unlisted companies, the Companies Act 2013 and the Companies (Share Capital and Debentures) Rules, 2014 govern the ESOP trust. As for listed companies, the ESOP trust is issued in accordance with the Securities and Exchange Board of India Employee Stock Option Scheme Guidelines.
But more often than not, start-ups can put multiple conditions that can put the ball in their court. He/she should always look out for an ESOP Trust specifically created in some companies to implement ESOP Plan. A company drafts a scheme and gets it approved by the members of the company. Simultaneously, an ESOP Trust is formed as per the provisions of Indian Trust Act, 1882 and registered to act as an intermediary between the company and employees. As and when options are exercised by the option holders, the ESOP Trust is responsible for issuing shares to employees.
ESOP employees have some voting rights attached to the ESOP plan. ESOP must have the right to direct the trustee on the voting of allotted shares i.e. sale of the company’s stock. In public companies, the employee’s voting rights are the same as other shareholders, given the equal status in the public limited company.
It goes without saying that the company also has to make disclosures in the explanatory statement for passing the special resolution for the issuance of ESOP. It’s impertinent to review it before accepting the offer. These are:
* The total number of stock options which is to be granted,
* The identified class of employees who can participate in the ESOP,
* Requirements of vesting period of ESOP,
* Maximum period within which the options can be vested,
* The exercise price and process of exercise,
* The lock-in period, if any,
* The grant of the maximum number of options for an employee
* The methods used by the company to value its options
It’s easy to be blinded by the monetary benefits of ESOPs offered by start-ups, given the examples we see in the market. But given how most start-ups struggle to survive in most cases, it’s pertinent to check the start-up’s background and the rules related to ESOP, along with taxes levied. End of the day, risk measurement always goes a long way than a regretful career move taken in the spur of the moment.
(By Brajmohan Singh, ESOP Expert & Managing Partner-BMSA)
