EVERYTHING YOU NEED TO KNOW ABOUT ESOPs

Swiggy’s recent Initial Public Offering (IPO) has made headlines for turning nearly 500 employees into crorepatis, with 70 becoming dollar millionaires, thanks to the company’s Employee Stock Ownership Plan (ESOP). This highlights the power of ESOPs in India’s fast-growing startup scene. They are now seen as a key tool for wealth creation and talent retention.

In this blog, we will explore ESOPs. We’ll cover how they work, their benefits, their taxes, and how they shape India’s startup scene.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a benefit plan offered by companies to their employees, allowing them to own a piece of the company in the form of shares. It’s a tool designed to align the interests of employees and the organization, encouraging long-term commitment and shared growth.

In simpler terms, an ESOP is a way for employees to become part owners of the company they work for. It’s like a reward system that says, “As the company grows, so will your wealth.”

Key characteristics of ESOPs:
– They are not immediate cash rewards but rather a promise of future ownership.
– ESOPs often come with specific conditions, such as vesting periods and lock-ins.

How Does an Employee Stock Ownership Plan (ESOP) Work?

The ESOP journey involves several stages. Let’s look at them in detail:

1. Granting ESOPs

The company offers employees the right to purchase or receive shares at a predetermined price (exercise price). This is not an immediate transfer of shares but a conditional offer.

2. Vesting Period

The shares granted are vested over a specific time, known as the vesting period. Employees earn ownership of the shares incrementally, based on a schedule.

Example: If 1,000 ESOPs are granted with a 4-year vesting schedule, an employee may receive 25% (250 shares) each year.

Companies may also include a “cliff period,” where no shares are vested for the initial period, often the first year.

3. Exercising ESOPs

Once vested, employees have the option to buy the shares at the exercise price. The difference between the exercise price and the market price determines the potential profit.

• Exercise Price: The price set by the company for employees to purchase the shares.
• Market Price: The current value of the shares in the market or based on the company’s valuation.

4. Ownership of Shares

After exercising, employees own the shares. They can hold them for long-term gains or sell them (if allowed) for a quick profit.

Example to Understand ESOPs

Imagine you work at a startup, and the company offers you 1,000 ESOPs with the following terms:

• Grant Price (Exercise Price): ₹10 per share
• Vesting Schedule: 4 years (250 shares vest each year)
• Market Price at Grant: ₹10 per share

Scenario: After Four Years

• All 1,000 shares are vested.
• The company’s share price has risen to ₹100 per share.

You decide to exercise your ESOPs:

• Cost to exercise: ₹10 x 1,000 = ₹10,000
• Market value: ₹100 x 1,000 = ₹1,00,000
• Profit if sold: ₹1,00,000 – ₹10,000 = ₹90,000

If you hold the shares longer, you might gain from a rise in their value if the company grows.

Why Companies Offer ESOPs to Their Employees?

Companies, particularly startups, use ESOPs as a strategic tool to achieve several goals:

1. Talent Retention: ESOPs ensure employees stay with the company for longer periods. Employees are unlikely to leave before their shares are fully vested.
2. Attracting Top Talent: ESOPs make job offers more attractive, especially when startups cannot match the salary levels of larger firms.
3. Alignment of Interests: Employees are more motivated to contribute to the company’s success when they directly benefit from its growth.
4. Cash Flow Management: Startups can conserve cash by offering ESOPs as part of compensation packages.
5. Building an Ownership Culture: ESOPs foster a sense of belonging, encouraging employees to act in the company’s best interests.

ESOP Taxation in India

Taxation for Employee Stock Ownership Plans (ESOPs) in India occurs in two distinct stages: at the time of exercise and at the time of sale. Employees must know the tax implications at each stage. This is key to optimizing their financial plans.

At the Time of Exercise

At this stage, the difference between the market value of the shares on the exercise date (also called the Fair Market Value or FMV) and the exercise price (the price paid by the employee to acquire the shares) is treated as a perquisite under “Income from Salary.” This perquisite is added to the employee’s taxable income and taxed as per their applicable income tax slab. Example:

Suppose an employee has the following ESOP details:

• Exercise Price: ₹10/share
• FMV on Exercise Date: ₹100/share
• Number of Shares Exercised: 1,000 shares

The taxable perquisite is calculated as:

Taxable Perquisite=(FMV−Exercise Price)×Number of Shares=(100−10)×1,000=₹90,000

If the employee falls in the 30% income tax slab:

Tax Payable = ₹90,000 × 30% = ₹27,000

The employer is responsible for deducting tax (TDS) on the perquisite value. This deduction may reduce the employee’s net salary in the month of exercise. In the case of start-ups, however, the government has relaxed the tax implications on ESOPs.

Start-up employees would not have to pay the tax on the perquisite in the year when they exercise the ESOP. For them, TDS on ESOPs would be deferred to the following dates, whichever is earlier:

1. Completion of five years from the ESOP grant date
2. Date when the employee sells the ESOP
3. Date of leaving the company

At the Time of Sale

When the employee sells the shares, the difference between the selling price and the FMV (as determined during exercise) is taxed as capital gains.

Types of Capital Gains:

• Short-Term Capital Gains (STCG): If the shares are sold within 12 months of exercise, the gains are taxed at 15%.
• Long-Term Capital Gains (LTCG): If the shares are sold after 12 months, the gains above ₹1,00,000 are taxed at 10%.

Example:

Continuing from the previous example, assume:

• Selling Price: ₹150/share
• FMV at Exercise: ₹100/share
• Number of Shares Sold: 1,000
• Holding Period: 14 months (qualifies as LTCG)

Capital Gains=(Selling Price−FMV at Exercise)×Number of Shares =(150−100)×1,000=₹50,000

Since the gains are below ₹1,00,000, no LTCG tax is payable.

Way Forward for ESOPs in the Startup Ecosystem

ESOPs are becoming an increasingly popular tool in India’s vibrant startup ecosystem. They offer a unique way for employees to share in the company’s growth and success, fostering a sense of ownership and loyalty. For startups, ESOPs serve as an attractive compensation tool, especially when cash flow is limited during early growth stages.

When a company like Swiggy goes public, its ESOPs gain substantial value and liquidity. After Swiggy’s IPO on November 13, 2024, nearly 500 employees became crorepatis, with 70 crossing the dollar millionaire mark, thanks to their ESOPs. With the company’s valuation skyrocketing, employees benefited not only financially but also from the pride of contributing to a publicly listed enterprise.

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