Reading Time: 4 minutes

ESOPs are a simple and effective method for fostering employee engagement in the company. ESOPs have proven to be a valuable tool in the startup ecosystem, motivating top talent and promoting employee retention.

The statistics further validate this trend, with data from Inc42 Plus indicating that in 2022, Indian startup employees reaped over $196.5 million through ESOPs buy-backs.

Are all ESOPs good at wealth creation?

Yes, but one needs to understand the actual worth of ESOP offered to them. Let us understand the same with an illustration.

As per the offer letter, employee ‘Sujit’ of M/s. XYZ Ltd. (CEO) was vested with a stock option of 1 lakh Equity shares. Company has worked out two options.

Particulars	Option 1	Option 2
Number of Stock Options	1 Lakh	1 Lakh
Fair Market Value (FMV) at time of Vesting of options	Rs. 50	Rs. 50
Exercise Price per share	Rs.   30	Rs.   20
Vesting period	End of 2 years	End of 1 year
Lock in	2 years post date of exercise	3 years post date of exercise

 

Projected scenario when Sujit opts for ESOP under respective options (basis Company financial forecasts)

Particulars	Option 1	Option 2
FMV on date of exercise	Rs. 100	Rs. 70
FMV at end of Lock in period	Rs. 300	Rs. 300

Financial impact on Company as well as Sujit need to be evaluated. (Assume Interest rate @8% p.a.)

The financial impact in hands of the Company would be:

Particulars	Option 1 (Rs)	Option 2 (Rs.)
FMV of Options on date of Vesting	50,00,000 (100,000 X Rs. 50)	50,00,000 (100,000 X Rs. 50)
Exercise Price for 100,000 options	30,00,000	20,00,000
Impact on Financials:
Discount on issue of Option to be debited to Profit/Loss Account as provision for Stock options over vesting period (Negative Impact on EBIDTA)	(20,00,000) (in 2 years) (100000 options X Rs. 20)	(30,00,000) (in 1 year) (100000 Options X Rs. 30)
Loss of Interest saving due to timing difference between Vesting and Exercise of options (@8% pa) (No impact on EBIDTA)	(3,20,000)	(2,40,000)
Overall Impact on Profit/Loss	(23,20,000)	(32,40,000)
Non-Financial but intangible Impact
Talent Retention tenure	At-least 2 years	At-least 1 year
Option Exercise implication	Time based Price as against milestone based	Time based Price as against milestone based
Lock in term implication	2 years non liquid event for employee	1 year non liquid event for employee

EBIDTA = Earnings before Interest, Tax, Amortisation.
Figures in bracket indicate negative profit.

Below will be the actual Financial impact in hands for Sujit

Particulars		Option 1 (Rs)	Option 2 (Rs)
FMV on date of exercise	A	1,00,00,000 (100,000 X Rs. 100)	70,00,000 (100,000 X Rs 70)
Exercise Price (100,000 x Exercise Price per option) (A)	B	30,00,000 (100,000 X Rs.30)	200,00,000 (100,000 X Rs.20)
Perquisite Value (A-B)	C	70,00,000	50,00,000
Tax on Perquisite @ 30%* (C)	D	21,00,000	15,00,000
Interest for lock-in years @8% p.a (Exercise price X 8% X Lock-in period).	E	4,80,000 (Rs.30L X 8% X2 yrs)	4,80,000 (Rs. 20L X 8% X 3 yrs)
Total Outflow (F= B+D+E)	F	55,80,000	39,80,000
Value realised in the hands of Sujit on account of receipt of ESOP at the end of the fourth year (G = FMV at end of Lock in period – F)	G	2,44,20,000	2,60,20,000
Return over outflow (no of times)		4.38 times	6.53 times

*Plus surcharge & cess

Our View

Growth oriented Companies need to carefully evaluate following:

Understand the financial impact of Stock Options Exercise price, Vesting period and Lock in post Exercise of options.

• Designing Vesting tenure – It depends on intangible factors like loyalty, Industry vis a vis Market conditions.
• Designing Exercise price – Depends on performance / milestone event leading to spur in Enterprise valuation, apparent benefit to employee, if he opts for exercise of Stock Options. However, impact on EBIDTA calculation must be evaluated.
• Designing Lock-in period – Depends upon Exit strategy which may be event of Security market public offering, secondary transfers, change of management etc.

Striking balance between Vesting tenure, exercise price vis a vis Fair valuation of entity on date of vesting:

• Stock Options increases Employee compensation expenses thereby reduces the EBITDA and Profit before tax.
• Differential value does have tangible economic implications for the Company’s financials.

From the employee’s point of view

• The investment value towards exercise price rationalises the saving ratio.
• Choosing such an option largely depends on the type of industry, product/ service portfolio and technology upgradation, and industry outlook in coming years rather than mere tax saving.
• Further, if there is no market for such a company’s shares or the company does not have a policy of buy-back, then it will be a sinking cost for Sujit with no realisable value for ESOP. Therefore, it is very important to understand the Company fundamentals, management vision, proposed milestone events, ethics of promoters, robust ESOP policies and real probabilities of realisable value of ESOPs from an employee perspective before accepting an offer letter.

Things to be kept in mind while negotiating ESOPs:

• Evaluate company factors: management, internal dynamics, growth prospects, social impact, policies, and attrition rates.
• Use ESOPs as a complement, not a substitute, to fixed salaries. Optimal structure: minimum fixed salary with variable components in cash and ESOPs.
• Beware of high ESOP offers with minimal or no salary for new hires in start-ups.
• Prioritize transparency: clear ESOP policies, management vision, and ESOP percentage of total salary.
• Align ESOPs to motivate employee commitment, considering the vesting to lock-in period lifecycle.
• Be cautious with the 3-4 year vesting schedule; consider potential pitfalls like employment continuity and strategic acquisitions.
• Low exercise price is advantageous with careful consideration of other parameters and realistic company valuation.
• Company valuation and successful funding rounds demonstrate confidence in ESOP pricing.

Conclusion

To embark on a path of growth, navigating the initial stages is crucial. Consider Stock Options as a catalyst for scalability. If Company’s aim is to establish a sizable and expandable business, leveraging Stock options proves advantageous in the early phases. By utilizing Option grants, state of art vesting tenure you can blend finance and right talent pool necessary to propel your business forward and broaden its impact.

Especially, for Start-ups, time sensitive Stock Option scheme such as ESOPs is required for the following reasons

• To attract and build right leadership-team and scale the business to new heights with proper blending of monetary as well as non-monetary compensation structure.
• ESOP in the initial years is generally viewed as investment into business and there should not impact valuation negatively before stage of Private Equity / Venture Capital /Institutional Finance round starts.

However, ESOP can work as a great wealth generation tool for well-informed professionals who do their research and pick the right companies at the right stage of their lifecycle.

Reading Time: 3 minutes

Employee stock option plan (ESOP) are liquid assets for listed companies as employees can see their value or wealth created. In the case of Startups or unlisted companies, ESOPs cannot be sold in an open market.

To mitigate this problem, many startups have started buying back the ESOPs issued to their employees, thereby providing them a chance to liquidate their holdings.

Statistics

Startups are increasingly announcing ESOP buybacks to retain and hire top talent amid the growing competitive market. Companies such as Oyo, Unacademy, Meesho, CarDekho, Razorpay, Swiggy, Byju’s, and Zerodha have rewarded their employees via ESOP buybacks.

(Source: Fintrackr, Media report)

What is Buy-back?

Buy-back is a corporate action in which a company buys back its own shares from the existing shareholders. A buyback allows companies to invest in their own shares.  A company can buy back shares either periodically or in a single transaction. A company can buy back the shares periodically or all at once.

Tax implication of ESOP Buy-back per Income-tax Act, 1961 (the Act)

Under the Companies Act, 2013, which funds can we use for buy-back of shares

As per the companies Act, 2013, companies can purchase their own shares out of:

• Free reserves;
• Securities premium account;
• Proceeds of issue of any shares or specified securities [no buy-back shall be made (i) out of proceeds of an earlier issue of the same kind, or (ii) out of the same kind of other specified securities].

Conditions for buy-back of shares as per Companies Act, 2013

• Authorised by Articles of Association.
• Special resolution to be passed at general meeting.
• Less than 25% of total paid-up capital and free reserves.
• Secured & unsecured loan post buy-back shlould not be more that twice paid-up capital and free reserves.
• All the shares and/or other specified securities for buy-back should be fully paid-up.
• Listed companies separate SEBI compliance.
• Separate regulation for unlisted companies.
• For unlisted companies – no offer of buy-back can be made within a period of one year from preceding offer of buy-back.

Process for Buy-back of ESOP

• Board Approval & Shareholder’s approval
• Determine the ESOP share buy-back price.
• Compliance with company’s act & SEBI regulations.
• Offer the ESOP buy-back scheme/terms to eligible employees.
• Employees may accept or decline the buy-back scheme.
• Arranging the fund for Buy-back of ESOP.
• Transfer the funds and buy-back the ESOP.
• Intimating SEBI if buy-back exceeds the threshold.
• Maintaining records and ensure compliance with tax regulations.
• Filing of required reports with regulatory authorities like Form SH-8, PAS-4, MGT-14.

Success Story of ESOP Buy-Back in the recent past

Caratlane was founded in 2008 by Mithun Sacheti and Srinivasa Gopalan. by offering an online platform for selling diamonds and jewellery. Over the years, it has grown phenomenally and currently boasts a base of over four lakh customers.

• ESOPs were given to 75 employees out of 400 employees of Caratlane holding almost 1.72% of the company shareholding.
• Balance 27.18 % is held by Mithun Sacheti and 62 % is held by Titan.
• In 2016, Titan bought 62% of Caratlane at a valuation of around Rs. 908 crores from Tiger Global Management

In September, 2023, Titan announced to buy the stake of Founder Mithun Sacheti (27.18%) and ESOPs (1.72%) at a valuation of around Rs.17,000 crores of the company.

Accordingly, based on above, Titan will buy ESOP’s of an employee holding 1.72% in Caratlane at around Rs.292 crores. Employees will receive around a five times increase in valuation as compared to the year 2016 valuation.

Conclusion

While ESOPs found their way into compensation packages offered by new-age start-ups. They should also give a plan for buy-back of ESOP, as it gives employees an opportunity to liquidate their ESOP and make money.

As the company grows, so will the value of its share and this concept of future gains can instil ownership in employees and motivate them to take charge and work towards building the company than just fulfil their targets.

Reading Time: 4 minutes

ESOP Taxation

ESOP Taxation is the most significant factor in determining the creation of wealth through ESOPs. When it comes to ESOP taxes, there are 2 instances when taxes are paid that is (i) At the time of exercise of ESOP and (ii) At the time of sale of ESOP’s.

Let us understand the implication of ESOP’s from the Employer’s perspective.

Tax implication of ESOP in hands of Employer & Employee

ESOP Taxation differs in the hands of employer and employee. Below chart explains tax implication of ESOP at different stages of ESOP’s lifecycle.

 

Tax implications in the hand of the Employer at the time of the vesting of ESOPs

Discount on issue of shares i.e. difference between FMV of shares on date of issue of shares and the grant price of ESOP’s, can be claimed by the employer as expenses incurred for the purpose of business over the period of vesting based on various caselaws[1]. The availability of discounts on the issue of ESOP as business expenses remains a litigable issue in the absence of any specific provision under the Act.

[1] CIT Vs. Biocon Limited (2021) (SC) (131 taxmann.com 188), Lemon Tree Hotels (P.) Ltd. (2019) (Del HC) and PVP Ventures Limited (Madras HC) (2012)(211 Taxman 554).

Tax obligation in the hand of Employer at the time of Exercise of ESOPs by employees

The benefit given to employees of exercising ESOPs at a lower price than the FMV on that day is taxable as a perquisite i.e. salary income in the hands of employees. The employer is responsible for withholding and deducting taxes from employee’s salary. The tax would be withheld by the employer at the time of the allotment of shares to the employees, i.e. the tax will be collected from the employee through the payroll of the corresponding month in which the shares are allotted. Typically, the allotment of shares takes place on the date of the exercise of options.

Method for Valuation of ESOP 

	At the time of Grant of ESOP	At time of Exercise of ESOP
Private/Unlisted Public company	Intrinsic/ Fair Value of share done by registered valuer	Valuation done by Merchant Banker
Listed Company	Intrinsic/ Fair Value of share done by registered valuer	Price quoted on recognised stock exchange

However, the company cannot have 2 different ESOP valuations for a specified date.

Illustration explaining ESOP Taxation in the hands of the employer

Mr. A was granted 100 options under ESOP Scheme by Company XYZ where, 1 option = 1 share of the company.

Grant Date	01st April 2022
Vesting period	2 years from the grant date
Vesting conditions	Continuous employment in the company
Exercise Date	01st April 2024
Exercise Price	Rs. 10,000 per option
FMV as of 01.04.2022	Rs. 11000 per share
FMV as of 01.04.2024	Rs. 12,000 per share (As per valuation report)

Assumed that the employee exercises the options on 01^st April 2024

Tax Implications in the hands of employer:

[a] At the time of Vesting that is 1.4.2022 to 31.3.2024 – Claim of business expenses by Employer

Particulars	Amount (In Rs)
Fair Market Value per share on 1.4.2022	11,000
Less: Exercise Price per option	(10,000)
Benefit under ESOP Scheme per share	1,000
No. of shares allotted	100 shares
Business expenses allowed to the employer over the period of vesting	1,00,000
Claim in year 1 (1.4.2022 to 31.3.2023)	50,000
Claim in year 2 (1.4.2023 to 31.3.2024)	50,000

[b] At the time of the Exercise of Options on 1 April, 2024 by an employee

Particulars	Amount (In Rs)
Fair Market Value (Rs. 12000 X 100 shares)	12,00,000
Less: ESOP Exercise Price (10,000 x 100 shares)	10,00,000
Perquisite in hands of employee	2,00,000
Tax @ 30%* (assumed)	60,000*
Tax to be deducted by the employer from employee’s salary for the month of April 2024	60,000*

*Plus applicable surcharge & cess

Tax Incentive for Start-ups in the hands of employer

There is deferment of deduction of tax on perquisites in respect of ESOP issued by start-ups subject to conditions under the Act. Please refer to our note on ESOP for start-up.

Basic Accounting entries per Accounting Standard and guidance note on accounting for Share-based payments.

8.1 During Vesting Period

Employee Compensation Expense A/c Dr              xxx

To Stock Options Outstanding A/c Cr                               xxx

(Being compensation expense recognised in respect of ESOP issued)

 

8.2 At the time of exercise

Bank A/c(Options exercised x Exercise Price) Dr                                                    xxx

Stock Options Outstanding A/c(Options exercised x Fair Value*) Dr             xxx

To Equity Share Capital A/c(Shares allotted x Face Value) Cr                                   xxx

To Securities Premium A/c (Shares allotted x Premium Value) Cr                          xxx

(Being shares issued to the employees against the options vested in them in pursuance of the ESOP Scheme)

 

8.3 After the expiry of the exercise period

The employees are eligible to exercise vested options only during the exercise price. In case any vested options remain unexercised at the expiry of the exercise period, then the expenditure booked for such vested options stands transferred to the General Reserve or Retained Earnings

Stock Options Outstanding A/c Dr.            xxx

To General Reserve A/c Cr                            xxx

(Being unexercised vested options transferred)

Conclusion

With the help of ESOP strategy, giants like Amazon, TCS, Apple, Flipkart, etc., have minted millionaire staff. In the era of transitional shift from traditional business models to digital disruption, as most millennial and Gen Z employees are inclined towards faster growth and success in their careers, these companies have become attractive employers.

Reading Time: 3 minutes

Employee stock option plans (ESOP) should help in building a skilled workforce, essential for company success in the modern world. Employee stock options have gained significant popularity in India thanks to the thriving ESOP startup culture, making them increasingly advantageous.

1. What is ESOP?

An Employee Stock Option Plan (ESOP) is a method of rewarding key employees for their performance. It grants employees the right to purchase or subscribe to company shares at a future date at a pre-determined price.

2. Employee eligibility for ESOP

The below table gives gist of Eligible employees for ESOP:

Sr. No.	Type of employee	Eligible per company’s Act   (Yes/No)	Eligible employee as per SEBI (Yes/No
1.	Permanent employee of the company (Co.) or subsidiary Co. in India or outside India	Yes	Yes
2.	Part-time employees, consultants, advisors, mentors	No	No
3.	Directors, investor/advisor on the board of directors	Yes*	Yes*
4.	Board observer or an independent director	No	No
5.	Employees of associate company	No	Yes
6.	Employee who is either a promoter or a person belonging to promoter group	No	No
7.	The founders/promoters of DPIIT recognized startups	Yes (subject to conditions)	Yes (subject to conditions)
8.	Future employee	Yes	Yes
9.	Foreign employee	Yes**	Yes**

* Should not either himself or through his relative or through anybody corporate, directly or indirectly hold more than 10% of outstanding equity shares of the Co.

** Subject to FDI guidelines and above eligibility.

Other versions of employee ownership include, direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.

3. Key terms that you should know about in ESOP

Grant date – Employer gives the employee the option to own shares of the company at a later date (Vesting date).

Vesting date – Vesting date is when the employee is entitled to buy options on fulfillment of conditions

Vesting period – The period between the grant date and vesting dates (minimum 1 year)

Exercise period – Once the vesting of shares is done, the employee now has a right to exercise the option within a certain period i.e. exercise period.

Exercise Date – The date on which the employee exercises the option to buy shares of the company.

Exercise Price – The price on which employees exercise the option is the exercise price. Once the payment of the exercise price is made, the shares are issued to the employee.

4. Life cycle of ESOP

Below is the flow of an Employee Stock Option Plan (ESOP), from policy execution to employee exercise: 

5. Documents required for ESOP as per the companies Act

• ESOP scheme
• Minutes of a board meeting
• Minutes of the general meeting
• A resolution, accompanied by an explanatory statement, that approves the ESOP.
• Boards report
• PAS – 3 MGT- 14.
• Valuation report from registered valuer at the time of grant of the option and at the time of determining Fair market value while exercising the option from Merchant Banker.

6. Pricing criteria

The companies have the flexibility to determine the exercise price for ESOPs. The exercise price shall never go below the face value of the shares. ESOP can be issued at a discount or a premium. Different exercise price can be done for different category of employees.

7. ESOP Trust Structures

8. How does an ESOP Trust work?

An ESOP Trust is a private entity established and registered to administer an ESOP plan. Here’s a typical flow of how an ESOP trust operates.

9. Exit Option

Employees holding publicly listed shares can sell their ESOPs in the open market. ESOP Exit in the case of private and closely held companies is a bit challenging as their stocks are not publicly tradeable. Below are the commonly used methods in private and closely held companies for ESOP exits.

Methods	Description
IPO- Initial Public Offering	Company may get their securities listed on the stock exchange for the first time.
Secondary transfer	Transfer of shares to existing shareholders, promoter group or any other third person at the instruction of the management
Buy Back	Company has the option to buy back the securities issued to the employee in lieu of cash or other consideration. The detail covered in the next article on Buy-back of shares.