ESOPs or Employee Stock Options Plans are a fascinating concept of wealth creation. It allows employees of any company to hold its shares, compounding their wealth as the company grows. There are rules that govern how the shares can be liquidated, but if done right, ESOPs can lead to substantial wealth growth for employees.
ESOPs are very popular in India as well. It has gained more traction in the past decade due to a massive rise of the startup culture. Many leading companies now make ESOPs a part of the employee's pay package, hoping to attract the top talent.
But ESOP value on paper is not the same as being able to use that money. Assuming an employee has Rs 20 lakh ESOP. Until there is a liquidity event, that number is theoretical.
How Does ESOP Money Become Real?
To understand how ESOPs work, one needs to understand three aspects that shape it: vesting, taxes and liquidity.
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Generally, ESOPs are granted with a four year vesting schedule. This means that the employees earn the right to exercise their stock options gradually over four years. Typically, a one-year cliff also applies, after which 25% of the options vest. The remaining options vest monthly or quarterly over the next three years, based on the policies and terms agreed.
Suppose an employee is granted 1,000 ESOPs with a four-year vesting schedule and a one-year cliff.
Year 1: 250 options vest after completing one year.
Year 2: Another 250 options vest, bringing the total to 500.
Year 3: Another 250 options vest, bringing the total to 750.
Year 4: The remaining 250 options vest, bringing the total to 1,000.
How ESOPs Are Taxed?
In India, ESOPs are taxed at two different stages: At exercise and again as capital gains.
At exercise, the gap between fair market value and your exercise price is taxed as a perquisite, added to your salary income at slab rates, even though you have received no cash.
Assuming that you are granted 1,000 options at an exercise price of Rs 100. After vesting, the fair market value (FMV) at exercise is Rs 500 per share.
Cost to exercise: 1,000 × Rs 100 = Rs 1,00,000
Perquisite: 1,000 × (Rs 500 − Rs 100) = Rs 4,00,000
This amount is added to your salary income and taxed at your slab rate.
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The second stage of taxation is the capital gains tax.
Years later, the company is acquired and your shares sell at Rs 1,200 each.
Sale proceeds: Rs 12,00,000
Capital gain: 1,000 × (Rs 1,200 − Rs 500) = Rs 7,00,000
If the shares are unlisted and held over 24 months, this is long-term capital gain, currently taxed at 12.5%.
Liquidity of ESOPs:
Till the company goes public or is acquired, you may have no market to sell your shares. Many startups also impose a limited post-exit exercise window, requiring employees to exercise their vested options within a specified period after leaving. This can create financial pressure without guaranteeing immediate returns.
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