If you work at a startup, you may be aware of the potential benefits that employee stock option plans (ESOPs) can bring to the table. However, it's no secret that understanding the ins and outs of startup stock options can be quite overwhelming.
Don’t fret! We will help you gain a clear understanding of what it’s all about, how ESOPs work, and what factors you should bear in mind when considering them.
This article covers some of the most commonly asked questions about ESOPs.
How do ESOPs work?
An ESOP gives an employee of a startup the right to purchase shares of company stock at a predetermined price and time. ESOPs have become increasingly popular in recent years as a way for startups to reward and retain key talent.
These stock options often come with a vesting period, which means the holder has to stay with the company for a certain period of time before they are fully entitled to the stock. They may lose their entitlement to some or all of the stock if they leave the company before the vesting period is up.
Apart from vesting, you must also be wary of the strike price - the price at which the holder can buy the stock - which can range from a nominal value to a discount to the market price, making it valuable.
In addition, ESOPs come with an exercise window, which is when a holder can exercise their right to buy the stocks. It may be a few months or several years, depending on the terms of the agreement.
A note of caution: your exercise window may shrink significantly once you leave the company. Take a close look at the fine print of your agreement before signing.
Are there tax implications?
Of course! In India, there are two taxes to be aware of when dealing with ESOPs: perquisite tax and capital gains tax.
There is perquisite tax that you pay on the difference between the exercise price (the amount you originally paid for the option) and the stock's market value at the time of exercise.
Capital gains tax is paid when you sell the stock. The amount of capital gains tax owed will depend on whether the gain is short-term or long-term.
What happens to my ESOPs if the startup I work for goes public?
When a company goes public, its shares start trading on a stock exchange. At this point, you can exercise your vested options and buy shares of the company. Considering how the strike price is typically set at a discount to the market value of the stock, it’s a good opportunity to make a fortune.
Not too long ago, Indian foodtech giant Zomato had a blockbuster initial public offering (IPO) that minted as many as 18 dollar millionaires!
Remember that timing when you exercise could significantly affect your potential earnings since the tax impact would depend on how long you hold the exercised shares (long-term vs short-term capital gains).
And what if my company raises a new round of funding?
This may or may not change much for you immediately, but most funding rounds come with a significant jump in valuation for the company. What that means is the value of each stock you will potentially hold is now higher!
But since there is lack of liquidity in the absence of a public market for the stocks, you will only see tangible benefits after a liquidity event such as an IPO, or a buyback, where the company decides to buy vested options back in exchange for cash.
If I leave the company, what happens to my ESOPs?
If you have unvested ESOPs, they will expire as soon as you leave the company.
For vested options, you need to be thinking about the post-exit exercise window. This is something you should discuss during offer negotiation, because startups with draconian policies often keep this to a minimum, meaning you may end up losing out on the fruits of your hard work.