The startup ecosystem in India is buzzing, and the best talent wants to work for startups due to the high growth potential. One of the most attractive aspects of working for a startup is getting a share of the upside through Employee Stock Ownership Plans or ESOPs.
With many startups announcing sizable funding rounds, a large amount of wealth has been created through ESOPs for early employees. In 2021 alone, close to Rs 3000 crore or $440 million has been spent by more than 30 Indian startups to buy back employee ESOPs.
What you need to know about ESOPs
The key to wealth creation with ESOPs is to understand them well.
1. ESOPs are an investment: An ESOP is a right (but not an obligation) to acquire shares of a startup, and most often at a discounted price. You’re an investor in the business and need to think with this mindset.
2. Comparing ESOPs: You can compare the salary packages that companies offer. But comparing ESOPs of one company with another is like comparing apples with oranges. The two firms may be in different businesses, at different stages of growth – and hence the upside can vary dramatically.
3. Value of ESOPs: There is a certain level of confusion here. Certain employers communicate the “at-the-money” value of these options, while others communicate “in-the-money”. Make sure you understand what you are being offered first.
4. Vesting and Exercise Periods: Look carefully at things like over what period you will get these options (vesting), and till when you can convert them to equity (exercise). Ideally, vesting should be as early as possible and exercise should be as long as possible!
5. ESOP vs Cash: This is the hard part, and it is personal. Our advice: first secure for yourself a comfortable lifestyle (so you and your family are secure) and then max out on the ESOPs you can negotiate. But it’s OK to compromise on cash if that works for you.
How ESOPs are taxed?
Here too there is some confusion among ESOP holders. Let’s try to break this down.
- When your company cashes out your ESOPs: At times, companies will cancel out your ESOPs and pay you a cash amount when doing it. In these cases, the cash amount is taxed as per your regular income tax slab.
- When you convert the ESOP to shares: The difference between the exercise price (what you need to pay to ‘buy’ the shares as per your ESOP grant) and the fair market value (the current value per share) is taxed as per your income tax slab.
- When you sell the shares: As with any sale of shares, you need to pay capital gains tax. Depending on whether such shares are listed or not, and how long you have held these shares, the tax rate varies. The tax is paid on the gain between your sale price and the fair market value at which you converted these ESOPs into shares.
The Finance Ministry has tried to address concerns of upfront taxation due to perquisite tax, especially in the case of unlisted companies where liquidity is not available.
From Financial Year 2020-21, an employee receiving ESOPs from an eligible start-up will be able to defer the payment of perquisite tax until certain events occur.
We hope the above perspectives will help you understand and negotiate your ESOP plan better, and maximise long term wealth via efficient tax planning.
Above all, the ESOP is your share of the company. The mission of the company and the team that you work with must excite you. Only then will you value this share, especially when the company goes through challenging times.
By, Sandeep Jethwani, Co-Founder, dezerv.in