How ESOPs work?
An organization grants ESOPs to its employees for buying a specified number of shares of the company at a defined price after the option period (a certain number of years). Before an employee could exercise his option, he needs to go through the pre-defined vesting period which implies that the employee has to work for the organization until a part or the entire stock options could be exercised.
Why Company offers ESOPs to their employees?
Organizations often use Employee stock ownership plans as a tool for attracting and retaining high-quality employees. Organizations usually distribute the stocks in a phased manner. For instance, a company might grant its employees the stocks at the close of the financial year, thereby offering its employees an incentive for remaining with the organization for receiving that grant.
Companies offering ESOPs have long-term objectives. Not only companies wish to retain employees for a long-term, but also intend making them the stakeholders of their company. Most of the IT companies have alarming attrition rates, and ESOPs could help them bring down such heavy attrition Start-ups offer stocks for attracting talent. Often such organizations are cash-strapped and are unable to offer handsome salaries. But by offering a stake in their organization, they make their compensation package competitive.
ESOPs from an employee’s perspective
With ESOPs, an employee gets the benefit of acquiring the shares of the company at the nominal rate, and sell them (after a defined tenure set by his employer) and make a profit. There are several success stories of an employee raking in the riches together with founders of the companies. A very notable example is of Google when it went public. Its founders Sergey Brin and Larry Page became the richest persons in the world, even the stock-holder employees earned millions too.
Tax Implication of ESOPs
Employee stock ownership plans is considered as perquisites with respect to taxation. On the other hand, for an employee, ESOPs are taxed at two below-mentioned instances –
While exercising – in form of a prerequisite. When an employee exercises his option, the difference between Fair Market Value (FMV) as on date of exercise and the exercise price is taxed as a perquisite.
While selling – in the form of capital gain. An employee might sell his shares after buying them. In case he sells these shares at a price higher than FMV on the exercise date, he would be liable for capital gains tax.
The capital gains would be taxed depending on the period of holding. This period is calculated from the date of exercise up to the date of sale. Equity shares which are listed on the recognised stock exchange are considered as long-term capital if they’re held for more than 12 months i.e. 1 year. In case the shares are sold within 12 months, these are then considered as short term. Presently, long-term capital gains (LTCG) on the listed equity shares are exempt from tax. However as per the recent amendments in Budget 2018, Sale of equity shares that are held for more than a year on or after 1st April 1, 2018 would attract tax at the rate of 10% and cess of 4%. Short-term capital gains (STCG) are taxed at a rate of 15%.
Benefits of ESOPs for the employers
Stock options are provided by an organization as a motivation to its employees. As the employees would benefit when the company’s share prices soar, it would be an incentive for the employee put in his 100 percent. Although motivation, employee retention and awarding hard work are the key benefits which ESOP brings to the employers, there are several other noteworthy advantages too.
With the help of ESOP options, organizations could avoid the cash compensations as a reward, thus saving on immediate cash outflow. For organizations which are starting their business operations on a bigger scale or expanding their business, awarding their employees with ESOPs would work out to be the most feasible option than the cash rewards.
Problems related to ESOPs for the employers
It’s easy to pitch the benefits of ESOPs for the companies considering the liquidity and succession alternatives. However, there are good reasons not to go for ESOPs.
Employee stock ownership plans have complex rules and need significant oversight. Although outsourcing this function to external advisors and ESOP TPA (Third Party Administration) firms could manage it, the ESOP company requires some internal personnel for championing this program. In case a company doesn’t have the staff to do the ESOP work properly, they could risk issues and potential violations.
Once the ESOPs are established, the company needs a proper administration including the third-party administration, trustee, valuation, legal costs. Company owners and the management must be aware of the ongoing costs. In case the cash flow which is dedicated to ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP scheme isn’t a good fit for such a company.
For companies requiring significant additional capital for carrying on business operations, they must avoid ESOPs. The ESOP schemes use the cash flow of the company for funding purchase of shares from its shareholders. In case a company requires the funds for additional working capital or capital expenditures, the ESOP transactions would compete with this necessary requirement, creating a crisis situation for the management.
Employee’s perspective
At the very outset, every employee should ask his/her employer for a copy of the ESOP scheme whenever he/she is granted stock options. This scheme will give a detailed insight into the terms and conditions associated with ESOPs. Once stock options are granted, there is a one-year cliff period. Any kind of vesting, i.e. the right to convert the stock options into equity, will only take place once the cliff period has lapsed. Thereafter, subject to the vesting schedule, i.e. how the vesting ought to take place, the employee will have a right to exercise his vested options by paying an exercise price to the employer. The exercise price is typically the face value of the shares. The entire exercise mechanism can be kept cashless as well, i.e. the vested options may be exercised and converted into equity without paying anything. All this information will be highlighted in the ESOP scheme and/or the Letter of Grant issued by the employer.
Let us explain the above with a simple example:
On September 01, 2015, a company grants its employee 100 options with a vesting period of two years and an exercise period of seven years at an exercise price of Rs 10 per share. Under the Company Rules, there is a one-year cliff period. This implies that the vesting will not commence till September 01, 2016. Since the vesting period is two years, half of the options (i.e. 50) will vest on September 01, 2016 and the remaining half on September 01, 2017. The exercise period of the vested options is seven years. This means that that the employee can convert his 50 options (that vested upon him on September 01, 2016) anytime before September 01, 2023. For the remaining 50 options that vested in 2017, the employee can exercise his right any time before September 01, 2024.
Let us now assume that on December 01, 2019, the employee decides to exercise his/her right to convert 70 options into common stock. At that stage, an Exercise Application will be addressed to the company. Assuming the exercise price was Rs 10 per share, the employee will pay Rs 700 (70 options * Rs 10 per share) to the company and the company will allot the employee 70 equity shares.
It is also pertinent to understand that in case an employee resigns, any unvested options (i.e. those that have not yet vested) will lapse. In case some options have already vested on the date of resignation, their treatment will be determined as per the terms of the ESOP scheme. Therefore, it is crucial that all employees who have been granted options read the terms of their company’s ESOP scheme very carefully.
In the end, I’d like to state that ESOPs are a great incentive for employees to put their heart and soul into an organisation. However, grant of options in itself does not mean that the employee will walk out of that organisation with millions in his bank account and employees should be conscious of this fact. Most young employees have only heard positive stories about ESOPs and often do not do their own diligence to understand the key terms governing their options. Some startups ask their legal advisors to make a presentation for their entire staff explaining how ESOPs work and how it can benefit them. This, in my view, is extremely beneficial. Failure to understand the intricacies is likely to leave you highly disappointed when you resign to move on to your next job.
