ESOP 101

Note: These notes are intended for my personal reference, please seek advice from a relevant expert for any decisions made.

Basic Terminology

  • General
    • Options: The company is giving the employees an option that sometime in the future they can buy the stocks of that company. An employee will not be able to own the share until the issued options are exercised(converted into actual shares).
    • ESOP pool: is the equity shares which are reserved for a company’s employee to grant esop. Usually the esop pool ranges from 10% -15%.
    • FMV: It is the current value of a share of a company where the buyers and sellers will mutually agree upon a price.
    • Buy back: is an event at which the employees have an opportunity to sell their vested options to the employer/company. A buy back will not involve sale of shares. Incase if an employee wish to participate in a buy back, the vested options are canceled and the employer will be giving the equivalent(probably there will be a discount price between 15-25% on the new valuation price of a unit) amount for those number of units the employee wish to sell as part of the salary.
    • Secondary sale: The shares are sold to a third party(private investors, VC, institutional investors) by the employees where the shares are sold to them on a FMV.
  • Vesting
    • Vesting period/schedule: An option given to an employee cannot be converted to shares until the options are vested. Industry wide the options issued to an employee are fully vested over a period of 4 years.
    • Cliff period: The time period between the options that are granted and the options are vested. The cliff period in India is 1 year by mandated by the law.
    • Accelerated vesting: A scenario occurs when employees’ stock options vest faster than initially planned(usually 4 years). Accelerated vesting can be triggered by events such as mergers and acquisitions, performance-based achievements, or company programs that allow employees to choose a portion of their cash compensation as special ESOP grants.
  • Exercise
    • Exercise: An option given to employees cannot be converted to shares until the options are vested. Industry wide the options issued to an employee are fully vested over a period of 4 years. The typical schedule involves a 25% release of ownership per year over the four-year period (this varies from company to company).
    • Exercise price/Strike price: It is the price at which an employee can purchase shares of the company.
    • Exercise date: The day at which the employee converts the options to share by paying the exercise price/strike price to the company.
    • Exercise period: The time period where the employee can exercise the options to shares once they leave the company.
  • Grant:
    • Grant: issue of options to employees under the ESOP scheme.
    • Grant date: On the day the options are granted, an employee receives a grant letter, which states that they have the right to purchase the company’s shares in the future at a specified exercise price of x.

What is ESOP

ESOP means the option given to a full time Directors/employees of a company the right to purchase a share/stock at a future date.

Taxation of ESOP

Taxes become applicable only when the options are exercised or while sale of shares. The amount gained from sale of shares will be part of the total income from salary for that financial year and taxed based on the tax bracket of the individual.

STCG and LTCG for unlisted shares

In India, gains or losses can be categorized as either short-term or long-term, depending on the duration of holding. If the holding period is 24 months or less, it is considered short-term, while holding for more than 24 months is regarded as long-term. The holding period is calculated from the day the options are exercised until the shares are sold.

What happens to the ESOP after the employee exit?

If an employee leaves a company all the unvested options will typically be forfeited. All the options which are vested, the company may offer an exercise period during which the employee can convert their options to shares at the agreed-upon exercise price. The length of the exercise period can range from 30-90 days to 10 years, depending on the policies of the company.

If the employee does not exercise their options within the exercise period, the options will expire and become forfeited. Once the options have been exercised and converted to shares, the employee will own those shares with no expiration date for ownership.

Events of liquidation in a company

  • IPO - When a company goes public.
  • M&A - When a company gets acquired by another company or merge with another company.
  • Secondary sales - selling the vested shares to private investors, institutional investors etc.
  • ESOP buyback - selling the vested shares back to the company.

ESOP policies comparison