ESOPs 101: How do they work?
ESOPs are non-linear wealth creation mechanisms that give employees the option to buy a certain amount of company shares at market value or at a discounted price.
- An employee with ESOPs becomes a potential shareholder and can buy vested stock options
- ESOPs can be partially or completely monetized on liquidity events such as buybacks, secondary sales, or an IPO
- This monetization of ESOPs (if the startup has a considerable valuation) will far exceed the employee’s standard remuneration
Before we explore the lifecycle of ESOPs, you need to be familiar with a few terminologies:
- Grant Letter: The letter through which ESOPs are issued to employees
- Vesting: The process through which employees can apply for shares of the company against their equity grants
- Exercise: The practice which allows employees to have ownership of ESOPs that were granted to them
- Exercise Price: The price at which the employee purchases ESOPs
Here’s an ESOP Dictionary that you can use to understand the basic nuances of ESOPs
Let’s take a real example to understand how ESOPs work.
Roshan was granted 1500 ESOPs via a grant letter on Feb 14, 2018 (grant date).
The exercise price is INR 500 per option.
Click to view the Grant Letter, Exercise Letter, and Share Certificate.
As per the grant letter, all the 1500 stock options have a compulsory 12-month cliff period, following which they will vest uniformly over 4 years. The complete vesting table and dates are as follows:
|Vesting Date||Total Options Vested (till date)|
|Feb 14, 2019||375|
|Feb 14, 2020||750|
|Feb 14, 2021||1125|
|Feb 14, 2022||1500|
After the cliff period, Roshan can exercise his vested options on Feb 14, 2019, and then on the same date in subsequent years. If he chooses to exercise on the same date (see the attached exercise letter), he will pay 375 X 500 = INR 1,87,500 as the exercise price.
Roshan will also have to pay exercise tax.
Let’s assume that the FMV of the shares is INR 8,500 per share. So, he will pay a tax on his notional income. The notional income can be calculated as
375 X (8500-500) = INR 30 lakh
On this notional income of INR 30 lakh, Roshan has to pay tax as per his tax slab. If the tax rate for his slab is 33%, he must pay about INR 10 lakh as income tax that year.
Let’s assume that Roshan decides not to exercise his vested options annually. After his third vesting schedule, he leaves the company on Feb 28, 2021. As of now, he has 1125 vested options. His unvested options (1500-1125 = 375) lapsed when he resigned.
But, the company has a policy of allowing employees to exercise within six years of leaving the company. If he doesn’t exercise in this time frame, all of his 1,125 vested ESOPs will lapse. If he chooses to exercise, he must pay a lot of exercise tax (apart from his exercise price); Roshan is thinking about what to do.
After a few years, as part of the Series C round, the company provides ESOP liquidity to select employees, including Roshan, for 20% of his vested ESOP.
Roshan decides to take part and exercises his vested options; he submits the exercise letter to HR and pays the company 1125*500*20% = INR 1,12,500. He also has to pay the income tax amount to the company.
The company will allot 1125*20% = 225 Equity shares to Roshan, who will receive the duly signed share certificates.
Then these shares will be transferred to the investor, and Roshan will, in turn, receive the sale amount.
Why opt for ESOPs?
While companies leverage ESOPs as a retention tool and growth multiplier, employees benefit from the overall process. To summarize, ESOPs can help you:
- Boost personal wealth (through equity ownership)
- Grow professionally (as primary contributors)
- Improve job security and satisfaction
- Actively participate in decision making
However, cashing out ESOPs can be a cumbersome process. Here’s a blog on the liquidity events that pave the way for monetizing your stock option grants.