Employee Stock Ownership Plans, or ESOPs are often used by companies as instruments to hire and retain talent whilst sharing ownership (and therefore, equity) in the company, and sometimes, they end up doing exactly what they are designed for - creating incredible wealth for those of us holding them.

Despite holding such power, ESOPs can be a difficult lot to understand - how do they work to the different kinds of options that exist - such intricacies can leave even the smartest perplexed, especially if we are only just getting introduced to them.

As self-appointed custodians of the belief that these instruments hold the power to change lives, we have created this guide to save you hours of scouring the internet and spirals of confusion.

What are ESOPs?

Consider ESOPs as rights to buy equity or shares in the company at a certain stage at a certain price. Sometimes when these are sizable in nature, these are colloquially referred to as golden handcuffs for their ability to keep someone firmly chained to a single employer given the potential future gains.

But before we get into understanding these seemingly life-changing instruments better, a quick look at some terms that will appear across this guide and if you already work at a startup, in your grant letter!

The Vesting Schedule

Vesting is the process through which option holders earn the right to sell their ESOPs. This happens over a stipulated period of time, which is commonly referred to as the vesting schedule.

While vesting schedules vary across the board, the most common one happens to be over a period of four years - with a one-year cliff (explained below) and quarterly/monthly vesting post that.

For example, an equally weighted vesting schedule would translate into 25% of the options vesting at the end of 12 months, and 2.08% per month/6.25% per quarter post that.

In India, the minimum cliff period for ESOP vesting schedules as mandated by the law is 1 year.

And what about the Strike Price or the Exercise Price?

The predetermined price at which one can purchase company stock. This varies but startups have increasingly made it a point to keep strike price at a nominal amount or lower than the current market value of the stock so the option holders benefit as they should for their time, effort spent in building the company alongside founders and investors.

Do I need to worry about my Exercise Window?

Short answer, yes!

The time period when one can exercise their right i.e. purchase the shares, after they are vested. While this is typically between 7-10 years, it drastically reduces after someone leaves the company, sometimes narrowing down to as little as 90 days.

Make sure to understand what the post-exit exercise window at your company is, for some draconian policies can leave you high and dry after quitting.

Are ESOPs really life changing?

This is better understood with an example.

Assume that you were granted 100 ESOPs in a company at a strike price of ₹1 four years ago. During this time, the value of the company’s stock has grown to ₹100 per share.

Considering all options to be vested, you exercise your right to purchase them, meaning you spend ₹100 (100*₹1 per share) and sell it back at potentially ₹10000. This would indicate a profit of ₹9900.

Now, take a step back and imagine this in the context of crores of rupees or millions of dollars. Do you see it?

It is important to note, however, that the above example has been broken down very simplistically and a real-life scenario may include some caveats (and taxes!)

Liquidity Events

The idea of being able to unlock wealth in sync with a company’s progress is exciting but it isn’t always so simple, especially in the case of startups.

Even if all of your granted options are vested, and you decide to exercise your options, it may not lead to any wealth creation. For a simple reason: someone has to buy the stock, and that can only happen during a liquidity event for a private company.

There are a few different types of liquidity events that occur, and we are going to look at some of the most common ones.

What’s a Share Buyback?

As it happens, it is the most common mechanism of providing liquidity via stock options in India. In fact, a few Indian startups splurged a record $440 million to reward employees holding ESOPs in 2021.

This is a straightforward liquidity event where a company uses cash-on-hand to buy back stock from employees to reward them.

There may be caveats here, with preference given on conditions of tenure, cap on how much of their vested options one can exercise, among other things. Such buybacks take place differently in different companies, and sometimes, you may not get anything at all despite having vested options.

What are these Secondaries we hear about?

Secondaries typically take place during a new fundraise, where a part of the round is company stock (primary) getting bought and another part is where founders, existing investors and employees directly sell to the investors.

A key reason for partaking in secondaries is the founders not wanting to dilute more of their equity, while also rewarding option holders.

My company is getting acquired or merging with another company, what happens to my options?

During M&A, what happens to stock options depends on the type of transaction.

In an all-stock deal, option holders get equivalent stock in the new company (merger) or that of the acquiring company.

Similarly, an all-cash deal is supposed to hand out the cash equivalent to the value of the stock that is vested. The same goes for deals that are a combination of cash and stock.

A note of caution: in many cases, option holders may end up making nothing depending on what terms the founders manage to negotiate. If there is a pending merger or acquisition, it is advisable to go speak to the senior management about such intricacies.

What happens when the company does an Initial Public Offering?

This is when a private company decides to list itself on a stock exchange and raise funds from the public.

While not a lot changes for option holders, there are a couple of things to note.

Shareholders typically have a lock-up period where they can’t immediately sell all or part of their shares until a set time after the initial public offering. This is meant to protect the share price by avoiding a sudden and large influx of shares in the public market.

There are also blackout periods where employees are not allowed to sell or trade their shares due to having access to information that may not be immediately available to the public.

Would I be taxed on my options?

There are two things in life you cannot avoid: Death, and taxes. It’s true for stock options as well. In India, taxes can come into the picture twice — once when you buy the shares, and for a second time after you have sold them.

Perquisite Tax

The company generally deducts TDS on the perquisite.

What that means is, for example, if you buy the shares at the predetermined exercise price of ₹1,000 and the current market price is ₹1,200, you will be paying a tax on the difference, or the perquisite, which in this case is ₹200.

Capital Gains Tax

The other is when one decides or gets the option to sell the shares. For RSUs and PSUs, it is simple: one is taxed on the total gains from the sale of stock.

For ESOPs, things are slightly more complicated. The taxable income is the difference between the value of stock when one exercised their options and their current value in the market.

Suppose you exercise options currently worth ₹50L by paying ₹10L. The perquisite tax will apply on ₹40L.

Now, if you decide to sell the stock later when the value has grown to ₹1.5Cr, then your capital gain that would be taxed is ₹1Cr.

More Caveats

But there’s more. Capital gain taxes are not straightforward - there is differentiation based on whether they are listed or unlisted shares and also on how much time one takes between exercising and selling them.

Short-Term Capital Gain: Publicly listed shares are considered under short-term capital gains when sold within a year of holding them, and this changes to a period of two years when it comes to unlisted or private company shares.

For listed short term capital gains, the tax rate is 15% and for the unlisted, it falls under the usual income-tax slab rates.

Long-Term Capital Gain: Stock held beyond one year in case of publicly listed shares and two years in case of private equity, is considered under long-term capital gains when sold.

The tax rate for the former is 10% and for the latter, it is 20%.

‍In this guide, you learned about stock options with information broken down into the simplest of details. We strive to do more of this at Infinyte. If you would like to get early access to what we are building for the next generation of wealthy, join the waitlist here.