Explained: What accepting ESOPs, especially if joining a start-up, might entail

• When exercising your ESOP options, you need to pay for the shares at the exercise price.
  
• There may be an additional tax burden if the ESOPs are provided at a value lower than the fair market value at the time of vesting.
  
• If the company fails to perform well, or lacks successful liquidity events, the potential returns on ESOPs may remain unrealised.
  

When talking about the glitzy world of start-ups, a discussion on employee stock ownership plan (ESOPs), always comes up. In recent news Swiggy announced that it will buy back shares worth $50 million from employees. Also, Paytm granted 1.7 million new ESOPs to employees. A few weeks ago Flipkart announced a $700 million ESOPs payout.

However, the world of ESOPs may not all be as rosy as it seems at first glance. ESOPs work in a certain way and there are a lot of factors which need to fall into place before an employee can make a profit out of them. Therefore, one needs to understand that with start-ups coming under a lot of pressure due to an uncertain economic scenario and a funding crunch, have ESOPs lost their charm?

“ ESOPs are often offered to outstanding performers to foster a sense of ownership, and nowadays, start-ups use them as a means to attract and retain top talent. However, it is essential to be aware that some companies might also offer ESOPs to compensate for situations when they cannot offer competitive salaries,’ says Anjali Raghuvanshi, Chief People Officer, Randstad India, a HR consulting firm.

What this essentially means is that when taking up a job offer, do note if ESOPs are a part of the salary package as this may come at the cost of foregoing some salary.

It is important to understand two major risks associated with ESOPs. Let us take a look.

You would need to fork out money upfront

Here is where owning ESOPs can get tricky. “There are two up-front costs you have to bear when you are exercising your ESOP options. The first cost is the amount you pay the company for those ESOPs,” says BM Singh, ESOP Expert & Managing Partner, BMSA, a consulting firm.

Suppose an employee is granted 1,000 ESOP options by a company. The exercise price or strike price of each option is ₹100. This means that the employee can purchase the company's shares at ₹100 per share at a future date, regardless of the market price at that time.

Now, let's assume that the market price of the company's shares increases to ₹150 when the employee decides to exercise their ESOP options. To exercise the options, the employee needs to pay the exercise price, which is ₹100 per share. The cost to the employee to exercise their ESOP options would be ₹100,000.

Additionally, there may be a tax implication

The next is the tax implication that arises here. If the ESOPs are granted at a value lower than the fair market value during vesting, there could be an extra tax burden, resulting in potential tax liabilities before fully realising the value of the ESOPs.

“ESOPs are taxable in the hands of the employees as perquisite u/s 17(2) of the IT Act. The taxable amount of such perquisite would be the fair market value (FMV) of the shares (computed in accordance with Rule 3(8) of the IT Act) on the date of exercising such option less any amount paid by the employee for such ESOPs,” says Suresh Surana, Founder, RSM India, an audit, tax and consulting firm.

In the above example, the employee would need to pay tax on the taxable amount of ₹50,000 at the applicable tax rate. The exact tax amount will depend on the individual's income tax slab rate.

A bigger concern

Poor company performance and uncertainty of liquidity events may render ESOPs worthless.

“If the company fails to perform well or lacks successful liquidity events, the potential returns on ESOPs may remain unrealised, potentially impacting the value of the effort and time invested over the years, “ says Raghuvanshi.

The value of ESOPs is closely tied to the company's performance and growth potential. If the company's value decreases, it can negatively impact the value of your stock options, potentially making it challenging to sell your shares at a profit.

Hence, it is important for an employee to evaluate the future prospects and growth of a company before making a decision to exercise the option. When an employee exercises the options, he should have trust in the company's future growth and performance.

“The employee should also be aware about the exit possibilities in case of unlisted shares i.e. buyback track record, funding rounds etc,” says Akhil Chandna, Partner, Tax, Grant Thornton Bharat, a professional services firm.

When exercising ESOPs, it is thus essential to conduct a thorough assessment of the company's current performance and financial well-being. This evaluation helps the employee make informed decisions about exercising their options. “Any significant changes since joining could impact the decision,” says Raghuvanshi.

Risk of ESOPs are higher in an early stage start-up

If a start-up is bootstrapped or in the idea phase, the risks are higher. In that case ESOPs are merely paper money. As the different rounds happen, the value of the ESOPs and the probability of liquidity increases.

“You should see at which stage of the start-up you are entering. At each phase the value of ESOPs is different. So if you are joining a company just on the basis of ESOPs and not getting a reasonable salary and the company is in its early stages, then you should also focus on the cash component,” says Singh. If it has reached the Series A or Series B funding stage, then you can consider the value of ESOPs when joining and can consider it an important part of your salary package.