Esops can help in wealth creation for employees

They tend to make the portfolio skewed towards one company, hence, book profits at the right time

Employee Stock Option Plan (Esop) is an option given to employees to purchase the company’s shares at a predetermined price. The origin of ESOPs can be traced back to the dotcom era when internet and technology companies started offering Esops to lure and retain the best talent. Today, most companies - be it banking, financial services, manufacturing, or FMCG offer Esops to motivate and retain key employees.

Rationale for issue of ESOPs
These options are allocated to individual employees based on performance, pay structure, seniority, and so on. The shares can either vest in a lump-sum manner, or in a staged manner - this depends on the company’s policy.

Esops offer significant wealth creation opportunities for employees. It helps to both incentivise and reward long-term employees, since it is linked to the market price. If the company; and hence the stock does well, the payout will be better. It thus helps align employee goals with that of the company and its investors. It has created many millionaires in India, especially during the technology boom when Esops were common.

TIPS FOR ESOPS:

• ESOPs can help wealth creation based on the stock performance
• Taxed as perquisite on the date of exercise; making the tax burden significant 
• Risk of high exposure to one single stock in one’s portfolio
• Hence, timely profit booking is recommended

While signing up for Esops, the employee needs to consider multiple factors such as the financial position, the tax bracket, risk appetite, liquidity, and long term goals. For example, this might not be a good option for anyone who is risk averse, as the returns are linked to the company’s stock price.

Mechanism
The Esops become eligible for exercise (called vesting) as per company policy; typically in a staged manner. Partial vesting each year with a typical cap of four-five years is common. For example, a company can issue 1,000 stock options to an employee with 250 shares vesting each year over a four-year period. The employees exercise their Esops on vesting at an Exercise Price communicated right at the time of grant (issuance). On the date of exercise, if the stock price is higher than its exercise price, it is profitable for the employee. If not, the employee need not exercise the stock option and it can expire. Employees are allowed to exercise their Esops over its term (normally about a year from the last vesting). Some companies issue shares at a discount to the market price at the time of issue to make it more attractive to their employees.

Another form of incentivising that multi-national companies use is Employee Stock Purchase Plan (ESPP). The employee is allowed to directly buy the company's stock on a monthly basis at a certain discount to the market price. For example, if the market price is Rs 150, the company will offer this to their employees at Rs 135, a 10 per cent discount.

Taxation
Currently, Esops are taxable as perquisites (that is, salary income) in the hands of the employees. The perquisite value is derived as the difference between the Fair Market Value (FMV) of the share on the date of exercise and the exercise price.

On the date of exercise the employee ends up paying 30 per cent tax upfront (on the difference between the FMV and the exercise price). For listed companies, current market price as on the date of exercise is usually considered as a FMV. For unlisted companies, the FMV of shares needs to be determined by the Category I Merchant Banker registered with Securities and Exchange Board of India (Sebi). The perquisite tax needs to be paid on date of exercise even though the shares are not sold.

The gains arising from the difference between sale consideration and the FMV on the date of exercise is also taxable in the hands of employees as capital gains. The capital gains tax treatment also depends on the holding period and whether the shares are sold on a recognised stock exchange in India. If the holding period is more than 12 months for a listed company, it is considered as long term and attracts no capital gains tax. However, if the same is held for less than 12 months, it is considered as short term and taxed at 15 per cent.

The timing of the Esop exercise is crucial due to the current taxation. Ideally they should be exercised when the company’s shares are trading at a low price; but the employee is confident of the company’s long-term prospects. Since it is difficult to predict the stock price movement, it also advisable to exercise the ESOPs in a phased manner.

Disadvantages
The main disadvantage of Esops is the risk level. It tends to create a non-diversified portfolio skewed towards one company. Thus, one can see significant volatility. Normally capital required to exercise is high. Some employees take loans to exercise their Esops. This is not advisable unless one is taking it for a short period.

To sum up, Esops are a good wealth creation tool for employees. It helps one participate in the equity upside of the company. Considering the significant upside, the taxation and the risks involved; one needs to use this judiciously to profit from it.

The author is CEO and Founder of ‘Right Horizons’