ESOPs have time and again proven to be a valuable tool for creating wealth. A prime example of this is Flipkart, India’s first e-commerce platform. Flipkart has constantly implemented ESOP programmes that have made many of its employees cash rich overnight. A recent example of this is its USD 700 million buyback announcement. The buyback is part of Flipkart’s initiative to provide liquidity to its employees in the form of a cash out.
Over the years, ESOPs have created exceptional returns to the employees of startups. In the year 2022 itself, Indian startup employees made over USD 196 million through ESOP buybacks.
How do ESOPs generate wealth to employees?
Let’s say you have joined a company in 2015 and have been offered 100 stock options as part of your compensation package with a strike price of INR 10. The company has grown in value since and the fair market value per share is now INR 2,500. If you decide to exercise all your options now, you will pay the company (100 x INR 10) = INR 1,000 although the current share price is INR 2,500. If you sell the shares thereafter, your return will be (100 x INR 2,500)- INR 1,000 = INR 2,49,000 before tax. INR 2,49,000 is the total wealth generated and this is subject to tax.
What are the different ways in which employees earn returns on their stock options?
1. Exercise and sale of options: Shares received after exercising the vested options can be sold to create liquidity. If the company is a limited company, employees can sell their shares on a stock exchange. On the other hand, private company shareholders can either transfer their shares to other shareholders or participate in a buyback to generate returns. On exercise of shares, tax is payable on the perquisite amount which is the difference between the fair market value of shares and the strike price on the day of exercise. Tax is also payable on sale of shares. This is taxed as short term or long term capital gain based on the period of time the shares have been held by the shareholder.
2. Buyout of options: The company may decide to buy back the vested options before an IPO, merger or acquisition. Additionally, the company may also choose to open a liquidity window that allows employees to cash out all or a portion of their vested options. The price offered by the company to buy back the stock options is usually linked to the fair market value of its shares on the date of the buyback. Since the exercise/strike price in most cases is at par or below the buyback price, employees benefit from the difference in prices.
For example, if the buyback price is INR 100 and the exercise price is INR 10, INR 90 is the gain made (before tax) per option. In 2022, several companies, including Cars24, FarEye, Bizongo, The Math Company, Headout, Jupiter, and more, announced ESOP buybacks.
Stock options and Risks
While there are plenty of examples to prove that stock options generate wealth, it is also true that they carry an element of risk. Firstly, stock options vest only after a waiting period. Secondly, since the returns are directly proportional to the price of shares, if there is a fall in the share price during this period, it may result in earning none or negligible returns.
The risk is particularly high when the company is an early age startup or has just completed the Seed funding or Series A funding round. However, as the company enters the growth stage, every subsequent round of funding assures the employees of the company’s growth potential thus lowering the risk.
Ultimately, if an employee has confidence in the company, taking the risk may be worthwhile. This is a personal decision that each individual must make based on their risk taking capacity and financial standing.
ESOPs can generate wealth in a single year or over a period of time depending on the terms of vesting. Generally, the vesting schedule is spread over a period of 4-5 years after the grant. However, there is no guarantee that all stock options earn good returns. This also holds true for any other securities linked form of investments
For this, founders and companies have to make changes to the terms of the options, such as the exercise price or the vesting schedule, to make them more attractive to employees.
Financial institutions may also give a hand in providing liquidity for option holders. Financial institutions can invest in startups and provide cash for liquidity, exercise, and taxes. This will enable employees to cash out their options and receive the benefits of their equity without having to wait for an IPO or acquisition.