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Esops make a comeback

However, in the case of unlisted firms or start-ups, it is a risk one is taking, as the valuations aren't known. Look at these only as additional benefits

Priya Nair 

2014 has been a good year for students graduating from the IITs and IIMs. Facebook and Google have offered annual packages of Rs 1-2 crore. With a catch - half this package consists of employee stock options (Esops).

Indian start-up companies such as Flipkart, Snapdeal and Housing.com, also offered Esops as part of their packages, to attract students. Is this a revival of the Esop culture, earlier seen during the dotcom boom of the early 2000s?

Stories of how Infosys, one of the earliest companies to offer Esops, created millionaires of employees such as drivers, are known. Similarly, SKS Microfinance, the only listed micro finance lender, created millionaires of its mid-tier and junior staff when it got listed in 2010. It is a different matter that the stock lost heavily after changes in the micro finance sector regulations made it difficult for the company to recover loans.

More recently, when Indian e-commerce giant Flipkart bought out Myntra.com, for a little over Rs 2,000 crore, about 500-odd employees of the latter who had received Esops saw an increase in their net worth. When Flipkart gets listed, these employees will be able to encash their Esops.

Similarly, when Facebook acquired WhatsApp, part of the transaction included $3 billion worth of restricted stock units to the WhatsApp founders and employees, locked in for four years from the time the deal was completed.

While listed companies use Esops as a retention tool for top-performing employees, start-ups use it as a tool to hire good talent, as they cannot afford to pay very high salaries. What makes an Esop attractive, other than the value or potential value of the shares or units, is the idea of ownership it imparts to the employee holding it.

According to Sudip Mukhopadhyay, managing partner, Vantage Health and Benefits Consulting, the trend emerging from the recent placements indicates a revival of the excitement around the information technology (IT) sector and start-ups, more than a revival in the Esop culture. "When start-ups offer Esops, it is not based on any concrete financial equation. It means the company is offering a vision and the candidate is willing to be part of that vision," he says.

There is a difference in the way Esops are perceived in India and how these are structured in foreign companies, says Harshu Ghate, co-founder and chief executive, ESOP Direct, a benefits services company.

HOW ESOPS WORK
  • Start-up companies use Esops to hire good talent, as they cannot afford to pay very high salaries
  • Those joining start-ups must understand how Esops are valued
  • Only if the company is in a high-growth sector will Esops see an actual rise in value
  • Ensure there is a proper exit mechanism, like promoter buyback, in case listing of the start-up is delayed
  • Listed companies could link Esops to performance as a tool to retain top-performing employees
  • They are taxed at the time of allotment and while exercising the option

Abroad, employees are given instruments that are not strictly Esops but restricted stock units. They might not work like Esops but be linked to the stock price.

Growth potential
If a candidate is offered a package with a larger share of Esops but a smaller salary component and one with lesser Esops but more salary, the decision should depend on the sector the company is in, says Mayur Shah, executive director-tax and regulatory services, EY.

"Even if it is a listed company but operating in a segment where growth is stagnant, then even if employees get Esop, it will not be remunerative. But if it is a start-up which has the potential to grow, there is scope for upside in the stock price," Shah says.

However, this does not apply to all start-ups. Again, one has to look at the particular segment and the revenue models. Not all IT sector start-ups will offer the same growth potential. Now, e-commerce firms seem to be on a roll, given the demography and scope of penetration of the internet in India. However, competition could take a toll on some of those operating in this segment. If valuations don't work out as projected, the employees could be left holding worthless shares, which cannot be liquidated.

Stage of evolution
The stage of evolution of the company is another point to consider. With an absolute start-up, that has only seed capital, an Esop might be the only way to attract talent, as the company might not have the funds to offer very high salaries.

"At the initial stage, even if the company tells the candidate that he/she will get two per cent of the shares, it has no valuation. But, here, the candidate is taking part in the future opportunities the company can offer. Here, the risk is the highest," says Mukhopadhyay.

In the case of start-ups that have received the second or third round of funding, the risk is less, since there is some tangible valuation. So, the choice for a candidate about joining a company that is offering Esops will also depend to some extent on the stage of evolution of the company. It is least risky in the case of listed companies.

Typically, start-ups would offer Esops as part of the compensation package and, hence, the share of Esops in the package might be higher. But a listed company might use Esops as an incentive scheme. In this case, the share of Esops might be lesser.

"Very few companies offer Esops to employees at the lower level. These are usually given to employees of the top three to four levels, who can understand how these work and how the valuations are likely to be in case it is an unlisted company or a start-up," says Ghate of ESOP Direct.

Documentation
In the case of a start-up, employees must look at the documentation thoroughly to see how the Esops have been valued. If the value being projected is Rs 5 lakh or Rs 10 lakh, one must check if it is the current value or one a few years down the line. Also, check if the person offering the Esop has the authority to do so.

Ideally, one must not opt for Esops with the expectation that they can make a lot of money. Stories of drivers becoming millionaires might not happen in all cases. In fact, in the case of start-ups, it is safer for candidates to consider only the salary component and look at Esops as an added bonus. "A pleasant surprise is better than a nasty shock," Ghate warns. While it is difficult to ascertain the valuation of the company if a start-up, one way is to see if they have been valued by a Category-I merchant banker. "This is from the tax perspective. But it can also be used as a rule of thumb for investors and potential candidates," says Shah of EY.

Exit mechanism
Another consideration is to check what is the exit mechanism offered by the company. Again, in the case of listed companies, this is easy. After the period of vesting, the shares can be sold on stock exchanges. In the case of start-ups the exit might become tricky, since these are not listed. In some cases, another investor might buy the stocks. Or the company might buy-back the shares if it is not able to go public, due to bad market conditions.

The vesting period, by regulatory requirement, is at least one year. After that, it is left to each company to decide the conditions. In some cases, a company might allow selling of 20 per cent every year. Most allow three to four years to sell Esop shares.

Taxation
The taxation of Esops is a bit tricky. When the shares get allotted, they are taxed as salary or perquisite. The tax will be paid on the Fair Market Value (FMV) and the price at which they are sold to the employee. The second time the Esop will be taxed is when the employee sells it or exercises the option. This will be taxed as capital gains. The tax will be paid on the difference between the FMV at the time of allotment and the price at which these are sold. Normal capital gains tax will apply; that is, no tax if held for more than a year provided it is sold on the stock exchange. In case of unlisted companies or start-ups, there are Sebi guidelines on how the FMV can be arrived at.

First Published: Mon, December 15 2014. 00:20 IST
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