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How ESOPs Make You Rich? Research Team | Posted On Wednesday, May 15,2019, 12:49 PM

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How ESOPs Make You Rich?



Flipkart has just given ESOPs to senior and middle-level staff. Some of Flipkart’s employees are now millionaires. Over the years, ESOPs have made many people rich.  What are these ESOPs?

What are ESOPs?

Employee Stock Option Plan or ESOP is an employee benefit plan. It offers employees, ownership interest in a Company. ESOPs may be direct stock, profit-sharing plans or even bonuses.

ESOP gives employees of a Company the right to acquire shares of a Company for which they have been working. ESOPs are options which can be purchased at a specified price before the exercise date.

How ESOPs Work?

Your company grants ESOPs to you and other employees. ESOPs help you buy specified number of shares of the Company at a set (defined) price after a certain number of years. (Option Period). ESOPs are not compulsory. You can choose if you want them or not.

Before you or any employee can exercise the option, he must go through a vesting period. (This is a pre-defined vesting period). You must wait out the vesting period, before exercising the option. You and other employees have to work for an organization until part/whole of the ESOPs can be exercised.

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How ESOPs Make You Rich?

Why Companies Give you ESOPs?

  • Companies use ESOPs as a tool to attract and retain high-quality talent.
  • Companies want the employees to work hard and become stakeholders in the Company.
  • IT Companies have very high attrition rates. The attrition rate at Infosys has been high for the last few quarters. ESOPs help IT Companies cut down on the attrition.
  • Startups offer ESOPs to retain talent. ESOPs have shown true value as employees of Paytm, Ola, Lenskart, Myntra, Citrus Pay, Flipkart, Rivigo, and Redbus made a lot of money.
  • Many startups cannot afford to pay high salaries to employees in the initial years. They make it up by sharing future profits through ESOPs.
  • ESOPs create a sense of ownership and belonging among the employees of a Company.
  • Companies can offer ESOPs instead of cash compensation. This saves immediate cash outflow. This helps Companies scale up and expand the business.

What is Vesting Date and Grant Price?

The date on which you and other employees are entitled to exercise the right to acquire shares. This is the “vesting date”. These rights may be fully or partially exercised over the vesting period. The grant price is the price at which you and other employees can buy shares from the Company. This is fixed and much lower than the prevailing market price of the shares. This is only if shares are listed.

Let’s say you are given 1,000 options on 31st March 2017. These options are exercised in phases like 20% in a year, 30% after the second year and the remaining 50% on completion of the third year. What does this mean?

The vesting date for 200 shares is 1st April 2018, its 31st March 2019 for 300 shares and 31st March 2020 for the remaining 500 shares.

SEE ALSO: Sweat Equity and Employee Stock Options

Taxation of ESOPs:

ESOPs are perquisites when it comes to taxation. The value of ESOPs is the difference between the fair market value (FMV) and the exercise price as on the exercise date. The difference between FMV and exercise price on exercise date, is taxed as a perquisite. Selling shares at a profit means you pay capital gains tax.

ESOPs are taxed depending on the holding period. This is calculated from the exercise date till the date of sale. If equity shares are listed on stock exchange like NSE or BSE, and they are held for more than 12 months, the profits/gains are called LTCG or Long Term Capital Gains.

After 1st April 2018, any LTCG you make on equity mutual funds including ELSS, (This is for equity oriented mutual funds with equity exposure of 65% or more), is taxed at 10%. This is only for gains above Rs 1 Lakh a year. Shares sold within a year at a profit/gain are called short term capital gains or STCG. STCG is taxed at 15% with cess.

When to Sell ESOPs?

Look at capital gains and liquidity before selling ESOPs. If the shares under ESOPs are not listed on a stock exchange, you cannot sell the shares until they are listed or the promoter of the Company offers an exit option. You will have to wait till the shares are listed on the stock exchange.

Cash or ESOPs

Cash or ESOPs the decision is entirely yours. Many people prefer cash to ESOPs as it’s a bird in hand. Many founders fumble with ESOPs, refuse to deliver on promises or don’t get the bonanza they expect. If founders share wealth, ESOPs are a great option.

Many employees prefer cash to ESOPs, especially in startups as with the arranged marriage culture, many brides refuse to marry those working for small tech firms/startups.

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