Got a tempting ESOP offer from your company? Here’s what you should know before tendering for it.
According to recent reports on the Indian startup ecosystem, startups are said to be mushrooming at an annual growth rate of 10-12%. This demands efficient planning of resources, right from getting the right assets and tools to putting together a powerful team in place. The fierce competition in the startup fraternity makes onboarding employees and retaining them very important. And this is only possible by rewarding them for their contributions. One such reward that startups give out these days are Employee Stock Options (ESOP).
Usually, startups roll out this scheme for selected employees, based on their position and ability to impact the company. ESOPs enable employees to buy the company’s shares at a discounted price.
Typically, this is a part of the retirement and employee benefit plan giving the ownership of interest to employees. This ownership comes in the form of company shares, which is assured upon fulfilling predefined conditions. But most often, ESOPs become a part of their compensation offering in startups, to motivate employees to give their best at work.
Benefits of ESOP
Employees can be a part of a company’s success by owning the shares directly. They can avail wealth benefits by selling profitable shares that were acquired at a lower rate. It also motivates the employees to give their best.
For the company
Helps to leverage employee’s morale urging them to perform better in their day-to-day tasks, boosts employee retention and thereby lowers turnover rate and savings on director remuneration for a private limited company as a part of salary by offering a certain portion of ESOPs
Making ESOP a part of offerings to employees is the best way to get the team working better and longer. There is a subtle sense of pride that employees may feel when you make them a part of business success. Also, it is a great way to retain worthy personnel by offering them a higher stake.
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.
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 deals 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.