ESOPs 101: How do they work, benefits & is it better than salary?
Watch the video on YouTube if you want to skip reading the blog 👆🏻
Let’s discuss a topic most of us are confused about: ESOPs
In my 8 years of working with SaaS startups, I’ve come across many employees who are left in the dark with regards to understanding the ins and outs of ESOPs.
And you can’t blame them: after all, in an emerging ecosystem like ours, people are less aware of the potential of stock options.
In this video, I’ll answer common queries on ESOPs and why you should consider it when companies offer similar or more assured compensation in cash.
Before we begin, take a look at these newspaper clippings.
Intrigued? Well, let’s jump straight into it.
First things first: What are ESOPs?
ESOP is the abbreviation for Employee Stock Option Plan. These plans act as additional benefits or compensation for employees apart from their salary.
Before we start understanding the intricacies of ESOPs, you need to understand two main definitions that we will repeatedly use in this video, that is Cliff and Vesting.
So what are Cliff and Vesting?
Cliff is nothing but the duration of your stay with the company that qualifies you to receive equity. Employers choose to provide various benefits to employees in return for their loyalty and service and to attract and retain them. The Cliff period is usually 1 year. Upon completing the cliff period, your vesting starts to occur incrementally over time, according to a vesting schedule.
Stock options are almost always subject to a vesting schedule. For example, if your equity had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you haven’t vested any part of your equity. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company.
A very common vesting schedule is vesting over 4 years, with a 1-year cliff. That is you need to wait for 5 years before you get the most out of your stock options allocated to you. The first year in the vesting period is the cliff. The intention of a cliff is to make sure new hires are committed to staying with the company for a significant period of time.
As an employee, if you’re leaving or considering leaving a company before your vesting cliff is met, consider waiting. Or, if your value to the company is high enough, you might negotiate to get some of your stock “vested up” early. Your manager may well agree that it is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency.
Once you complete the cliff period, you will be given a grant letter, which is a formal document issued by the company for the purpose of granting ESOPs to an employee. This letter will have information about the following:
- Number of shares allocated for you
- Vesting schedule
- Vesting date
- Exercise date
- Grant/strike price
- Other T&C
Now say you’ve completed 4 years of employment, meaning your vesting period is over. That means you’ve reached the vesting date — the date you as an employee are entitled to buy shares after conditions agreed upon earlier are fulfilled. You can now exercise the ESOP (if you wish), by paying the grant price or strike price mentioned in the grant letter, regardless of the true value of the shares at the time of liquidating it, also known as the fair market value.
The date on which the employees exercise their option to buy the shares is known as the “exercise date”.
How do I benefit from ESOPs?
If the company does well, the share prices will go up multiple times while the agreed price is much lower. You will stand to make a huge profit. Say a startup offers you 1000 units of stock at 1 USD exercise price each with a 4-year vesting period and a 1-year cliff.
Now, at the end of the vesting period, you can purchase the stocks by paying the company 1000 USD. The benefit is that even if the price of each share is 100 USD after 4 years, you will only pay 1 USD to buy a share.
That, my friend, is the upside of ESOPs.
What if the company doesn’t do well?
Well, in that case, you don’t have to buy the shares-remember I said it’s a gamble? You’d lose the years you worked there but gain experience.
Just a word of caution: Before you decide to join, you need to consider the start-up’s chance of succeeding, the founder’s record of building and scaling the business, and the strength of the investors.
Is it compulsory to purchase stocks after the vesting period?
No, it is not. As the name suggests, it is only an option without any obligation attached to it, meaning it is not mandatory for the employee to exercise the option. In case the prevailing market price of the shares is lower than the exercise price, you may decide to let the option lapse.
Is there a pre-set schedule for the vesting process?
The most common vesting schedule is uniform annual vesting over 4 years, i.e. after the first year of compulsory ‘cliff’ — you receive 25% of the total ESOPs promised to you every year for 4 years.
On the other hand, some companies offer performance-based vesting, which is dependent on you meeting some targets and goals linked to your job function. For instance, 10%, 20%, 30%, 40% over 4 years.
Do I have to wait until my vesting period is over to exercise my option?
Not at all. Let’s take a real example so you will get a clearer picture.
Let’s say Roshan has been granted 1500 ESOPs via this grant letter on Feb 14, 2018, as the (grant date). The exercise price is INR 500 per option. The options will vest annually over 4 years (vesting period) after a 12 month cliff period. The complete vesting table and dates are as follows:
Source of the information: Trica.co
After the cliff period, he can exercise his vested options first on Feb 14, 2019, and then on the same date in subsequent years. If he chooses to exercise on the same date (see the attached exercise letter), he will pay:
375 X 500 = INR 1,87,500 as the exercise price
Roshan will also have to pay the exercise tax
Let’s assume that the FMV of the shares is INR 8,500 per share. So, he will pay a tax on his notional income. The notional income can be calculated as
375 X (8500–500) = INR 30 lakh
On this notional income of INR 30 lakh, Roshan has to pay tax as per his tax slab. If the tax rate for his slab is 33%, he needs to pay about INR 10 lakh as income tax in that year.
Now, let’s assume that Roshan decides not to exercise his vested options annually. He leaves the company on Feb 28, 2021, after his third vesting schedule. As of now, he has 1125 vested options. His unvested options (1500–1125 = 375) lapsed the moment he resigned.
But, the company has a policy of allowing employees to exercise within six months of leaving the company. If he doesn’t exercise in this time frame, all of his 1125 vested ESOPs will lapse. If he chooses to exercise, he has to pay a lot of exercise tax (apart from his exercise price); Roshan is thinking hard about what to do
After a few years, as part of the Series C round, the company provides ESOP liquidity to select employees, including Roshan, for 20% of his vested ESOP. Roshan decides to take part, and he exercises his vested options; he submits the exercise letter to HR and pays the company 1125*500*20% = Rs 1,12,500. He will also have to pay the income tax amount to the company. The company will allot 1125*20% = 225 Equity shares to Roshan, and he will receive the duly signed share certificates. Then these shares will be transferred to the investor, and Roshan will, in turn, receive the sale amount.
What happens if I fail to exercise the option?
You will be given a time period during which you have to exercise the option, failing which the vested rights may lapse.
What’s the point of opting for ESOP over my salary?
That’s a million-dollar question.
It’s true, the shares you have received are ‘illiquid’, meaning they are not easily converted into cash.
That being said, there are four ways in which you can make money from ESOPs.
At the time of the funding round, the investors may buy a small portion of the vested common shares from the founders and early employees. A recent success story is Paytm, Nykaa, and Freshworks, where early employees of those companies turned millionaires through ESOPs.
When a company gets acquired, the purchasing company will try to buy all the shares of the company for cash or in exchange for their stock. For example, when Walmart acquired Flipkart, it bought the shares of Flipkart’s founders and shares worth $100 million from employees.
When the company lists itself on the stock exchange to sell its shares to the general public, you can sell your shares too. However, there will be a cooling down period for the employees and founders for 6 months. This means you need to wait for six months from the time the company goes public before you can start selling your shares.
#4 ESOP Trust
Companies that are growing at scale set up ESOP Trusts. This enables them to delay going IPO as much as possible because they want to grow further before hitting the public markets. If you want, you can sell a part of your stock units to them at the current 409A price. However, the 409A price is much less than the price at the time of the last round of funding. Hence, your profit margin will be relatively lower too.
What happens to my shares when I leave the company?
After you leave the company, you will be given 90 days to buy the vested shares. At the same time, most well-respected companies can even allow you a few years to exercise this vested option. Once you buy them, your shares will remain with you until the company comes public, secures a round of funding, or gets acquired.
What if the company doesn’t go public, gets funding, or is acquired? Will it affect my stock?
Your stock units have a shelf life that is usually 10 years from the date of purchase. If you buy the shares but the company doesn’t go public, secures the next round of funding, or gets acquired, your purchase options will expire. But most companies that are doing well get approval from the board to push the expiry by another year.
What if I’m working or looking for a job remotely?
Most of the companies have started hiring globally and work is becoming distributed and global now.
Speaking of which, if you want to learn more about landing a dream job in top companies abroad, then you should check out the video I made a few months back. I have shared my personal tips on how I landed a remote job in Europe. Here it is.
Now, while overseas companies may provide ESOPs to their employees, this can increase the compliance burden as most of these companies lack in-depth knowledge of the specific laws and regulations of each country. To nullify any confusion, here’s a tool that will come in handy — Oyster’s Equity Assessment tool.
With this tool, companies can efficiently leverage stock options and equity as compensation on a country-by-country basis, as the tool will calculate the feasibility of providing different types of equity in multiple countries and make informed decisions about their global compensation policy.
Are there any tax implications to ESOP?
Tax on ESOPs is calculated at two stages — Source: Taxguru.in
- The first deduction occurs when you have exercised the option on completion of the vesting period and the shares have been allotted to you.
- The second levy occurs when you sell the allotted shares under the ESOP.
Let me explain in detail:
Imagine you are exercising your option — now, if the Fair Market Value (FMV) of the share is more than the exercise price, this difference amount called a ‘perquisite’ will be calculated and taxed as per Section 17 of the Income Tax Act, 1961. And how is it calculated? Your employer — the company — will deduct it depending on the tax bracket you fall under, and the same will have to be deposited with the government before the 7th of the next month.
Now if you’re selling the shares which were allotted to you under ESOP, then tax is levied on any amount of profits you make from such a transaction. This is categorized into two parts:
Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG).
Tax implications on STCG will arise when shares are sold within 24 months of exercising. Here the rate of tax is 15%.
Here is the formula:
Amount = (sale price — FMV on exercise date) x No. of shares sold
Tax implications on LTCG will be applied when shares are sold after 24 months of exercising. The rate of tax in this case is 20%.
Is my ESOP taxable if my company sends me abroad after a few years of service in the parent country?
Normally ESOPs are granted by the parent entity to their employees. But taxation challenges surface when such employees migrate from the parent organization in one country to subsidiaries in another country for assignments.
So how are these taxed?
ESOP perquisites are taxable in a country on the basis of the number of days services rendered in the country.
For example, tax in India will be from the date of grant to the date of departure, and tax in the foreign country will be considered from the date of arrival to the date of exercise/vesting.
In my opinion, a job offer that comes packed with ESOPs is a great opportunity. However, it is important that you understand the basics of ESOPs before signing your grant letter and you must also completely believe in the company, founding team, and the product. Also, do not shy away from asking questions to your employer about what ESOPs will look like for you.
Awesome, that’s it I have for today. If I have missed out to explain something do let me know in the comments below.
Best of luck!