By TV Mohandas Pai & Siddarth Pai
Employee stock option plans (Esops) symbolise “skin in the game”, marrying employee economics with shareholder value to democratise start-up success. It converts labour into equity, kickstarting a participative and prosperous virtuous cycle. India’s archaic laws on Esops are counterintuitive for the world’s third largest start-up ecosystem.
India has the aspiration of a $10-trillion economy with the regulations of a $0.5-trillion economy. The policy mindset is extractive, not expansive. Some aspects of tax laws and practices would make even the colonial British blush. India’s laws on Esops suffer from two fatal flaws: fair market value fallacy; and the promoter prohibition.
The taxation of Esops worldwide is similar. Esops are granted at a nominal price (grant price). When Esops are exercised, the fair market value (FMV) and grant price differential is taxed as “salary income”. When the shares are sold, sale price and FMV differential are taxed as capital gains.
Yet this is broken in India. Fair market value fallacy. The phrase “fair market value” is a misnomer for start-ups, as it is neither fair nor there is a market, and the value is hard to realise.
Start-ups are valued based on future performance, with investors negotiating special rights such as valuation readjustment (anti-dilution rights) and priority during exits (liquidation preference). This merits the prices they pay for their shares.
This same price forms the FMV for Esops, despite employees not getting the same rights. Private companies offer differential rights, unlike listed companies. Yet boards, auditors, and advisors fail to permit any FMV reduction, fearing scrutiny notices and prolonged litigation.
Hence the more successful the start-up, the greater the tax bill on the employee upon exercise. Employees often go into debt for Esop exercises. Employees of listed companies can exercise Esops, sell their shares on the stock exchange, and pay their taxes. For employees of start-ups, there is no market. Start-ups need to raise capital to survive and can’t afford diversion for secondaries. Yet this illiquidity merits no consideration during taxation.
Esops can’t be used to pay taxes or rent. The value is only realised if the company goes for an initial public offering (IPO) or a full sale where the sale is higher than all the capital raised by the company and the FMV of the exercise. This is a 10-15-year journey, if lucky. Many start-ups go bust and employees get into debt just to participate in their company’s equity.
India’s tax policies have made “skin in the game” costs a pound of flesh.
India’s tax laws require Esops to be at FMV while the equity shares they convert to are valued at book value. The right to purchase is taxed much higher than the actual asset one purchases, a cruel irony. It shows how simple the solution is, yet the reluctance to do so is baffling.
Promoter prohibition
Two recent stories—Elon Musk’s $1-trillion Tesla package and the Lenskart founder’s pre-IPO incentive—highlight how performance-linked incentives create value for all. In Musk’s case, he will get an additional 1% of Tesla for every $500 billion of market value created. At a $8.5-trillion valuation, his overall stake will be worth $1 trillion.
While one can debate the economics, one thing is certain—India will never see such a situation. This is not a commentary on our stock markets; it’s an indictment of our laws. India’s Companies Act prohibits promoters (founders) from getting Esops—a relic of a time when shareholders of “promoter-led” Indian companies required protection from the promoter and their voracity. But in an era of founder-led companies and professional managers, this archaic law prevents willing shareholders from creating such incentives aligned to their interests.
Rather than letting shareholders (barring the promoter) vote on such a matter, India’s answer is to ban it. The Lenskart founder’s pre-IPO incentive was structured as a secondary purchase from existing shareholders as he couldn’t get Esops by law. Though executed late, it is common due to India’s archaic prohibitions.
His price was locked at 8,700 crore, while the IPO band was70,000 crore. This affected perceptions of India’s only consumer start-up that has successfully gone global. In the US, he would be lauded as a hero and get Esops; in India, he’s portrayed as a shark, like his TV avatar.
India’s solution
Budget 2020 saw an attempted Esop reform which didn’t address the core FMV issue. Instead, it deferred taxation for the handful of Inter-Ministerial Board-registered start-ups. Those lucky companies whose revenue is less than Rs 100 crore, whose age is less than 10 years, and certified by the government as “innovative”, may defer Esop taxes till sale or 48 months, whichever is earlier.
A comparison with the US and China (the largest start-up ecosystems) and Singapore shows the following:
Founder Esop: Permitted, subject to board and shareholder approval (excluding founder). Taxation: The US permits adjustment based on investor rights, illiquidity, etc., never at the investor’s price; China taxes at sale as capital gains; Singapore taxes FMV at book value.
India’s Esops are a sob story for employees and founders. Founders have chosen the US or Singapore as their headquarters, despite their business and team being in India, due to such restrictions. The tax department’s hesitation to change is emblematic of its extractive nature. The tax collected by Esop exercises is minor compared to the value created by these start-ups and taxes paid during sales.
The fix is simple: Founders should be permitted Esops, subject to shareholder approval. Esops’ FMV should be book value, the same as what is prescribed for equity shares. Esops are a way to nail a founder’s trousers to the mast of the start-up; India’s approach is to use Esops to nail founders and employees to the wall. Skin in the game should not cost a pound of flesh.
TV Mohandas Pai & Siddarth Pai are respectively chairman at Aarin Capital and partner at 3one4 Capital
Disclaimer: Views expressed are personal and do not reflect the official position or policy of FinancialExpress.com. Reproducing this content without permission is prohibited.