Starting a new job is never easy. New colleagues, new tasks, new policies — it can be a lot to wrap your head around. And if your new job offer comes with employee stock option plans (ESOPs), well, that’s one more complication added to the mix.
ESOPs have been gaining traction over the past few years. It’s still quite a nascent subject, though, especially in India. There isn’t a lot of awareness, and people often struggle to understand them.
If you’ve just received ESOPs with your employment contract, and you’re not entirely sure what to make of it, this guide is for you.
So let’s get started, shall we?
What are ESOPs?
ESOPs offer employees the chance to become shareholders in the company where they work and form a part of their compensation plan.
Let us explain this with an example.
Suppose you work for Infinyte Club, an early-stage startup and as part of your compensation, you are granted 1,000 ESOPs at a strike price of ₹10 per share.
The vesting schedule, which determines when you can exercise or buy the shares from the company, is set at four years with a one-year cliff. In a typical scenario, you will earn the right to exercise 25% of your ESOPs after the cliff period, with the remaining vesting over the next three years on a monthly or quarterly basis.
If you decide to exercise your 250 vested options after one year, you would pay ₹2,500 (250 x ₹10 per share) to purchase shares of Infinyte Club.
If you hold on to them, and sell during a potential liquidity event (acquisition, IPO or a buyback) where the company’s stock is valued at ₹1,000 per share, you have a potential upside of
₹247500 (250 x ₹1000 - ₹2500), notwithstanding the tax implications.
Tax implications?
As the saying goes: the only two certainties of life are death and taxes.
When you invest in equity shares on the open market, you pay capital gains tax on the profit you make. In case of ESOPs, however, you are taxed twice.
First, when you exercise your right to buy the shares, and second, when you sell those shares during a liquidity event.
When you exercise, perquisite tax is paid on the difference between the exercise price and the current market price of the shares. If we consider the scenario from earlier, if the market price of Infinyte shares was ₹500 when you exercise those shares, you will be taxed on ₹122500 (250 x ₹500-₹10).
However, there is some respite here. If your company is register as a startup with DPIIT, you can defer your perquisite tax by 5 years or when you have quit the company (whichever is earlier).
What should you look for in your grant letter?
Once you’re clear on what ESOPs are and how they work, evaluating becomes a lot easier. Here are some things to look out for.
First, understand what the vesting period is like
In India, typical vesting periods are four-years-long with a one-year cliff.
But not all ESOPs are made equal. Some companies continue to have less-than-ideal policies wherein vesting can happen over an even longer time frame.
In fact, there are companies which have backloaded vesting schedules, which means a majority of the ESOPs vest in the latter part of your time with the company.
For example, a backloaded schedule might vest 10% of the options after one year, 20% after two years, 30% after three years, and the remaining 40% after four years.
What happens to your ESOPs if you leave?
One would imagine that if your ESOPs have vested, it should not be an issue whether you’re with the company or not.
It’s not that simple though. The post-exit exercise window can be an important factor. In some cases, the company might give you a small window, for instance, a few months, to exercise the ESOPs, even if you leave after the vesting period.
Companies with friendly ESOP policies keep this at a maximum, sometimes as long as 10 years or more. This is an important detail to note when you are weighing your offer.
Liquidity Events
Let’s assume you’ve been a stellar employee. You’ve met all the targets, and exceeded expectations. You’ve also completed the vesting period, and are now the proud owner of 1,000 shares of Infinyte.
What now?
Unless the company has had an IPO and the shares now trade on the open market, you will have to wait for a suitable, liquidity event to make any real money.
That could be in the form of an IPO, an acquisition or a buyback where the company rewards its early believers with liquidity.
Fun fact: In 2022, Indian employees in startups made $196 million through buyback programmes alone!