Decoding ESOPs: A Guide to Understanding Employee Stock Options

This blog explores the basics of Employee Stock Option Plan (ESOP). By the end of this blog you will have a clear understanding of your ESOP policy.

Introduction

ESOPs offer a way for employees to participate in the financial growth of the company apart from their regular salary. They are a tool to generate wealth and should not be misunderstood for income. They are a fare and legal means to generate wealth if the company does well.

Why do companies offer ESOPs?

ESOP is a great tool to align long term incentives with the right employees.

• Induce Ownership: ESOPs induces a sense of ownership and can help promote a high ownership culture.
• Employee Retention: ESOPs incentivize the employees who believe in company's growth to stay longer.
• Building Founding Team: Early-stage companies, which may not afford competitive salaries, offer ESOPs as a way to attract and retain talented teams by compensating them in the long run.

Core Concepts

ESOP Pool

Company offers ESOPs from an ESOP Pool, which has a fixed number of reserved shares for this purpose. Every time an employee is granted ESOPs, the pool deplete by the allotted shares. Once all these shares get allotted, the ESOP pool gets exhausted. Creation or expansion of the ESOP Pool typically requires approval from the company's board and depends on various factors beyond this blog's scope.

Exercising your ESOPs

As the name suggests, ESOP grant options, not shares. To convert options into shares, employees pay a nominal exercise price, often much lower than the market value, allowing employees to benefit financially. This price is typically the face value of the share.

Vesting

Your options vest gradually over a vesting period, meaning you gain the right to exercise them incrementally over time. Vesting ensures that employees contribute to the company's growth during their tenure.

Vesting Schedule: Decoding your ESOP Policy

If you have ESOPs, terms like cliff, vesting period, and exercise period are crutial to understanding your policy. The vesting schedule determines how many options can be exercised after how much time.

Cliff

Cliff is the time period after which your first set of options vest and can be exercised. Before this period you are typically not allowed to exercise any options. The no of options that you would vest after the Cliff period is mentioned in your policy.

In other words, the cliff ensures employees serve a minimum period before they can have any shares, aligning ESOPs with employee retention goals.

Periodic Vesting

After the Cliff period, remaining of Options are vested periodically until all options are vested or the employee leaves the company.

Exercise Period

Once you have some vested options, you can exercise them. The exercise period specifies the time period within which vested options must be exercised, starting from the date of vesting.

Bring it together

Let’s break it down with an example.

Let's decode it.

• Issue Date: 1st January, 2025
• Grant: 12 options
• Cliff: 2 years
• Vesting Schedule: (if you remain with the company for the next your years from the date of issue):
• 1st January, 2027: 6 options (50%)
• 1st January, 2028: 3 options (25%)
• 1st January, 2029: 3 options (25%)

Exercise period:

• First 6 options: Exercise by 1st January, 2032.
• Next 3 options: Exercise by 1st January, 2033.
• Final 3 options: Exercise by 1st January, 2034.

Exit Opportunities: Turning Shares Into Money

Also known as Liquidation events, these are events when you can sell your shares and reliase monetary benefits.

Below are the most common exit events.

• Buyback: Company is doing good and launches an ESOP buyback program, where they buy back shares from the employees.
• Company Acquisition: The company is acquired, and employees can sell their shares to the buyer.
• Grey Market: Investors reach to employees to buy their shares if an IPO is expected soon.
• IPO: Company goes public and you can now trade your stocks direct on the stock market.

Taxation

In India, ESOPs are taxed at two events: at the time of exercise and upon selling the shares. Here’s a detailed overview of how ESOPs are taxed:

Taxation at Exercise

When exercising ESOPs, the difference between the Fair Market Value (FMV) of the share on the exercise date and the exercise price is considered a taxable amount. This amount is treated as salary income and is subject to be taxed at your income slab. The employer is required to deduct tax at source (TDS) at the time of exercise.

For Example, If the FMV = ₹2,000/share, exercise price = ₹10/share, and you exercise 1,000 shares:

• Taxable income = (₹2,000 - ₹10) × 1,000 = ₹19,90,000.
• Tax (at 30%) = ₹5,97,000.

Taxation on Sale of Shares

Capital Gains Tax: Upon selling the shares, any gains realized are subject to capital gains tax. The calculation is based on the difference between the sale price and the FMV at the time of exercising the options. For capital gains calculation, the cost of acquisition for shares is considered as their FMV on the date of exercise.

• Short-term Capital Gains (STCG): If shares are sold within 12 months of exercise, gains are taxed at a rate of 15%.
• Long-term Capital Gains (LTCG): If sold after 12 months, gains exceeding ₹1.25 lakh are taxed at 12.5%.

Wrapping Up

Here is a quick summary of what we learned:

• ESOP grant you options that vest over a period of time.
• You need to exercise your options to convert them into shares.
• Taxation can be optimised by clubing the exercise with the selling of shares.

In the next blog, we will learn about:

• Understanding risks and valuations associated with ESOPs.
• How to negotiate ESOP offers effectively.
• When to choose income over ESOPs and vice versa.
• Deciding whether to stick with a company to vest ESOPs or explore other opportunities.
• Factors that significantly impact your exit opportunity.