esop - Treelife

What’s the hype behind ESOPs?

Because of the tremendous competition in the startup world, acquiring and keeping staff is critical. And the only way to do so is to reward them for their contributions. Employee Stock Options (“ESOP”) are one type of compensation that many firms provide these days. The hype might be explained by examining the benefits from both the employee and the company’s perspectives.

For Employees:

Boost employee morale by encouraging them to do better in their daily responsibilities.
Increases staff retention and, as a result, minimises turnover.
Savings on director salaries for a private limited business by giving a share of ESOPs as a component of salary.

For Company:

Employees might directly hold shares in a firm and participate in its success.
Can gain from riches by selling lucrative shares that were purchased at a lesser price.
Encourages employees to do their best.

2. Why is it called ESOPs and does it differ from the stocks that a founder holds?

It is called ESOPs because it is an employee benefit plan that provides employees a share of the company’s ownership. Each qualifying employee receives a set percentage of the company’s equity shares at no cost to them.

Founder Stocks	ESOP
Founder’s equity, sometimes known as founder’s stock, is a type of shares awarded to a company’s founders or early members. In actuality, founder’s stock is just common stock that has been distributed to the company’s founders.	ESOPs are given to directors and workers as an incentive and as a retention plan. They do not constitute an obligation, and they are offered to workers in the form of a right to exercise their option to acquire shares.

3. At what stage of a company’s growth are the ESOPs most valuable for an employee?

The various stages of growth in the lifecycle of the start-up can be divided into:
Early Stage
Companies are often less liquid in the early stages (seed and angel rounds). They might not have enough money to hire C-suite executives and other key staff who are essential to the company’s success. Founders should offer ESOPs aggressively in such circumstances since they will have a lesser cash component to offer. Grants from ESOPs can be substantial, thus policies should be flexible. At this point, the primary goal is to recruit personnel.
Growth Stage
A startup’s business has expanded by the time it receives a Series A or B round of funding. Employees’ monetary expectations should be matched by founders, and ESOPs should be limited to the most valued employees. ESOP grants may be reduced, but cash components should increase. Employees should be granted ESOPs as a form of compensation. The retention of high-performing individuals becomes crucial at this point in the process. Employees who were not given ESOPs when they started must now be given ownership options if they are key players in the company.
Maturity Stage
Startups reach a mature stage after raising a Series B financing. Both the cash component and the ESOP pool are most likely balanced at this point. Satheesh recommends that founders raise performance-based ESOP awards at this time. Because the monetary component is so large, ESOPs should only be issued when absolutely required. It’s also worth noting that the company’s valuation rises at subsequent phases, implying that each ESOP’s Fair Market Value (FMV) rises as well. As a result, entrepreneurs should take a balanced approach to the awards that should be given to workers based on their success.

From the above it is clear that no matter the stage ESOP are valuable for the employee. However while signing up for ESOPs the employee should ask the following questions:

Is an Esop Scheme in place?
Quantum of options You will get
The value of the Options
Liquidity and valuation of Shares
How to decide between full-monetary salary hikes & ESOPs?

Although common sense would dictate that cash should be preferred over ESOPs, such a comparison may be difficult to establish because the predicted price of shares under an ESOP plan is often substantially greater than the cash component being provided. Furthermore, the option of opting for cash instead of an ESOP may not always be available.

If your company’s financial performance falls short of expectations, not only your pay but also your fortune will be jeopardised. As a result, only use your ESOP right to purchase shares if your company’s fundamentals are sound. The issue of taxation must also be examined. You must pay tax on the difference between the fair market value and the exercise price when you execute the option.

5. What are the things to look out for when offered ESOPs? What are cliffs & vesting periods?

The following things need to considered when ESOPs are offered:

i. Is the exercise price fixed or based on the FMV (Fair Market Value)?

The exercise price of options can be whatever the corporation chooses when issuing the ESOP grant letter. Some firms use a minimal exercise price (for example, INR 10) while others choose an exercise price depending on the company’s latest round value. The greater the difference between FMV and exercise price at the time of ESOP sale, the more money you create.

ii. Is there a vesting schedule? Is it a one-size-fits-all approach, a back-loaded approach ,or performance-based approach?

When you participate in an Employee Shares Option Plan, you have the ‘option’ to acquire the company’s stock at the time of exercise. The procedure by which you obtain the right to acquire these stocks on a systematic basis or according to a pre-determined calendar is known as ESOP vesting. Think of the vesting schedule as a timetable by which you obtain the right to ESOPs. The most typical vesting plan is uniform yearly vesting over four years, which means that after the first year of mandatory ‘cliff’ vesting, you will get 25% of the total ESOPs guaranteed to you every year for the next four years.

iii. When you leave the company, what happens to your ESOPs?

Your unvested ESOPs are returned to the ESOP pool when you depart or your employment term ends, but you should be aware of how your vested options are treated. Here you must consider how much time you will have to consider your alternatives after resigning. Consider that if you just have a few weeks to exercise, you’ll have to pay a few thousands or perhaps crores of rupees to obtain possession of your shares. Most well-known companies let workers months or even years to exercise their vested options.

iv. When you exercise your options, what are the transfer restrictions?

There may be a clause in the ESOP programme that allows the firm or the founder to forcefully purchase back (call option) such shares at market price. A ‘Right of First Refusal’ or ROFR clause, for example, permits the business to review any sale or transfer offer you have received first, and only if the company agrees to waive the ROFR clause can you proceed with the sale or transfer of shares.

v. How does the corporation make ESOP liquidity available to employees?

Check the ESOP policy and grant letter to see how ESOP liquidity has been or will be made available to startup workers. Is this even brought up by the management? Remember that you will only profit from your ESOPs if a liquidity event occurs, such as a secondary transaction, repurchase, or ultimate IPO.

The concept of ESOPs has evolved with a sense of sharing ownership responsibilities with employees and retaining talent that is necessary to startups.

Nowadays, it is popular amongst startups to create an ESOP pool typically about 10% to 15% of the capital before fundraising as it is tax efficient and helps especially when a company has to attract and retain talent with minimal cash outflow.

Employee Stock Option Plan (ESOP)

An Employee Stock Option Plan (ESOP) is an employee benefit plan by which a company offers its employees ownership interest in the organisation.

In the case of ESOPs, eligible employees who meet specified criteria as per the company’s ESOP scheme will be offered the option on a grant date to buy the company’s stock after vesting period (specified time for which employee has to continue his service in the company). After meeting the vesting conditions, if any, an employee can purchase the company’s stock at a predetermined value.

Sometimes in the case of group companies, employees of subsidiary companies will be offered with options of the parent company.

Tax consideration

Tax liability will trigger at 2 stages in the hands of employee as detailed below:

At the time of exercise

Difference between Fair Market Value (FMV) as on the date of exercise and the exercise price (i.e. amount paid by the employee) is taxed as a perquisite or a part of salary income in the hands of the employee at the time of exercise.

At the time of subsequent sale or transfer

When the employee subsequently sells or transfers the shares, the difference between actual sale considerations realized and FMV as considered in the previous step is treated as capital gain. Fair market value can be adjusted for indexation if the holding period of the share is more than 12 months in case of shares of listed companies and more than 24 months in case of shares of unlisted companies as it is considered as long term capital gain.

Example:

Grant date: 1^st April 2018 Maturity date: 1^st April 2021 Number of options exercised: 700 Fair market value as on April 2021: INR 150 Amount collected from employee: INR 50

In this case on 1^st April 2021 employee will be taxed on INR 70,000, (i.e., 700 shares * (150-50)) as perquisites under the head of salary income.

Note: There will not be any tax implications on lapsed options.

Subsequently, if in October 2022, the employee sells or transfers the share at INR 200 per share, then the employee has to pay a capital gain tax on INR. 35000 (i.e.,700 shares * (200-150))

Note: Since in this case the shares are sold within 24 months of acquisition the taxability will be on short term capital gains

Tax implications in the hands of employer

The amount treated as a perquisite upon exercise of option as detailed above, is considered as salary cost and is an allowable expenditure in the hands of the employer. However, the employer is required to deduct TDS on the same as per the provisions for TDS on salary.

Sometimes it may so happen that the benefit arising from an ESOP discount might be more than the salary of the employee itself, say the perquisite amount might be INR 13 lakhs, whereas cash payout might be INR 9 lakhs. In such situations, the company generally has to ensure proper documentation & put in place a system to deduct the number of exercised options for TDS compliance.

Considering such difficulties faced by the employees, an option is given to defer the tax liability on perquisites till 14 days from earlier of the below events instead of date of exercise of option.

Expiry of five years from the end of year of allotment of shares under ESOPs
Date of sale of the such shares by the employee
Date of termination of employment

However such option is available only for eligible start up holding Inter-ministerial Board Certificate (IMB certificate).

Date of allotment	Date of sale	Date of Termination of employment	Expiry of 5 years	Perquisite tax triggering event	Perquisite tax triggering date
01-Oct-20	01-Jul-23	01-Jan-24	01-Apr-26	Date of sale	01-Jul-23
01-Oct-20	01-Feb-24	01-Jan-24	01-Apr-26	Date of Termination of employment	01-Jan-24
01-Oct-20	01-Oct-27	01-Oct-26	01-Apr-26	Expiry of 5 years	01-Apr-26

Cross border ESOP transactions

In the case of group companies that have global presence, an employee may migrate to work in different countries for deputation. Therefore, a situation may arise where residential status at the time of grant of ESOP might change at the time of exercise of option after vesting which leads to double tax of the same income.

Generally, global income will be taxed in the hands of residents after giving the credit for taxes paid in foreign countries.

In such cases, ESOP perquisites are taxable in a country on the basis of the number of days of services rendered in the country. Below example may be considered for the clarity of the situation (this example is only taken for understanding of the concept, however legal provisions of both countries have to be looked in real situations)

Example:

If the resident employee of an Indian parent company, say P. Ltd., is granted 500 ESOPs at INR 30 each in May 2021 which will vest after 4 years in April 2025. He migrated to Dubai on deputation basis to a subsidiary there in April 2023 and continues to be resident in Dubai till May 2024.

If the fair market value at the time of exercise of option is INR 150, then total perquisite of INR 60,000 (INR 120 * 500 shares) will be taxed both in India and Dubai proportionately based on period of service in each country. In this case an employee has worked 3 years in India & 1 year in Dubai. Accordingly INR 45000 will be taxed in India and INR 15000 will be taxed in Dubai.

Issues for consideration

In India, it will be challenging for the parent company to comply with TDS requirements as there may not be any other source of income of the employee at the time of exercise
At the time of subsequent sale of shares in the foreign country, it may not accept FMV on the date of acquisition as cost of acquisition. This may lead to double tax for the employee

FAQs about ESOPs

Q. How does ESOP work in India?

A. An Employee Stock Option Plan (ESOP) is an employee benefit plan that enables eligible employees to buy equity shares in their company at a predetermined price after completing a specified vesting period. After vesting, the employee can exercise the option to buy the shares at the predetermined price, which is usually lower than the market price.

Q. What are ESOPs in India?

A. ESOPs (Employee Stock Option Plans) are a popular employee benefit plan which grants eligible employees the right to buy shares in their company at a predetermined price in the future.

Q. What are the tax benefits of ESOP for the employer?

A. ESOPs amount treated as a perquisite upon exercise of the option is considered a salary cost and is an allowable expenditure in the company’s hands.

Q. Is ESOP expense taxable?

A. ESOP expenses are considered a salary cost and are an allowable expenditure in the hands of the employer. However, the employer must deduct TDS on the same as per the provisions for TDS on salary.

Q. Are ESOPs part of CTC?

A. Yes, ESOPs may be included in the Cost to Company (CTC) of an employee.

Q: What is the tax treatment for ESOPs in the hands of the employee at the time of exercise?

A: The difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price (amount paid by the employee) is taxed as a perquisite or a part of the employee’s salary income at the time of exercise.

Q: What is the tax treatment when the employee sells or transfers the shares later on?

A: When the employee subsequently sells or transfers the shares, the difference between the actual sale considerations realized and the FMV considered at the time of exercise is treated as capital gain.

Q: Can the Fair Market Value be adjusted for indexation during subsequent sale or transfer?

A: Yes, the Fair Market Value can be adjusted for indexation if the holding period of the shares is more than 12 months for shares of listed companies and more than 24 months for shares of unlisted companies.

Q. How do I defer tax on ESOP?

A. One way to defer tax liability on perquisites related to ESOPs is to opt for an Inter-ministerial Board Certificate and defer the tax liability on perquisites till 14 days from earlier of the below events instead of date of exercise of option.

Expiry of five years from the end of year of allotment of shares under ESOPs
Date of sale of the such shares by the employee
Date of termination of employment

Q. How is tax calculated on ESOP?

A. Tax on ESOP is calculated based on the difference between the fair market value of the shares at the time of exercise and the exercise price.

Q. How are ESOPs taxed in India?

A. ESOPs in India are taxed as perquisites at the time of exercise and as capital gains at the time of sale or transfer of the shares.

Q. Is TDS applicable on ESOP?

A. Yes, the employer must deduct TDS as per the provisions for TDS on salary on the perquisite amount at the time of exercise of the option.

Q. How is perquisite tax calculated on ESOPs?

A. Perquisite tax on ESOPs is calculated as the difference between the Fair Market Value (FMV) of the shares at the time of exercise and the exercise price.

Q. What is the taxability of dividend on ESOP shares?

A. The dividend earned on ESOP shares is taxable as per the applicable tax rates, which can vary depending on the individual’s income tax bracket.

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