How ESOPs can boost employee compensation and drive wealth creation | Mint

The startup revolution has changed the employment space in a big way. The youth is willing to take the risk of joining startups to work for the potential high reward of a fast career and monetary growth.

ESOPs play a vital role on the monetary side and smart candidates negotiate with the startup employers for a good ESOP deal. But, can ESOP be the key reason to choose a job? The answer is subjective to the potential of the company.

Risks of ESOPs

You may land up with huge ESOPs which may turn out to be pittance in value if the company is not able to flourish or goes bust. So ESOP shouldn’t be taken as a sure-shot wealth creator as it depends on the success and thereby valuation of the company.

If one joins an established company then the ESOPs may not give as much monetary growth as a startup. However, an established company’s shares may be stable in growth though may be lower. So, unless the ESOPs are granted at a much lower price to the market price the ESOPs of a well-established company may not bring a great fortune.

An ESOP of a company that is yet to be listed generally tends to have a higher multiple of value appreciation than a listed one. Once the share gets listed there is no certainty that the share will move one way upward which is true even for a company which listed years back.

This also means that an ESOP doesn’t guarantee profits and if the shares fall down below the ESOP offer price after they are exercised, you can even land up in losses.

Also one needs to know that ESOPs may make you bound to stay with a company until the vesting period. You may tend to compromise your career goals, peace of mind, culture and health for the sake of staying till the vesting period. In a broader sense, ESOPs should not be the basis for choosing a job or holding on to a job.

ESOPs and Asset Allocation

While ESOPs can be a huge source of wealth creators, the core philosophy of investment suggests no investment portfolio can be overweight on any asset class.

It’s true that in the initial years, one will have to hold the ESOPs allocated regardless of their value outweighing all other asset classes put together so that he gets the full advantage of the value multiplication.

However, once a substantial value has been reached, it’s important to begin liquidating some of those shares to diversify and maintain an ideal asset allocation across various asset classes, particularly to mitigate the portfolio risk. This approach should be adopted regardless of how high the stock’s growth potential may be.

The common mistake most ESOP holders make is getting emotionally attached to the ESOP due to the value appreciation it has given over time or due to the loyalty to the organisation. Any such emotional holding not only to ESOP but to any investment could turn detrimental to the portfolio’s health and risk.

The next big mistake is that they tend to evaluate this stock’s (ESOP) past performance and future potential on a standalone basis without making relative comparisons. There would be a lot of other sectors performing better and stocks in the same sector delivering better. From a risk perspective such diversification is essential and it’s not just about the returns.

ESOP Taxation

Taxation of ESOPs happens at 2 stages:

1. At the time of allotment of shares

2. At the time of transfer of shares by the employee

At the time allocation – The initial tax event occurs at the time the securities are allotted.

The value of any securities allotted to employees either free of cost or at a concessional rate would be treated as perquisite. When an employee exercises the option, the taxable amount is the difference between the Fair Market Value (FMV) of the securities on the date of exercising the option and the price the employee paid for those securities.

The FMV of the securities at the time of allotment is not taken into account for calculating the perquisite value; rather, it is the FMV at the time the option is exercised that is considered. This is treated as part of the salary and taxed accordingly.

At the time of transfer of shares – When an employee sells securities received through an ESOP, any profits generated will be subject to taxation as ‘Capital Gains,’ categorised as either long term or short term. The holding period for these securities starts from the date they are allocated and not from when the option is exercised, and it ends on the date the employee sells the securities.

Additionally, the fair market value of the securities at the time of exercising the option will be considered the acquisition cost for calculating capital gains. If the time between the allotment and the transfer is less than a year, the gains will be classified as short term and taxed at a rate of 20%. If the holding period exceeds a year, the long term capital gains tax will be charged at 12.5% on gains exceeding ₹1.25 lakh, including any long term capital gains from all equity-oriented investments.

ESOP Funding

ESOP funding is an efficient method to finance your ESOP acquisitions without having to sell off your assets, to buy shares and keep them until a time when they get a desired price. Lenders offer ESOP funding only for companies listed on the stock exchange. If you believe that the share price is likely to increase soon, you can exercise your ESOP options using convenient financing options. However, the choice to pursue ESOP funding should depend on your evaluation of the market price compared to the grant price of the shares.

Lenders fund an employee to exercise his/ her vested shares under the Employee Stock Option Plan by asking to pledge those receivable shares at the time of allotment. The interest rate for ESOP funding varies from 9 to 15% and can be for up to 36 months. The shares funded shall be held in a demat account and lien marked in the lender’s favour.

V.Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Ltd.