It is not uncommon nowadays for employees to be offered employee stock ownership plans (ESOPs) when joining an organisation. Some employees get this option while moving up the corporate ladder. However, volatility in stock prices can cast a cloud over ESPOs. In the case of a start-up, there can be sharp and sudden changes in fortunes. So, it can work both ways. We tell you how an ESOP works and how you can check if it is in your best interest.
How does an ESOP work?
Typically, a company offers its employee an option to buy a fixed number of stocks after a vesting period at a predetermined price that often comes with a big discount. It gives double benefits to the employees.
Stock ownership: It works like an automatic saving-cum-investment option from your remuneration. “Employees can get ownership in the firm as ESOPs allow them to acquire a portion of the company's share capital,” says Vineet Patawari, Cofounder and CEO of StockEdge and Elearnmarkets.com.
Buy shares at a discounted price: The main attractiveness of an ESOP is the discounted price at which you get the stock. “Employees often have to pay only a modest amount to purchase the shares granted to them when they exercise their ESOPs. As a result, they can invest in the company at a lower cost,” says Patawari.
This is how an ESPO usually happens: A company whose stocks are being traded at Rs 100 offer each employee an option to buy 10,000 shares at Rs 60 a piece after three years provided they are still with the company then. If the stock price goes to Rs 300 after three years, the employees will have to only pay Rs 6 lakh to get shares that are worth Rs 30 lakh. This would be over and above the annual salary employees get. This is why ESOPs are being used to attract and retain talent.
The quantum of stocks, the vesting period and exercise price — at which an employee can buy the shares — will depend on the organisation’s road map. “In reality, the exercise price can vary even among employees of the same company. This is because the company may award ESOPs to various individuals with different goals in mind,” says Tarun Birani, Founder & CEO, TBNG Capital Advisors.
Continuity during vesting period a must
There is a gap between the time you are offered ESOPs and when you become eligible to exercise the option to get these stocks. This period is known as the vesting period. “If an employee quits before the vesting term is completed, they will be unable to exercise the ESOP and convert it into shares,” says Patawari.
Know the risks while going for an ESOP
There are two variables that have to work in your favour before you get any profit from ESOPs. First is that you become eligible to exercise the ESOP — remember that it can be linked to time or performance — and the stock price moves in your favour. “Gain from performance-linked allotment depends on the performance of not only the employee, but also the organisation as a whole. So it would depend on the conversion efforts of the employee along with the monetisation of those efforts to eventually help the employee access those performance-linked allotment of shares,” says Manish Khanna, Co-Founder of Unlisted Assets, an online platform to trade unlisted shares.
Even if you become eligible to exercise the option after the vesting period, there is no guarantee of making gains. “Normally, as the vesting period gets over, employees get the right to buy the shares at the exercise price. Hence, the gain or loss that an employee will make would be a function of what the fair market value is at that point,” says Birani.
For instance, if the stock price falls it would not be an advantageous situation for an employee to exercise the ESOP. The stock could be cheaper in the market.
Consider the case of Zomato, which was listed at Rs 126. Even if an employee had the option to exercise the ESOP at a discounted Rs 80, he would not get any profit now as the stock is trading at Rs 63.45.
How to evaluate ESOP from an established company
Stock options are a statement of the company's faith in the employee's talent and efforts, and an attempt to keep the employee on board for the long haul. Generally, employees of established companies are more convinced about the future of their organisations than those working in start-ups where a business model is not yet proven , or scale and profitability not yet achieved. Here are the things employees need to keep in mind while evaluating a stock offer from an established company:
- 1.Be very sure about its growth prospects: “When you exercise an ESOP, you are betting that the company's valuation will improve. But there is always a possibility of devaluation. So, before deciding on an ESOP, make sure you have confidence in the growth of the company,” says Patawari.
- 2.Compare it with what peers offer: As the ESOP policy varies from organisation to organisation, you should do some research to compare the offer you are getting with what is being offered in the market. “The employee should also compare the terms of the ESOP with that of other organisations and should evaluate any material variation and its impact on his or her compensation. There could be a huge disparity from organisation to organisation when it comes to ESOP compensation,” says Khanna.
- 3.Pick the right benchmark to compare: In the case of an ESOP from an established company, employees should compare it with what the peers in the market are offering, both on total compensation and ESOP compensation. That will give them an idea if they are being adequately compensated, says Khanna.
- 4.Get the total mix right: “While evaluating the ESOP plan, an employee must look for transparency regarding the scheme's rules and procedures; growth prospects of the company; his long-term plans with the company; and the incentive arbitrage between the fixed, variable and ESOP portion, says Birani.
How to evaluate ESOPS from a start-up or unicorn
Start-ups and unicorns need talented people to stick around for longer and contribute enthusiastically during its aggressive growth phase. The compensation proposed by the management these days gets broken down into a fixed payment structure and an ESOP structure, to ensure employees have more skin in the game. Here are the things you need to keep in mind while evaluating such an offer:
- 1.Pick a fast-growing firm to multiply your wealth: ESOPs can increase an employee's income and perks. “In a fast-growing industry, an increase in share value can be more financially beneficial to an employee than a fixed income. Thus, a new employee must look at the company’s growth prospects, the role he is going to play in decision-making, overall compatibility with company culture along with the vesting terms, exercising price, etc,” says Birani.
- 2.Do your own due diligence: Khanna points out that there are multiple yardsticks employees can use to decide if an ESOP is worth it. “This can include external and internal benchmarking with its peers and comparing it with other similar size companies of other domains, besides a reference check on the company and management and its outlook,” he says.
- 3.Excessive ESOP weightage may not be the right sign: “One must remember that the ESOPs are valuable only if the company is valuable. So, new employees must look at overall terms. For example, if the fixed salary is very low and the ESOPs are relatively higher in a company that is not valuable and has bleak prospects, then going for ESOPs might not be a very attractive proposition,” says Birani.
- 4.What will happen if the company goes for new funding: Growing start-ups may often require regular fund infusion and this can impact your ESOP. “Each ESOP holder’s holdings get diluted whenever there is equity infusion or there is convertible into equity. The total number of ESOP remain unchanged and only the percentage of the shareholding of an ESOP holder goes down with newly issued equity shares,” says Khanna. However, if there is an overall rise in the valuation, the employee may be a net gainer despite the frequent dilution of stake.
- 5.What happens in case of merger: In case of a merger or amalgamation of the company with another, the ESOP holder of the transferor company will get the ESOP of the transferee company of the equivalent prorated value that has been fixed on the basis of the swap ratio for the transferor and transferee companies, says Khanna. “In case the employee owns the ESOP of the transferee company, then the total number of ESOP held remains unchanged and only the percentage of the shareholding of the ESOP holder goes down with newly issued equity shares/ESOP.”
- 6.If the company is taken over by another company: In case of a takeover, the ESOP holder may or may not get the value of the option depending on the valuation of the business of the company in which the ESOP was given, says Khanna.
Many small companies are often acquired at very high valuation. “In case the valuation of the company is higher than the valuation at which employees got ESOPs, then there will be a distribution of the proceeds according to the waterfall mechanism, and the ESOP holder will get a pro-rated value which will be higher than the value at which they invested in the ESOP of the company,” says Khanna.
However, if the company was not doing well, it might become an unpleasant experience for ESOP holders. “In case the business gets transferred at a lower valuation than the ESPO value, there could be zero or lower value for the ESOP,” says Khanna.
Don’t forget to factor the impact of taxation on your ESOP
Taxation is one of the most critical factors to look into while evaluating an ESOP offer. Suresh Surana, Founder of RSM India, a tax consultancy, explains how the taxation on ESOPs work. It would be twofold: tax on perquisite as income from salary at the time of exercise and tax on income from capital gain at the time of sale.
At the time of exercise: In accordance with Section 17(2) of the Income Tax Act, 1961, ESOPs are taxable in the hands of the employees as perquisites in the financial year in which such ESOPs are allotted to the company. The taxable amount would be determined as the fair market value (FMV) of the shares on the date of exercising such option less any amount paid by the employee for such ESOPs. Such fair market value would be computed differently for listed and unlisted securities in accordance with Rule 3(8) of the Income Tax Rules, 1962.
At the time of selling: ESOPs sold by employees would be subject to capital gains tax. The rate would depend on the category of the share — listed or unlisted — and the holding period .
In case of listed shares, long-term capital gains — arising from shares held for more than one year — would be subjected to tax at 10% (without indexation) u/s 112A of the IT Act. It would be levied on gains exceeding Rs 1,00,000. Sshort-term capital gains would be levied at 15% in accordance with Section 111A of the IT Act.
In case of unlisted shares, the threshold period for determining the nature of gains would be 24 months. Accordingly, long-term capital gains would be subjected to tax at 20% (after indexation) u/s 112 of the IT Act and short-term capital gains would be taxed according to the marginal slab rates applicable to the employee.
It is pertinent to note that for computing the nature of capital gains, the period of holding would be considered from the date of allotment of ESOPs till the date of sale or transfer of shares by the employee.
ESOPs of foreign companies are required to be reported in the I-T return of every resident and ordinarily resident (RoR) in the schedule for foreign assets of the ITR. In case of non-disclosure of such foreign ESOPs, the authorities can issue a notice to the individual and treat such income tax return as a defective return u/s 139(9) of the IT Act. Moreover, the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015, imposes a stringent penalty of Rs 10 lakh for non-disclosure of a foreign asset in the schedule for foreign assets.
