Why should I consider ESOPs?

In India, equity compensation, particularly through Employee Stock Option Plans (ESOPs), are gaining significant recognition because:

• 87% of founders believe equity compensation helps with talent retention, according to a report by Siason Capital.
• ESOPs offer a path to wealth creation for employees. Between 2020 and 2023, over 80 companies bought back ESOPs worth $1.45 bn (₹12,118 crore).

For employers, ESOPs not only align employees with the company’s goals by fostering a sense of ownership but also help conserve cash. At the same time, employees view equity as an opportunity to participate in the company's future success.

What are ESOPs?

Employee Stock Option Plans (ESOPs) are incentive programs that offer employees the opportunity to purchase company shares at a predetermined price. This price is known as the exercise or strike price and can be exercised within a specific time frame.

ESOPs allow employees to benefit from potential future growth in the company’s value. They can buy shares at a lower price and sell them at a profit if the company performs well.

Key components of ESOPs

‍1. Vesting

ESOPs typically include a vesting period. It is the timeframe during which employees gradually earn the right to a specified percentage of their stock options. This vesting schedule is designed to incentivize employees to stay with the company longer. 

The vesting schedule can vary by plan, but the most common structures include:

a. Time-based vesting: This structure typically involves a four-year vesting schedule with a one-year cliff. Employees must stay with the company for at least one year before earning any stock options. Once the cliff ends, they immediately vest a portion of their options for the previous year. After the cliff period, they may vest a portion of their options regularly, such as monthly, quarterly or annually.

b. Performance-based vesting: In this structure, stock options vest when employees achieve specific performance metrics or meet defined company goals. For instance, vesting could be tied to individual sales targets, project milestones, or overall company profitability. This approach ensures that employee incentives are closely aligned with the company's performance objectives, motivating employees to contribute actively to the company’s success.

By linking vesting to measurable achievements, performance-based vesting fosters a culture of accountability and high performance within the organization.

2. Cliff

A cliff is the initial period in a vesting schedule during which employees do not earn any stock options.

For instance, in a four-year vesting plan with a one-year cliff, an employee must remain with the company for a complete year before any of their options become vested. After the cliff period ends, a specified percentage of options becomes available for the employee to exercise. 

3. Exercising options

Exercising happens once the options have vested. It’s the process where employees turn their stock options into actual shares.

Employee Stock Option Plans (ESOPs) provide employees with the right to purchase company shares at a predetermined price, which is often lower than the current market price. When an employee exercises their options, they choose to buy the shares at this agreed-upon price.

Employees usually have a designated window of time—often several years—during which they can exercise their vested options. If they do not exercise their options within this timeframe, they may lose the right to purchase the shares, as the options will expire.

‍4. Tax implications

Typically, employees are not taxed when they receive stock options. However, tax liabilities come into play at two key stages in the life cycle of ESOPs:

i. At exercise:

When you exercise your stock options, the difference between the exercise price and the Fair Market Value (FMV) of the shares on the exercise date is considered taxable income. 

This amount is treated as a perquisite under the Income Tax Act.

Example:

Let’s say you have been granted 1,000 Employee Stock Options (ESOPs) with an exercise price of ₹50 per share. The Fair Market Value (FMV) of the shares on the exercise date is ₹150 per share.

Calculation:

Exercise price: ₹50 per share

Fair Market Value (FMV): ₹150 per share

Taxable income = (FMV - Exercise Price) × Number of Shares

Taxable income = (₹150 - ₹50) × 1,000

Taxable income = ₹100 × 1,000

Taxable income = ₹1,00,000

Even though you haven’t sold the shares or received cash, the ₹1,00,000 is treated as a perquisite and is taxed as part of your salary income. This amount is reported by your employer in your Form 16, and you must pay tax on this amount in the relevant financial year.

ii. At sale:

When you sell the shares acquired through stock options, capital gains tax is applicable to the difference between the sale price and the FMV at the time of exercise.

Example:

Sale Price: ₹200 per share

FMV at exercise: ₹150 per share

Capital gain per share: ₹200 - ₹150 = ₹50 per share

Total capital gain = Capital Gain per Share × Number of Shares Sold

Total capital gain = ₹50 × 1,000

Total capital gain = ₹50,000

Tax rates:

Short-Term Capital Gains (STCG): If the shares are sold within one year of exercise, the gains are taxed at 20%, an increase from the previous rate of 15% following the Budget 2024 announcement.

Long-Term Capital Gains (LTCG): If the shares are held for more than a year, the gains are taxed at 12.5%, up from the previous rate of 10%, also following the Budget 2024 announcement. 

This rate applies to gains exceeding ₹1.25 lakh, which is the threshold for long-term capital gains tax exemption. This exemption applies to all assets, not just equity compensation sales, in each fiscal year.

When and how can I make money with ESOPs? Understanding ESOP liquidity events

‍1. Buybacks

A buyback takes place when a company repurchases its own shares from employees, offering them liquidity.

Liquidity = converting stock options into cash.

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Unlike IPOs, buybacks are more common. 

Recently, India has experienced a rise in both the number and value of buybacks, as illustrated in the chart above. Many companies are even opting for multiple rounds of buybacks.

We believe the actual number of buybacks is considerably higher than reported.

The ease of doing buybacks has encouraged companies to pursue smaller, more frequent buybacks instead of larger, less frequent ones. At EquityList, we witness this firsthand by enabling buybacks for companies like Shipsy, Bizongo, and Slice.

2. IPOs (Initial Public Offering)

An Initial Public Offering (IPO) enables a private company to sell shares to the public for the first time. This process also allows employees to sell their stock on the open market, offering liquidity.

While recent ESOP buybacks provide partial liquidity, a public listing offers full liquidity.

Once a company goes public, employees need not wait for buybacks to cash their ESOPs, they can do so anytime.

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India is witnessing a growing trend of IPOs. Companies in the country often achieve valuations that are 30-50% higher than those of their U.S. counterparts. This disparity is driven by factors such as scarcity premiums and brand recognition, prompting many companies to relocate their headquarters back to India.

Additionally, Indian firms can access public markets with revenues of approximately ₹1,037.5 crore, whereas U.S. companies typically need around ₹2,490 crore. This lower threshold enhances the attractiveness of domestic IPOs for Indian companies.

For example, Zomato listed at ₹115 on the BSE, a premium of 51.3% over the IPO price of ₹76, peaking at 81% above the issue price with a day’s high of ₹138. 

Globally there has been massive wealth generation with liquidity events like IPO for startup employees. For instance, in the case of Facebook, the first 3,000 employees of Facebook made roughly $23bn at the time the company went public thanks to a variety of equity compensation schemes.

More recently, Airbnb announced a $2 billion buyback plan, and Snap announced a $500 million share repurchase plan.

3. Acquisition

During an acquisition, employees’ shares or stock options may be bought out by the acquiring company, allowing them to cash out on their equity. This process often involves various structures, such as cash payouts, stock swaps, or a combination of both, depending on the terms of the acquisition agreement.

For employees, this can represent a significant financial opportunity, especially if the acquiring company has a higher valuation than their current employer. Cash payouts provide immediate liquidity, while stock swaps can allow employees to participate in the potential growth of the acquiring company.

Additionally, the treatment of unvested stock options varies based on the deal structure. Some companies may accelerate vesting schedules, enabling employees to realize value from their unvested options, while others may cancel them.

Can ESOP help generate substantial wealth? ESOP millionaires

Owning equity in a startup brings a unique combination of rewards and risks.

On one hand, it provides the opportunity for significant financial returns, especially if the startup experiences rapid growth and success. This potential for exponential appreciation aligns your interests with the company's performance, creating a shared vision for success.

Numerous examples, both in India and globally, illustrate how equity compensation has transformed the fortunes of employees.

In 1999, Mark Cuban sold Broadcast.com to Yahoo for $5.7 billion in stock, resulting in 91% of his employees becoming millionaires.

In 2013, as many as 1,600 of Twitter’s employees became millionaires following its IPO.

A survey conducted among over 3,000 NVIDIA employees revealed that more than one-third of them had a net worth exceeding $20 million.

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Zomato’s IPO in 2021 created 18 millionaires.

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As reported in an Inshorts article from May 10, 2018, over 100 Flipkart employees were valued at more than $1 million each following Walmart's acquisition of a 77% stake.

However, the risks associated with equity compensation are also significant.

Startups are inherently unpredictable; many fail, and the value of your equity can decline or even become worthless.

Who gets an ESOP?

In the early stages of a company, typically before the first hires are made, an employee stock option pool is established to facilitate the distribution of Employee Stock Options (ESOPs).

The size of the option pool typically ranges from 5% to 10% of the total stock during the seed stage, increasing to 20% to 25% by the time the company reaches Series D funding.

Once the option pool is established, the company grants stock options to employees as they join. Additionally, as the company grows, it may offer options selectively during biannual or annual performance appraisals.

I have vested all my options. Now what?

Once your vesting period is complete, you gain full ownership of your options, granting you the right to purchase shares of the company. At this stage, you can acquire actual shares and become a direct stakeholder on the company’s cap table. However, this is contingent upon the company permitting you to exercise your options.

We hope you found this blog-post helpful and no longer question the need for ESOPs. If you have any questions, do reach out to us here.