Introduction
So you are paying tax, out of your pocket unnecessarily. Which does not know whether it will happen next or not? Zomato's IPO is coming. Who is going to get a lot of money from this, obviously from the founders to the investors? But there is another one that will make a lot of money. That is the company's employees who had the company's ESOPS? They have stock options. Now that time has come in India when start-ups are doing IPO & are getting acquired and not only their founders & investors are getting money. Rather, the company's employees are also getting money. And people understand the value of ESOPs. Earlier it used to happen that when the employee joined the company, he used to say no to ESOPs.
Whether you take the example of this employee of Paytm or the example of Flipkart, and now tomato & by us. These precedents are going to come in many companies. So in today's video, we will know the complete details of ESOP.
So if you are an employee who wants to join a startup and you are getting an ESOP offer or you are already getting ESOP then definitely watch this video till the end. So I have invited two people to add more details and values to this video. The first one is my college senior whose company's majority stakes have been recently bought by the reliance industries.
What is ESOPS?
ESOPs do not mean stocks. This is the most important thing. The full form of ESOP is Employee Stock Ownership Plan. That is, you are getting an option to buy, to own the company's stocks. This is only an option and until you don't exercise you have not become a shareholder of the company.
Why ESOP Option? Why does the company give ESOP options?
There can be multiple reasons for giving the company's ESOP. If it is a listed company then different reasons are there and if it is a startup then different reasons are there as well. Different company has different ways of giving ESOP Some company provides ESOP as a retention strategy. Some company gives ESOP as a performance/bonus strategy. Some company gives ESOP so that the employee feels that I have ownership of the company. Some company gives ESOP because they cannot afford the full salary to augment that salary, they give ESOP. Stages of Getting ESOP. So now let's understand step by step that if the company has offered you ESOP, then through which process they will be delivered to you.
Let me take an example, you are an employee in labor law advisor Pvt Ltd and now how will you get your ESOPs. So first of all when you will join the company, looking at your performance we want you to join us for the long term so that you give good performance with us. We will give you a grant letter. In this grant letter, you have to take care of 5 things. The first one is the number of ESOPs. Here's written that You will get 80 shares this means that You will get 80 shares out of all the shares of the labor law advisor, As per the terms and conditions mentioned in the grant letter. The second thing is written here, that you will get this option at the exercise price of 100 rupees.
What is this exercise price?
To understand this, we have to understand some small things about a private limited company. Whenever a private limited company forms, a lot of its shares are made. Of these shares, a face value will be decided so that initially some capital can be invested in the company. Generally in India, it is kept at Rs 10. So this is the initial value of a share, it is called face value.
Second is our exercise price, by default, the minimum exercise price is the face value of the company. But as the company progresses, the exercise price also changes. The simple reason for this is that when you joined the company the risk you took joining the company, that risk is progressively reduced as the company grows. So because that risk is progressively less, then your exercise price will be higher. If you have joined the company very early then your exercise price will be below and if you have joined very late then your exercise price will be very high. There is no such rule but usually, the exercise price is the last round's share price of that company. The third price that you have to keep in mind, is of a private limited company. that is the fair market value of their stocks. That is, at the time you are getting that share.
What is the market cost of that share at that time?
So it may be that apart from the number of shares on your grant letter, you should also be told that you are getting stocks worth one crore. This is because the fair market value of all the options you are getting at that time is one crore rupees. So now you understand that the 100 rupees exercise price of labor law advisor private limited is mentioned here. This means that the money you will have to pay to buy these stocks will be 100 rupees per stock. Often these three things will be different. If you have got the grant just now. And a valuation round of the company has just happened, so your exercise price and the fair market price of the company may be the same for that grant at that time. okay
Assume that these three prices are different. In which your face value is lowest, then there is your exercise price, then there is your fair market value. Believe this thing that when you are exercising, then essentially you are getting shares at a price that is less than today's fair market price. Because let's take an example, you joined the company between series A and series B. At the time of Series A,
the value of the company's share was Rs 100. You get ESOPs, an exercise price of 100 rupees. In Series B, the value of the company's shares became Rs 500
and you exercised after Series B, but your exercise price would still be Rs 100, but at that time the company's fair market value is Rs 500. So your delta gain is Rs 400 per share. You have gained this amount. The third thing is written here that your cliff is one year.
What is this cliff?
Whenever the company gives you a grant letter, it does not mean that you will get the shares immediately. There is a minimum period that much you have to work in the company so that you can get those ESOPs or stock options. Generally, the Duration of this will be one year. The next point is the vesting schedule.
What is this vesting schedule? How is vesting done? When does it happen?
That every company can decide for itself. But that vesting is there. Now you get all that in one day, or in four years, or even in those four years you get it every month, every quarter, or every year. That company decides everything. So what are the things you should understand as an employee? One is the vesting, for how long is it going to be done, and at what frequency your vesting is going to happen. Is going to be monthly or quarterly or is going to be annual.
What is the vesting period going to be that1 year, 2 years, 3 years, and 4 years?
So the vesting period and the vesting frequency, you have to keep it in mind. The company tells you that we are giving you a grant letter and it will be an exercise in 4 years. Since the first year is a cliff, you won't get a single ESOP in it. At the end of one year, you will get 20 of the 80 shares we have committed to you. For the remaining 60 shares, you will get five shares in every quarter i.e. 20 shares in a year. In this way, you will get the full 80 shares in 4 years. Now it may be possible that these shares are getting per half-year instead of per quarter. Or if you don't get half-yearly, you are getting 20 shares at the end of every year. It depends upon the company and its policy. But it is called vesting. That is, the amount of time you will work with the company, you will get as many ESOPs according to the terms and conditions are given in that grant letter. Let's say that I have decided whether or not to work for 4 years, I have to leave the labor law advisor private limited in 2 years. So I got only 40 ESOPs in 2 years out of 80 ESOPs, and the remaining 40 options lapsed. I didn't even get those ESOPs. The last thing is written in it, your exercise period is 5 years. So there is a big catch here, many companies say that when you leave your job from our company. so in our company, ESOPs lapse in 3 months. So within 3 months, you have to convert it into shares by exercising it. You say, what's wrong with that?
So if they force you to exercise the option in 3 months, otherwise, your ESOPs will lapse. Even then he will have to pay tax without liquidity. Yes, if he has to exercise then he will have to pay tax. If you do not want to exercise then you will not have to pay tax. Read the fine print, how much time you are getting for exercising. For example, there is a company whose name I am forgetting. It has given an exercise period of 10 years after you leave your job, which is fair. but I believe 3 months, 6 months, and 1 year is not fair, Not at. So exactly what you said Rishabh, The exercise period matters a lot in this particular scenario. There are practical examples
that has happened in real life when people have to give up their stock options because their exercise period is short. And they have to arrange for liquidity. on top of that if you, take your and my example. Suppose you have to pay tax and there is no liquidity. And who gets the ESOPs, only all the salaried employees get them. and Salaried employees never have this type of liquidity except 1-2% of people. Ultimately most people will have to leave so we must read very carefully
what is the exercise period?
because that is a very crucial thing. So you understood the basic terminologies of the grant letter. Now exercise word is coming into it again and again, so do you have to put some extra effort to take these shares? Let us understand the meaning of Exercise.
Exercise of ESOP You haven't got this stock yet, you just got the option to buy this stock. When you exercise this option, then you will get shares of the company. Exercise means that you tell the company that my vesting is done and now I have the option to exercise these shares. Now in our example, Rs 100 is its exercise price. I am giving that to you and in return give me whatever my shares are and I want to become the official shareholder of the company. This is called the exercise of ESOPs. For example, an employee joins the company and usually, the company gives him the ESOPs option that at the end of every year we will give a certain number of ESOPs. For our understanding let’s assume, the company said we will give you ESOPs of 1 crore rupees at the end of every year. So what will happen at the end of the first year is that I will get a stock option of one crore rupees and then next year I will get one crore rupees. Then the next year I will again get a stock option of one crore rupees. So at the end of 3 years what will happen; if I have a stock option of Rs 3 crore for the company.
Now I have a stock option but what should I do now?
The vesting period is one year in which the company told me that I will get shares worth Rs 1 crore every year. So my completion of one year means that my vesting period is of one year. As soon as my one year is over, now I have the option that I can exercise the shares of that one crore rupee. the certain price which is defined. For example, the company said that this share is worth 10000 rupees, but I will give it to you for 10 rupees at that time. So I will pay 10 rupees for each share and I will exercise those options. When I say exercise means that I got those shares in my account. Till then it was only an option. So technically at the end of one year now I have got shares worth one crore rupees in that company.
Finally, the question comes that we have got the shares of the company but the money has not come, and finally, it is about money. So how will the money come to you? Suppose you are getting shares of a listed company. In the case of a listed company the process is very simple;
their shares are listed on the stock exchange. You have shares worth Rs 3 crore in your account. In whichever stock exchange you want to sell, you can sell whenever you want. Whenever you feel that it is the right time to sell a part of your shares, you can sell easily and you make money. But in most cases, we are talking about those companies which are not listed, are startups. So there can be 4 events in which you are expected to get money. one is that you gave time to the startup and the startup became very big after 5-7 years. Like now Zomato is also going for IPO. So Zomato would have given stock options to the employees of Zomato 5-7 years ago.
So now that tomato is going for IPO, then now as soon as the company will be listed on the stock exchange. The employee can sell his shares and liquidate the same. This is one option.
Let's take a second example, suppose tomato is not going for the IPO. For example, if a tomato would have been bought by some third company then this is a buyout.
What happens in that scenario? That is normally the small pool, which is minorities’ shareholders. By cashing out all of them, the company liquidates them. That is another liquidation event; The Company did a buyout here and liquidated it. Or in that scenario, it may also happen that the company does not give you cash, but gives you its shares.
Shares will be swapped. Normally those shares are not very valuable, because the acquirer is always big. So his shares will be more valuable and are more prone to liquidation. So this could be a second case. The first case was that tomato went for IPO and you sold it at the time of IPO. In the second case happened the tomato itself was bought by a big company. That company did a buyout and liquidated it.
The third option is that Zomato itself said that I buy out the stock options of all my employees. Recently Zerodha has bought the shares of their employees. That is, those shares got buyback.
So in that case the company bought back the shares of its employees. It also has multiple reasons that the company has to correct its capital. To give more confidence to the employees. In the future, to introduce more new schemes in the company, the company thinks that we buy the shares now. Because the company knows that going forward, its shares are to be in multiples. So there could be multiple reasons. The third thing is the buyback. So IPO, Acquisition, Buy Back.
The fourth thing is the secondary sales what normally happens is that, for example, I have shares of Zomato. Three years ago today, I had only shares of Zomato. I knew what the future of Zomato was going to be. And everyone in the investor community knows what the future of Zomato is going to be, that the company is going to grow multifold. I have shared and Rishabh is a very experienced investment banker. Rishabh knows that Abhishek has shares worth Rs 3 crore today, which will become 12 crores in the future. Rishabh will tell me that Abhishek you have shares worth Rs 3 crore, I am giving you Rs 5 crore today and you sell these shares to me. So this is an example of a secondary sale. So this is ESOP's rosy picture. But it is unfair to talk about ESOPs without talking about taxes. So let's understand
how much tax will be charged on ESOP?
Tax on ESOP. So tax is levied on 2 events, one while exercising and the other while selling shares. While exercising, note that you are only getting shares; You have to pay more for its strike price or exercise price, plus tax. For example, the year ended, and at the end of the year, I got the option of one crore rupee. Now I can exercise them.
So if I exercise them today, then today I will have to pay tax on it. And on what amount will I have to pay tax?
That is its fair market value today. Like in our example, a share was worth Rs 50000 and the exercise price was only 10 rupees.
So technically I will have to pay tax on that difference amount, and that tax will be imposed on me as salary tax, whatever tax criteria will be coming in my salary slab. If it comes under equity then why is LTA GST not applicable. Now, this is not because now the company has given you the option. The company gave you 50,000 rupees shares for 10 rupees that is the company is like a prerequisite that the company gave you. The company gave you something worth Rs 50,000for Rs 10 so that's why it is taxable as a prerequisite within the salary. What many companies do and employees should think about it. If you are not in the situation to pay that tax liability now so don't exercise now.
Exercise is when you have sufficient liquidity. In this, you need to understand only one thing every ESOPs plan has a particular exercise period. After how much time of vesting you can exercise ESOPs. Some company says that you can exercise lifetime. Some company says that as long as you are in the company, you can exercise. A company says that as long as you are in the company, for the next 6 months or 6 months from now. So you should try to extend that as late as possible. If you do not have liquidity today otherwise, you will have to pay unnecessary taxes, without any income. This is a deemed income on which you are paying tax. For the first time, you have to pay tax now. Now you will pay the second tax when you sell it. While selling, as I said at the beginning you exercise it becomes shares, you now have those shares in your Demat account. So while selling at that time you have to pay capital gain tax because at that time you are selling a share. Whatever you sold at the time of selling subtract it from the fair market price.
For example, it has been sold for 80,000 rupees. Then you need to pay tax on the difference of (Rs.80000 - Rs.50000)and that will be taxed as capital gain tax. Whatever the short term & long term, the rate is according to the slab. It will become taxable accordingly. So I hope now you must have understood the whole thing. So now let us understand what the company has to do, to give these stock options. Company End Preparation, First of all, you have to make an ESOP plan. In that ESOP plan, you have to write 4-5 things what will be your cliff period, vesting schedule, and exercise window. Once this is done, the pool of your ESOP is visible separately on your cap table. that you have reserved so many shares to give in your ESOP pool. Then after this, you have to define for what reason you are giving ESOP.
Why are you giving ESOP?
Once it is clear, then you have your grants, so each of your grants has a grant letter. Whom you want to offer ESOP now you give that grant letter to him. And that your team member either accepts or rejects that grant letter. Now that grant letter essentially tells 3 - 4 things. First, how many ESOPs you have to give to that employee, then what should you keep his cliff and vesting schedule, then what should be the exercise price or strike price for the employee, and then what should be your exercise window for that grant. You have to do these four things as a start-up. At the time when your employee has to do ESOPs exercise, and then you have to take bank cheques from your employee. Whatever ESOP option is vested, multiplied by the strike price and the exercise price. For that much, you have to take a cheque from the employee so that you can give them shares by exercising their options. And next time when there is a revision of your shareholdings then you have to include the names of those team members along with the number of their shares in the cap table.
If ESOP Pool Was Not Made?
And suppose a start-up founder has registered a private limited company but forgot to create an ESOP pool, what to do in that case? You can create in the future also but when you create an ESOP pool means that all your shareholders will be diluted to create this ESOP. You can vary or you can say that my investors will not dilute, only the founders will dilute. But accept this one thing. The sooner you make it, the better it is for the company. Because assume your company is growing, then your share price is increasing. So as soon as you made the ESOP pool. The more your strike price will be reduced and the more your perceived cost price will be reduced.
IS ESOP Legal Structure?
After seeing all this, this question may come to the mind of the employees that all the things like grant letters, etc. are fine, But if the company cheated on me. The company told me that I will give you the shares and if not given. So why can't it happen? You have to register your ESOP plan. There is no need to wait till the release of grant letters. The company also has to show on its balance sheet how many stock options are there, how many stock options they have given to employees, and how many are lying with them in reserve. so it is a very valid and legal document. But very few of you would know that before starting the labor law advisor channel. I was a full-time start-up founder. I have also raised funding for my start-up, and I have also given an ESOP plan. Everything is done. Which a typical start-up founder has to do. And using the same experience, my younger brother and I have created a course A to Z of start-up funding courses. Which is available at our LLA Professional Training Institute. Whose mobile app and website link you will find in the description. That's all in today's episode, if you have any suggestions, then do let us know in the comment box.
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