- Date : 24/05/2022
- Read: 4 mins
ESOPs were once the silver bullet for retaining top employees in the IT sector. But it’s been accepted across industries, and has found popularity in start-ups looking to save cash and keep their best minds. However, when the employees do leave, are ESOPs as beneficial as they’re made out to be, and when is it best to cash out?
Making employees stay longer in the company is not easy, especially given the increasing occurrence of talent jumping ship for better pay elsewhere. To stem the attrition, and encourage ownership and loyalty in the company, organisations often offer Employee Stock Option/Ownership Plan (ESOPs). ESOPs give specific employees the option to buy a certain number of shares of the company at a predetermined price.
How is it beneficial?
For the company, it helps in talent retention by promising key employees wealth in the long run. Furthermore, when employees buy shares of the company, they become stakeholders and are more motivated to work harder towards the organisation’s goals. Spread this financial gain over a certain period of time, and companies are assured of retaining their talent at least for that duration. Also, cash-strapped companies can offer ESOPs to promising employees as a means to retain them.
For the employee, there is potential for long-term wealth creation, as the shares are generally offered at a lower price compared to the market. The better the performance of the company, higher are the potential returns. The gains from selling those shares at a future time, may outweigh the short-term increment in the salary.
For example, during the salary negotiation on April 1, 2021, Arun is offered 100 options at Rs. 100 each, after a period of one year (called the vesting period). He can exercise this option for upto two years (exercise period) after the vesting period ends. The current market value of each option is Rs. 120. From 1 April, 2022, Arun can buy 100 shares of the company at Rs. 100, at any given time until the end of the exercise period of two years. Hence, it would make sense for him to buy the share at Rs. 100, if the current price of each unit is more than Rs. 100, thereby giving him immediate gain.
Things to note:
- The difference between the exercise price and the current or fair market value of the shares is taxable as perquisites (salary income)
- The offering of stock is usually staggered (eg. 20, 35 and 45 per cent of total ESOP at the end of each year, for three years) to retain employees
- The employee has the option of not buying stock if the offered price is higher than the current market price
- Capital gains tax is also applicable on sale of the options
After having bought ESOPs, if an employee wishes to quit the company, what should they do?
What happens to the ESOP when an employee exits the firm?
There are two scenarios to consider here:
For a listed company, if the options are vested, the leaving employee can hold on to the shares and treat it as a regular equity investment.
The company usually buys back the shares at the fair market value (FMV). However, it is best to refer to the company’s policies on the same.
However, in both scenarios, options that have not been vested, will be forfeited in the event of resignation or termination.
Should you cash out your ESOPs?
Once you leave a company, you can watch to see how it performs. For listed companies, you can hold on to the stock if the fundamentals of the company are strong, and your need for capital isn’t high.
However, for unlisted companies, you will most likely not have the option to hold on to the stock as the company will buy back the shares when you resign. So, from a financial standpoint, it is best to resign when the market price of your share is considerably higher than the exercise price, and when all your options are vested. Then you would make the most of your ESOPs, considering you’ve foregone additional cash-in-hand (increase in salary). Companies usually pay a lumpsum amount, boosting your immediate capital, or may pay in instalments, depending on their policies.
ESOPs are a kind of equity compensation given by companies to their employees. Whether to exercise the ESOPs or not is entirely your choice. Your ESOP liquidation may create long-term wealth if the company does well, but it is also important to bear in mind that ESOPs are taxed twice while you exercise the option to be vested, and at the time of selling the allotted shares.