Employee stock options (ESOPs) have been widely used by start-ups to attract talent. In recent times, several start-ups announced ESOP buybacks to reward their employees.
For an employee in a start-up, ESOPs can form a significant part of overall compensation.
Through an ESOP programme, a start-up can make an employee a partner in the company’s growth.
But, how do ESOPs work? Here are the details and key terms to note.
An ESOP is not a common equity share. Companies or start-ups give ESOPs to employees over a period of time. There is a vesting period. It’s that time over which the employee’s ESOPs accumulate, before which they cannot be converted to shares and sold. This vesting happens with specified schedules and milestones, which you can see in your grant letter.
For example, you can have 25 percent each of your total ESOPs getting vested over a period of four years. Your company may also have set rules. For example, you would get ESOPs amounting to 0.1 percent of company’s share capital after you complete five years.
After the ESOPs get vested, you can exercise them. This means, you convert the ESOP into a common equity share of the company (that’s the time the shares can be deposited in your demat account) and then you can subsequently sell them in the open market.
“The idea behind granting ESOPs and letting them vest over a period is to make sure that important employees stay on and not leave the organisation while it is being built,” says KK Ram, VP-Venture Investments at Sapient Wealth.
The vesting period can also indicate the founders’ attitude towards employees, says Pravin Jadhav, founder of Raise Financial Services and former CEO of Paytm Money. “Founders’ attitude towards rewarding employees makes the most difference when it comes to ESOPs. For example, at Raise, we are putting a structure where ESOPs for employees vest in four years, while founders’ shares vest in five years,” he says.
“While many employees join start-ups for the long haul, several also join for the short-term. Companies are also now selling short-term to employees, with the vesting period being three years in quite a few cases,” says Kamal Karanth, co-founder, Xpheno, a specialist staffing company.
When do I sell my ESOP shares and make money?
Privately-held companies can also stipulate a lock-in period. This ensures that employees do not sell the shares in the open market, as soon as they get them.
“Private limited companies can have a lock-in period for transfer of shares by amending the clause related to restriction on transfer of shares in the Articles of Association of the Company. The same should be mentioned in the Employee Stock Option Plan,” points out Champak Dedhia, Chartered Accountant and an ESOP expert.
If the start-up gets new investors at a later stage, it can even insert a lock-in period on the new ESOPs that the company may grant in the future.
“An investor infusing fresh capital can ask for an insertion of a condition in the shareholder agreement that prevents important employees and the founders from selling any fresh ESOPs granted to them till a certain period. This is again to ensure important personnel stay put in the company,” says Ram.
Next round of fund raising
It also helps if the employee has some awareness of the funding stage of her start-up. “Usually, buybacks happen during fresh rounds of fundraising. A new set of investors come in and take the ESOPs of employees and infuse capital in the company,” Karanth says.
“So, employees should also keep in mind whether the vesting period is too long that they might end up missing the next round of fundraise and therefore miss out on a possible ESOP buyback,” he adds.
After the vesting period is over, the employee can usually exercise the ESOPs – she can sell the shares.
According to Jadhav, if you join a very early-stage venture, and taken a lower compensation or give up other opportunities, risks involved are much higher. “So, the upside should be much better compensated for via stock options versus when you join a start-up which has already scaled up in its journey,” he says.
The value of shares granted on the exercise of the ESOPs is treated as ‘perquisite’, which gets added to the employee’s salary for taxation purpose.
“Tax is payable on the difference between market value of the shares allotted or transferred to an employee, and the vested price paid by the employee, if any. Ordinarily, exercise price is equivalent to the face value of the shares,” points Nakul Batra, Associate Partner at DSK Legal.
Generally, the face value of the share can be Re 1 or Rs 10, but the exercise price finally depends upon the terms and conditions laid down by your company.
Employees would also have to pay taxes on their ESOPs when they sell the shares. This is when capital gains tax comes into the picture. “Such income is taxed as short-term or long-term capital gains based on time period of holding the shares,” Batra says.
The time period is from the date on which you exercise the ESOPs. So, remember, for favourable tax treatment of long-term capital gains tax of 10 percent, you would have to wait for a year to sell the stocks.
Otherwise, you will be taxed at the short-term capital gains tax rate of of 15 percent.