Esop: Why you shouldn’t be blinded by stock options offered by startups – Economic Times

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Last week, Flipkart, the poster boy of India’s startup success story, sold a stake in its employee trust fund for Rs 180-240 crore. This came as a rare opportunity for many of its on-paper crorepati employees — those with stock options — to finally get cash in their bank accounts.

They are a lucky lot, given most startups struggle to survive. And, in most cases, the stock options given out by startups aren’t even worth the paper they are printed on. Employee Stock Option Plans or Esops are offered as a part of an employee’s compensation.

Esop holders have the right to purchase a certain number of shares in the company at a pre-decided price, agreed upon at the time of salary negotiations. With the rise in the company’s valuation, the stocks will be worth much more than the discounted rate at which they are offered to the employee. That’s the idea.

However, you need to be wary of Esops given out by startups. You are betting that the valuation of the company will rise. But, there is always a risk of devaluation. In fact, as happens with most startups, the company may even have to shut shop. “Employees of companies that fail, end up holding worthless stock,” says T. Srikanth Bhagavat, MD and Principal Advisor, Hexagon Capital Advisors.

In the e-commerce industry, where monthly attrition rate at the junior and middle management level is 15-20%, Esops are a talent-retention tool. At senior levels, they are used by cash-strapped companies to hire talent they otherwise can’t afford. Esops are a high-risk gamble.

“While the upside might be quite high, if there is no visibility of money coming in, they are not worth the risk,” says Pratyush Prasanna, former VP, Paytm and now an entrepreneur. Gains from Esops, even if the valuations soar, take time to materialise. In fact, accumulating stocks via Esops takes considerable time, known as vesting period. And even before the vesting period begins, there is something called a cliff period.

You have to wait out the cliff and the vesting period before getting a chance to see some cash. The vesting period at an Indian startup is typically four years, with a 12-18 months cliff. So, you become eligible for exercising Esops after at least an year of joining and then you have to accumulate stocks over the next four years. If you quit or get fired before your Esops get vested, you lose your money.

Even the number of Esops that you vest per year during the vesting period often follows a schedule that does not favour the employee. “Some companies with a four-year vesting period, have increasing slabs of 10%, 20%, 30%, 40%, rather than equal vesting (25% per year), which is unfair for shareholders who might quit early,” says Prasanna. Apart from the vesting period, your eligibility to accumulate stocks is also linked to your performance.

“By providing Esops, companies make sure that employees are putting in their best efforts for the success of the venture,” says Praveen K. Dewan, Managing Partner, Antal International. So, unless you meet targets, you may not be able to vest your Esops. If all goes well—your company is a success, the perceived valuation becomes a reality, you are able stick around and are recognised as a contributor to its success, there is still no guarantee that you will get the cash you believe you deserve.

Remember, you have Esops of a startup and not a listed company. Unless the company goes public, there are few options of cashing-out— and they are not of your choosing. You may be able to monetise your Esops, if your company gets acquired. For instance, Fashion e-tailer Myntra, which was acquired by Flipkart in May 2014, allowed its employees, who had quit by the time of the acquisition but had vested Esops, to sell their shares. However, this may not be the case with all companies that get acquired.

Your stocks could get transferred to the acquiring company, or you may be allowed to encash just a portion of your stock holding. Theoretically, whenever a company gets some cash, there is a possibility of Esop monetisation, however, at times, founders partially encash their shares when they receive funding, but employees aren’t given that option. Further, as the company sells stake, the employees’ stock holding gets diluted.

“As a company grows and raises more rounds of funding, even key employees don’t get commensurate stocks that is being diluted with multiple funding rounds,” says Prasanna. In rare cases, holders may get some cash, if the company announces dividend, or if the board offers to buy back employee shares. If you are joining an early-stage startup, make sure you evaluate the scalability of the idea and the founders’ background before accepting Esops as part of your remuneration.

Also, says Dewan, “Discuss the exit plan for your Esops, in case the IPO of the company does not happen in a reasonable time.”

Esops are riskier than usual equity investment

1) Given the trend, it is more likely for startups to fail, making Esops worthless

2) You have to wait out the vesting period

3) There are limited options to encash Esops

4) They often come with tough employee targets

Beware of the taxman

Archit Gupta, co-founder and CEO, Cleartax.in, explains Esops’ tax implications.

1) Tax impact on Esops arise when these vest. At the time of vesting, your gains are not capital in nature and the income earned by you has to be disclosed under other income in your income tax return. This may have been included as part of your salary income in your Form 16.

2) When you sell these stocks and have a gain, the gains are taxed as capital gains.

3) If the shares are listed on a stock exchange, on sale, you may earn a short-term capital gain, if these are sold within one year of vesting or a long-term capital gain, when sold after more than a year of vesting. Shortterm gains are taxed at 15% while long-term gains are exempt from tax.

4) If shares are unlisted, no STT is paid. Unlisted securities are considered long-term holding after 36 months. Short-term gains get added to your total income and are taxed at marginal rates and long-term gains are taxed at 20% after indexation.