What Is Employee Stock Options (ESOPs)

Let’s say you are working for a company which is doing exceptionally well & at the end of every month, you are getting a salary check. But as an employee when you see that the company is making huge profit & you are just getting a small chunk of that massive profit for your hard work.

You might feel that you are not being part of the growth that the company is experiencing.

And what may happen because of this mindset? The employee may leave & search for another job. In another job, he/she may get a raise.

This becomes one of the challenging tasks for employers: How do they retain talent? Your company is only as good as the people building it.

To retain the existing talent & attract new talent, employers nowadays offer salary + shares of the company (ESOPs).

Most people are comfortable with the salary aspect of the compensation that they get. Still, the same is not valid for ESOPs.

In this blog post, we will find out

  • What are ESOPs?
  • What are the things you should beware before getting ESOPs?

Every company has stocks (also called as shares) according to the companies worth. If somebody wants to own the company, they must own the company’s shares & too own the shares you have to pay money.

This above concept will be familiar to those who invest in the stock market.

ESOPs is an acronym for Employee Stock Option Plan. Companies use this plan to offer you shares of the company as part of your compensation.

You should note here that ESOPs that are given to you as a part of your compensation are not stock but are stock options. There is a difference.

ESOPs are not stocks but are stock options.

It means that the company is giving you an option to buy the stock of this company sometime in the future.

Let’s understand the above with an example, assume that you have joined a company called “X” in the year 2000, whose worth is 1000 having 100 shares. Then the value of the individual share is 10 — simple Math.

At the time of joining in the joining letter, you were offered some salary + ESOPs of worth 20 (2 shares of X).

As time passed, the company has grown exponentially. Similarly, companies worth has also increased.

Now the individual share of the company is worth 1000 compared to 10 in the beginning. Similarly, as you had 2 ESOPs of X, you now have 2000, rupees which is good compared to your static salary.

Are you Feeling happy now ? and want to get more ESOPs compared to the salary. Happens with all the people when I explain ESOPs for the first time. At this time, I want you to remember this quote.

All that glitters is not gold.

Similarly, ESOPs are also not that simple. It comes with its own terms and conditions.

Let’s understand the 3 important aspects of ESOPs

It specifies, At what point or by what time you will get the ESOPs

A company doesn’t want if they give 2 ESOPs to you when you join & after one month you decided to leave the company & take the 2 ESOPs with you. The company isn’t getting benefited at all.

So what they do is, They put the ESOPs given to you in a vesting period.

This means you will not get the ESOPs immediately you will get them over a period of time.

What does it do for the company?

  • It ensures that if the ESOPs are essential to you, you will be associated with the company for that period.
  • It also helps them spread ESOPs over a period of time.
  • It is also interesting for you because as you spend time in the company, you will keep getting more ESOPs.

So, how does it usually work?

It is mostly year vesting, meaning every year it is equal vesting & Generally, in India the vesting period is four years.

Let’s understand with an example.

Suppose you have got 100 ESOPs, with a vesting period of 4 years. You will get 25 ESOPs every year.

But different companies bring there own approach for the vesting period.

Some aggressive companies who want you to stick for four years & don’t leave them before they backload these ESOPs.

These companies don’t give you 25 ESOPs each year but do a split of 10, 20, 30, 40.

Some employee-friendly companies do the reverse. They will give you 40, 30, 20, 10.

Some companies feel that yearly vesting is unfair.

You might ask why?

Let’s say you spent 18 months in a company & now you want to leave the company, but you are not leaving just because you want to complete the remaining six months to get the ESOPs & then go.

Companies don’t want if an employee is checked out or not contributing much is just staying because of ESOPs.

So such companies do quarterly vesting.

Let’s say you have 100 ESOPs, instead of getting 25 ESOPs in a year. You will get 6 ESOPs in the first three quarter & 7 ESOPs in the final quarter.

It specifies for how long will you have to be in the company to get the ESOPs.

In a quarterly vesting scenario, companies don’t want you to work for 2 quarters & then leave the company with the ESOPs you got in the past 2 quarters.

They want you to spend a minimum amount of time in the company & this is called the cliff.

Most companies have a cliff off one year.
Which means if you leave the company before one year. You won’t get any ESOPs. Only after completing one year, you will get the first allotment of ESOPs.

Let’s continue with our example. As you got 100 ESOPs as per the compensation agreement, you won’t get anything for the first year, but you will get your first allotment after the first year.

If quarterly vesting after 12 months you will start getting ESOPs of the first year & then you can see the magic quarterly vesting.

Let’s remember the acronym of ESOPs. It is EMPLOYEE STOCK OPTIONS. You haven’t got companies stocks yet. All you have is companies stock options.

Which means you have an option to buys companies stock. That doesn’t mean you still have it.

To convert this stock option into stock, you will get a time & that is called the exercise period.

A lot of companies in India keep the exercise period to 3 months. If you resign your job, you have a period of 3 months to convert the ESOPs that you have collected into stocks.

If you don’t do that, then your ESOPs are gone. They are not there any more.

There are also companies which feel that three months is not a reasonable exercise period. They give an exercise time of 5–10 years.

You might ask, How does this exercise period matter to me if I want to convert ESOPs to stocks. I’ll tell the company that I want the stocks & they will give it to me.

It’s not that easy.

As per the Indian government & it’s income tax laws, ESOPs is a part of your income. Because the company has given it to you for free or at a massively discounted price. So whatever you get is an income.

So when you try to convert ESOPs to stocks, which is equivalent of generating income. Then you have to pay income tax. & this is not a great feeling because you haven’t got any money for these stocks.

Let’s say you have got 100 ESOPs, and after resigning you want to convert these 100 ESOPs into 100 stocks. And the price of each stock is 10 rupees.

The government will then say you have an income of 1000 rupees & according to the income tax bracket you fall (suppose you fall under 20% bracket), you have to pay 200 rupees.

You are in a terrible situation now, because you haven’t got any money(1000) you just got the stocks, but you have pay 200 from your pocket to the government.

That’s why most people don’t do that. They wait for an event where they can convert these ESOPs into cash.

The events can be one of these

  • IPO
  • Funding Round
  • Sale
  • Secondary Purchase

At these events, employees exercise their ESOPs. Let’s say you got 1000 from the conversion process. You will give 200 to the government & keep the remaining 800.

Now, you are good position to answer any question related to ESOPs or negotiate the terms & conditions with your employer regarding ESOPs.

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Engineer at spaceuptech