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A Beginner’s Guide to Reading Stock Option Plan

How should employees read stock option plan

You’ve been granted stock options by the company where you work. The company has also shared the stock option plan with you. What should you note from these two documents? A few terms may be standard, while others company-specific. 

In this blog, we break down the most common terms of stock option plans, focusing on how you should read and understand them.

First, let’s understand what a grant letter and stock option plan are: 

A stock option plan sets the stage for a grant. It’s the foundational document that sets out how stock options are granted, how they vest, and how they can be exercised. A grant cannot be made unless an option plan is in place.

A grant letter on the other hand is a brief document that lays down the terms of the options granted, such as the number of options granted, vesting period and conditions, and so on. The terms in the grant letter must be within the scope of the stock option plan. While the terms in a grant letter can change from employee to employee, the plan is fixed for all employees.

Things to note in a stock option plan:

1. Type of plan

Your right to exercise, hold shares, receive returns etc., directly depend on the type of plan. For example, if options have been granted under a trust structure, the legal ownership stays with the trust, and employees will be eligible to only receive the economic benefits of shares like the right to receive dividend, vote, etc. 

2. Stages of plan

  • Grant : 

A plan typically mentions the modes in which a grant can be made and the methods by which employees can communicate their acceptance or rejection of the grant. A grant letter is important because once signed, it will establish a contractual relation between the employee and the company.   

  • Vesting :

Vesting is a process of earning the right to purchase shares. Not all options vest at the same time. How and when options will vest will depend on the vesting schedule. Vesting may be time-based, performance-based, or both. Understand how and when your options will vest. For example, if the vesting is performance-based, your options will vest when you successfully complete a project or client engagement. Also, check to see if the plan has a provision that allows acceleration of vesting when any specific events occur, like a change in the control of the company, merger, demerger, etc. 

  • Exercise : 

a. Exercise conditions: Some plans will allow exercise of options only when there is a liquidity event, like a company’s shares being listed, acquisition, merger, demerger, and so on.             

 b. Exercise period: Make sure you understand the timeframe within which options must be exercised. The exercise window may vary based on your status of employment (employed, resigned, terminated). Your options will lapse if you don’t exercise them within the mandated time frame.  

c. Payment: Look for options to pay to purchase shares at the time of exercise. Companies typically accept payment in the form of demand drafts drawn in the name of the company.

3. Separation from company

Separation from the company can happen in two ways: resignation or termination. Pay attention to how options are treated in both these scenarios. Standard ways of treating vested and unvested stock options are:

  • Resignation/Termination without cause: When you resign, you can exercise your vested options. However, the exercise request must be sent within the timeframe (exercise period) set out in the plan, failing which you will not be allowed to exercise options. Unvested options are cancelled and added back to the pool.
  • Termination: If your employment is terminated by the company, all vested and unvested options lapse. This means no options can be exercised. Both vested and unvested stock options are added back to the pool. 

4. Tax

While the plan will not specifically mention on whom the onus of tax payment lies, generally, you must be aware of the following:

Tax is payable on the returns earned. Returns are earned on the stock options in the following ways:

1. On exercise- The difference between the fair market value of shares on the date of exercise and the strike price(which is typically the par value of shares at the time the grant was made) is the income the employee earns. It is treated as perquisite and taxable in the hands of the employee. TDS is deducted by the employer on the perquisite amount.

2. Buyback- If there is a stock option buyback, the company deducts TDS and pays the employee for the options surrendered. If the employee exercises the options and immediately sells the shares to the company, the income is taxed as short term capital gain. 

3. Secondary transaction– Shares can be sold under a secondary transfer too. When an employee exercises options and receives shares, the employee(now the shareholder) can sell shares to an incoming investor or another existing shareholder. The returns earned are taxable in the hands of the employee. 

Sale can result in short term capital gain or long term capital gain. If the employee sells the shares within a period of 12 months from the date of exercise, the income is treated as short term capital gain. If the employee holds the shares for more than 12 months, then income is treated as long term capital gain.  

As seen, tax is paid at multiple levels of a stock option grant. A typical plan contains a snippet on when tax is payable. Understand the tax structure clearly as it dictates the returns that finally reach your hands. You can consult a tax consultant if need be.   

5. Liquidity

Look for how the company aims to provide returns on the stock options you hold. While the traditional way would be to wait till the options vest and then request exercise, the company may provide other liquidity options that allow you to surrender the vested options you hold for cash. This will mean you don’t have to exercise options and later sell the shares to earn returns or wait till the company’s shares are listed on a stock exchange (IPO).

6. Transfer options

Transfer of stock options is not allowed under Indian law. However, analyse if there are any restrictions to transferring shares once you have exercised your options. The plan may state that unless the approval of the board is taken, shares cannot be transferred. 

An exception to transfer restrictions could be transfer of options to an appointed nominee in case of death. Transfer of options may also be allowed if there is a drag sale, i.e., if one or more shareholders of the company convince all other shareholders to sell their equity to a third party on the same terms as they are selling their holding. In such cases, vested options may be exercised, and you will be able to participate in the drag sale.

7. Amendment of plan

See how you will be notified if the company wants to amend the plan. Pay attention to the steps the company might undertake to ensure that the terms of amendment are not unfavourable to the interest of employees. 

8. Corporate restructuring

Understand what happens to your stock options if the company merges with another entity or is demerged. Check to see if your rights will be protected. For instance, in case of a merger, option holders of the company that is being merged into the other may be granted options in the new company or provided an exit by way of cash settlement. 

9. Stock restructure

Understand how the company will adjust the number of stock options you hold if there is a stock restructure. Stock restructure can be  share split, share consolidation, issuing bonus shares, etc. Since any increase or decrease in the number of issued shares affects your shareholding, it is important to understand how you will be compensated. A few companies increase the quantum of stock options granted to adjust for the restructure. Pay attention to what the plan says about this.

10. Shareholder rights

Shareholder rights will only be applicable once the options have been exercised and the option holder becomes a shareholder in the company. This may relate to the right to receive dividend, vote, or participate in shareholders’ meetings.

Stock option plans are profit-sharing plans. Pay attention to how each type of stock option plan functions. Understand your plan type because your returns are dependent on it. 

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