Initial cash outflow: A start-up, which needs funds, generally issues stock options at an exercise price (EP). The EP is benchmarked based on present or expected rounds of investment. Thus, at the time of exercise of options, employees are required to part with some cash, depending on the EP and quantum of options. Furthermore, at the time of exercise of options too, there will be tax implications (as discussed below), which will lead to further cash outflow. However, there may not be an immediate cash inflow, especially if the ESOP comes with a lock-in period before sale or if there are no immediate buyers.
Will value be created? An ESOP is a tool meant to incentivise employees over the long term. If an employee accepts ESOPs as part of its compensation package, he will have to accept a lower fixed pay. This lower monetary compensation will last throughout the vesting period (which refers to the time until which the employee becomes eligible to exercise the shares underlying the ESOP). Hence, employees must do a cost-benefit analysis before accepting an ESOP plan, taking into consideration factors such as reduction in cash salary, expected cash outflow on payment of EP, cash outflow on payment of tax, and cash inflow at the time of sale of shares. In addition, they should also weigh a few other factors such as the company's financial situation, realistic chances for growth, etc. If an employee feels that he may not derive the desired benefit from the ESOP, he should take up the matter with the employer and seek adjustments to the vesting period, the EP, or asked for a higher quantum of options to be earmarked, so that he is adequately compensated for his current sacrifice.
Tax implications: In case of stock options, there are tax implications at two stages: on exercise of option and on sale of shares. On exercise of option, the difference between the fair market value (as determined by a category one merchant banker) and EP will be taxable as perquisite, with the employer withholding the necessary tax. Thereafter, on sale of shares, the difference between the selling price and the fair market value will be taxed as capital gains. The tax rate will vary depending on the duration for which the shares were held before sale.
Blindfolded: At times, the employer is not in a position to pay a high salary or bonuses that are at par with industry benchmarks. In such cases, ESOPs provide the necessary pull factor, especially in case of companies that have great prospects. Here, the call to sacrifice current cash salary against the grant of stock options is based on expectations of future growth, which will lead to a higher valuation of the company. These future projections may or may not be achieved. Actual gains can vary significantly from projections, either on the positive or negative side. Moreover, if the company doesn't do well and its valuations don't rise, the stock options may become underwater, which means that their value may fall lower than the EP. In such cases, employees will not be able to exercise their options and will not be rewarded for the compensation that they have sacrificed. Thus, at the time of grant of options, future growth and valuation expectations are all projections, which means that the employee is essentially blindfolded until the gains are actually realised and locked.
Marketability issues: Shares of listed companies can be sold on the stock exchanges. But in case of start-ups, disposing their shares can pose a challenge given their limited marketability. In case of unlisted companies, the ESOP plan generally provides for specific exit mechanisms to employees. These could be linked to an expected round of investments. There may also be a provision for selling to existing shareholders or to a special purpose vehicle created for buying back the shares. However, since they are not selling in a regulated market, exit by employees at the desired price may be a myth or may take longer than expected, especially if the private equity or venture capital funding gets delayed. This could happen due to a variety of reasons: internal conflicts, mismatch in stakeholder expectations, regulatory challenges for foreign funding, and so on. Thus, before accepting ESOPs, employees need to factor in risks such as the possibility of having to sell at a lower price or wait for a longer period.
While drafting an ESOP plan, most employers do consider all these points to ensure that the plan is beneficial and achieves the desired objectives of both the employer and the employees. If employees do not perceive significant benefit from it, the ESOP plan will fail. Nonetheless, employees must evaluate the offer keeping in mind the points mentioned above and take an informed decision. If after weighing the pros and cons, the ESOP appears to be attractive, employees should go for it since it has the potential to offer high gains, especially in case of start-ups that have high growth potential. The sense of ownership that ESOPs provide will also give employees the motivation to work harder each day.
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If you accept ESOPs, you will have to accept a lower cash salary
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You will also have to pay an exercise price
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You will have to pay taxes at the time of exercise of options and sale of shares
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Weigh the growth prospects of the company before accepting the plan
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Remember that in case of unlisted companies' shares there is no open market where you can sell at the existing price
Mistry is partner, Nagarsenkar is director, and Vakharia is manager with Deloitte Haskins and Sells
 "Employee Benefits: ESOPs can be risky but profitable")