Okay but laana:
What are these ESOPs about?
26th June 2021
Reading time ~ 3 minutes
Hi there,
SEBI recently relaxed some rules around ESOPs, i.e. Employee Stock Ownership Plans and we thought it might be good to cover some basics, especially since you are more than likely to benefit from ESOPs in your career. So for this week's edition, we talk about ESOPs, what they really are, how they're taxed, and what they mean for your investing journey.
Stay with us while we become your HR team for the next 3 minutes:
Let's say you start an early-stage startup - you folks have all the motivation, all the ideas, all the coffee, but unfortunately the team is running low on money. Work is crazy, but given the ₹₹ constraint, you can't pay the team a huge salary every month. So, what do you do? You hop over to your friendly HR team and are like okay, I want to make my employees part-owners in the company, basically compensating them partly in company stock, and partly in cash. Cool?
Cool, so you decide to do this for two reasons:
(1) It allows you to recruit and retain high-performing folks, that you otherwise could not afford.
(2) There's "skin in the game" for employees - they're building the company as if it were their own.
This particular benefit, where the employees get the option to own the company stocks, is called an ESOP: Employee Stock Option Plan/Program. Now, the ownership in the company is offered in terms of an "option to own the stocks", so technically - you (as an employee) don't own the stocks on Day 1 itself, but if you fulfill certain conditions (that we'll go through below), you can very well get the right to own the stock in the future. If the company is private, you'll be getting ownership in a private company. If the company is public, you'll be getting publicly traded stocks.
ESOPs first started becoming mainstream in India when Wipro offered options to its employees. The legacy has then been continued by many many startups. Even billion-dollar businesses, like Amazon and Microsoft - that were first startups - and are now are publicly traded, still offer ESOPs to their employees (although with their own terms and conditions).
So, let's say you join a startup, and you're given 10000 "options." There will be conditions outlined by the company around this, and it's important to understand the technicalities:
First, you don't get the stocks on day 1 itself, the options become stocks over a period of time, called the "vesting period." You essentially start off with 0 stocks, after Year 1 perhaps, 10% of the options will vest - i.e become stocks; Year 2 - 20%, Year 3, 50%, and so on. Vesting periods can vary. The idea is to incentivize and reward employees who end up staying with the company for longer periods of time.
P.S. in a thoughtful move, SEBI recently put out a rule relaxing the vesting period for deceased employees. Essentially, the one-year vesting period will not apply and the deceased employee's nominees or heirs will have the options vested in their name.
Next, in most cases, the company will give you the options for a very negligible amount. The price is usually set when you first join the company and is likely below the current market value of the stocks (i.e what non-employees would be paying in order to buy a stock from the stock exchange). So, let's say you stay on for a couple of years and have options that have vested. You then pay that set amount and "exercise your options," getting the stocks in return. This is usually done within an exercise period (i.e the period of time after your options are vested in which you can exercise the options).
So, you were granted options when you joined -> they vested -> you exercised them -> now you own the stocks. You can now sell the stocks in the market, if they are publicly traded. The price between what you paid while exercising the options, and what you get at the time of the sale is your reward.
But what if it's a private company? Well, you can't sell your stocks in the market, since they're not publicly traded. Many private companies then do a buyback of the vested stocks. Basically, the company will set a price for the stocks, and you have the option to sell your vested stocks back to the company itself. This way, the company is able to re-gain ownership, and you are able to get cash for your stocks. Other times, you have to wait until the company is able to IPO (and you can then sell the stocks in the market), or the company gets acquired and you are able to sell off the stake.
Now, all this sounds great and if you have faith in the startup, the upside is pretty crazy - if they end up going for an IPO or get acquired, you'll be bringing all the ₹₹ notes home and can go and live in the Maldives. However, we all can agree that there is a downside to having ESOPs as well - if you leave before the vesting period, you basically don't get anything. Other times, the startup fails, or it's not growing well enough to IPO, and you're left with pretty worthless stock. It's good to know these risks as well, especially if a major part of your compensation is coming from ESOPs.
So, what does this mean for me?
Well, first of all, if you have ESOPs, make sure you look at all the terms and conditions, the vesting period, exercise price, conditions on termination, etc. Know that if it's a private company, in most cases, you will only get cash for your vested stocks if the company conducts a buyback, if it gets acquired, or IPOs. And when you do exercise your options, big boss will knock on your doors and demand taxes. The good thing: from FY2020, you don't have to pay taxes in the year you exercise options, on certain conditions, which you can find here.
Next, big boss will again knock when you end up selling the stock:
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In case it's a public company and you sell a year after you exercise, you pay long-terms gains. If it's before you gotta pay short-term capital gains.
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If it's a private company, you pay taxes in the short-term, depending on your tax rate; in the long-term (here, if you sell after 2 years) as long-term capital gains.
Basically, you might have to pay taxes twice - once, while exercising and the other, while selling. Obviously, always check these things with your company's HR and finance team, and make sure you are aware of the tax obligations.
Thoughts or questions? Reach us at rujgupta@laana.club.
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