Why ESOPs are given?
Employees are granted stock options for a variety of reasons. Stock options are more frequent in start-up companies that can’t afford to pay their employees significant wages but are willing to share in the company’s future success. In such cases, stock options are given to employees as part of their remuneration package. In some cases, the employee is also given stock options, which he can exercise at a later date/s, in order to ensure his long-term commitment. Employee stock ownership plans (ESOPs) assist to build a sense of belonging and connection among employees in addition to giving monetary benefits.
When a stock option is provided to an employee under an ESOP program, it is free. The ESOP scheme spells out the terms and conditions under which an employee can use his rights. After a specific lock-in time, which is usually more than a year, the employee’s option can be exercised.
How do they work – vesting portion
The right to exercise the option may vest in the employee at a later time. The “vesting date” is the date on which an employee becomes eligible to exercise his or her right to purchase shares. The rights may vest fully or partially over the vesting period.
For example, on 31 March 2018, an employee is granted 1000 options, which can be exercised in three phases: 20% at completion of the first year, 30% with completion of the second year, and 50% on completion of the third year from the date of the grant. So, in this situation, the vesting dates for 200 options are 1 April 1 2018, for 300 shares, 31 March 2020, and for the remaining 500 shares, 31 March 2021.
For such vesting, the plan may specify the same or a different grant price or exercise price. The grant price, or the price at which an employee can purchase a share from the company, is usually set and is significantly lower than the current market price of the shares.
It is not mandatory for the employee to exercise the option because it is only presented as an option with no obligation linked to it. In the event that the current price of the shares is lower than the exercise price, the employee can choose to execute the option or let it lapse. The employee is granted a certain amount of time to execute his option, after which his vested rights may lapse. The ‘exercise date’ is the day on which an employee exercises his option to purchase shares.
When options are granted, as well as when they are vested in the employee, there are no financial outflows or tax ramifications.
Exercising options: why, how much, and when?
If your current cash curve isn’t doing as well as you’d like, exercising stock options may be able to help.
Exercising, on the other hand, is an investment in terms of money. Is it therefore worthwhile to pay the price?
When executing options, you pay money to increase your cash curve. The more options you utilize, the more money you spend; nevertheless, the curve improves as you utilize more options.
The numbers will change depending on your situation. You boost your chances of making more money in the future by paying today. However, if your company fails, you will lose that money.
An employee’s option does not have to be exercised after it has vested in him. The employee has a certain amount of time to exercise his or her privilege. When an employee should exercise his or her options is a crucial subject from a financial and taxation standpoint.
The employee must pay the preset price for the shares when he exercises the option, resulting in a financial outflow. Because the shares cannot be sold unless they are listed on a stock exchange, the money is locked up until the shares are listed or the promoters offer you a way out. Furthermore, extending your exercise date has tax implications because the capital gain holding period begins on the exercise date. As a result, the decision must be taken carefully after considering the cash flow and tax implications.
You exercise your options and officially have shares
When it comes to exercising, you have complete control. As long as you work for the company, you can buy shares whenever you want, and you don’t have to buy them all at once. When you leave a company, you usually have 90 days to decide what you want to do next (a few companies extend this to 5, 7, or 10 years).
You can exercise closer to the exit and then pay for it with the money you earn, so there are no out-of-pocket expenses. However, there are a number of disadvantages to this method.
It’s a big decision to decide which tactic to use.
Your company exits – finally!
When a business closes, one of two things happens:
- It is acquired, which means that another firm buys it. Microsoft purchased GitHub, Amazon purchased Twitch, and Facebook purchased WhatsApp. It goes public, which means it sells its stock in an initial public offering on the open market (IPO). Slack, Uber, and Lyft have all done just that.
Employees usually have a 90- or 180-day ‘lock-up’ period after the IPO during which they are unable to sell their shares.
You can sell your shares for a profit if the company’s exit value is high enough.
Your alternatives would be pointless if you didn’t have a way out.
Determination of your shares’ exit value
Your cash curve determines how much money you’ll make if your firm goes bankrupt.
Your ISOs and NSOs are in place to make you money in the future. “Exit” was the moniker given to that particular day. This occurs when your firm goes public via an initial public offering (IPO) or is acquired by another company. The amount of money you receive if and when your company closes is dependent on how successful it has grown. Your company’s exit value is determined by its level of success.
Regrettably, the exit value is unpredictably variable. You’ll never know how much money you’ll make as a result of your efforts. The only certainty is that when the exit value rises, you will make more money.
When should you sell the shares?
Selling an ESOP stock is equivalent to selling any other type of investment. You must evaluate the capital gains implications as well as the need for liquidity when making a decision. The selection will also be based on the Company’s future prospects.
It’s also possible that the shares you purchased through an ESOP aren’t listed, in which case you won’t be able to sell them until they are, or until the promoters offer you an exit, which may or may not be under very favourable terms. It would be advisable to wait until the shares are listed on a stock exchange in this scenario.
Tax implications when exercising the option
The taxes of ESOPs have a common structure. It is subjected to two levels of taxation.
The employee’s option to purchase shares at the exercise price is exercised in the first stage. The shares are eventually sold in the second stage.
When an employee’s ESOP options are exercised, the difference between the exercise price and the security’s value is treated as a prerequisite in the employee’s hands. The employer must deduct tax from the employee who exercises the option at source, recognizing it as a prerequisite. If the shares are listed on any stock exchange in India, the value of the shares given to the employee will be the average of the market price (average of highest and lowest price) on the date the option is exercised. In that instance, the fair market value will be determined by the merchant banker’s valuation certificate. The certificate of share valuation must be no more than 180 days old from the date of option exercise. Even if the shares are listed outside of India, the Company must get a certificate from a Merchant Banker because such shares are considered unlisted for ESOP purposes.
When the employee sells his/her stock. Capital gains tax will be imposed if a sale occurs. Depending on how long the employee has owned the shares, the gains can be either long or short term. The holding time requirements for both listed and unlisted shares are different.
Starting from F.Y. 2016- 17, If the holding period is more than 12 months, the listed shares will become long-term. However, if the holding period is more than 24 months, unlisted shares will be considered long-term.
The period of holding begins from the start of exercise date and ends at the date of sale.
At present the long-term capital gains on listed equity shares (on a recognized stock exchange) is tax free, however, short-term capital gains are taxed at 15%. Let us explain!
When shares are traded through a broker the long-term capital gains are fully exempt under Section 10(38) of the Income Tax Act. However, as per the newly inserted section 112A via Finance Act 2018, if the amount of long-term capital gain exceeds Rs 100,000 than the amount in excess of Rs 100,000 shall be chargeable to tax at 10% without indexation (plus heath and education cess and surcharge). However, the application of sec 112A is subjected to certain conditions, one of it being the transfer should have taken place on or after 1st April 2018. Moreover, such short-term capital gains shall be taxed at flat rate of 15% under Section 111A.
If the shares are not sold through the stock exchange’s platform, long-term capital gains are calculated by indexing the original purchase price. Indexed gains will be taxed at a 20% flat rate, plus any applicable surcharges and cess. Short-term capital gains are treated like any other form of income, and they are combined with other kinds of income and taxed at the appropriate slab rate.
For the purposes of computing capital gains, the cost of acquisition is treated as FMV (fair market value) on the date of exercise, which is taken into account for the purposes of perquisites of the options, rather than the amount actually paid by the employee.
Taxation of Foreign ESOPs
If a foreign company grants an ESOP to an Indian resident, the ESOP will be taxable in India. Furthermore, the tax regulations of the company’s home country, as well as the double taxation avoidance agreement, must be investigated in order to determine the actual tax implications. Furthermore, because these shares would not be offered on Indian stock exchanges and are unlikely to be listed in India, the long-term capital gains exemption under Section 10(38) or the concessional rate of 15% tax on short-term capital gains in respect of such shares would not be available.
When you have incurred a loss
In case you have incurred a loss you are allowed to carry forward short term capital losses in your tax return and you are eligible to set them off against short term capital gains in the coming years. Long term loss on equity shares is a dead loss and has no treatment, simply because gains are not taxable as well.
Torre’s Offering: Non-recourse financing and how it benefits startup employees
Employees in private enterprises (like you) can execute stock options using non-recourse financing. Because the loan is non-recourse, your other personal assets are never in danger.
For example, if the loan is non-recourse, the lender accepts the risk and you are not required to put up personal assets as collateral, such as your automobile.
Before we get into the technicalities, let’s take a look at why financing is useful in the first place.
It’s usually better to execute your stock options as soon as possible rather than later. If your company grows, exercising sooner means paying less tax both during the exercise and after the IPO— which means more profit for you.
However, exercising options can be financially out of reach for many employees of high-growth businesses on the verge of an IPO or exit. Consider this: exercising options costs nearly twice as much as a household’s annual income.
Furthermore, as the value of start-ups rises, exercising options becomes more expensive and prohibitive. That’s because the higher your options’ 409a valuation, the more tax you could owe.
Non-recourse finance can aid in this situation. It works like a cash advance, allowing you to exercise your start-up stock options without having to pay for them out of pocket.
How it works?
The lender delivers you the funds you need to execute your stock options and pay your taxes. You wait for your company to go out of business. There are no monthly interest payments, unlike a traditional loan.
If your firm has a successful exit (such as an IPO), you repay the money you borrowed plus any fees. You owe nothing if your company does not exit or falls out of business entirely. The lender is responsible for the loss. Your other personal assets are never at risk because it’s non-recourse finance.
If you already own stock in your company, non-recourse financing might enable you to access cash for other financial goals, such as buying a house or diversifying your stock portfolio, without having to sell your stock.
Is non-recourse financing too good to be true?
So what’s the catch?
To summarise, non-recourse financing does not put your personal assets at risk, and the financing source bears all of the adverse risk. So, what’s in it for the financial service provider?
Case 1: The supplier benefits from your success: the more effective the exit, the better for everyone. In the end, the amount you owe is determined by the value of your equity.
For example, you have $100,000 worth of ESOPs and on a successful exit you gain $50,000 then a commission of 30% would be charged which is $15,000 plus the principal amount. Similarly, if your gain is higher let’s say $80,000 then you owe a charge of 30% of $80,000 that is $24,000 plus the principal amount, hence the amount you owe will be determined by your equity value at the exit event.
Case 2: The financing provider receives a share of your pay-out plus a return of the initial advance if you successfully depart (plus any interest).
Continuing the previous example along with the commission on profit x% of interest will be levied on the principal amount. Suppose you borrowed $80,000 for exercising the ESOP, x% of that amount will be charged as interest in addition to a $15,000 commission.
Case 3: The funding provider bears the brunt of the loss if the exit fails. There is no payoff for the lender to take a portion of, and you are not required to repay the original advance.
Carrying forward the previous example of $100,000 worth of ESOPs. Suppose, the exit the value of your position is $90,000 and you are in loss of $10,000. Hence, there will be no payoff to take commission and we will bear the loss without bothering the borrower. Plus, the borrower will not be required to repay the principal amount, nor his personal assets be liable.
We are ready to take such a risk because we are very selective about the companies we engage with —thus, the people we finance. As finance providers, we also diversify the risk by investing in multiple start-ups.
How Torre can help?
We’re on a mission to assist start-up employees and shareholders understand, maximize, and unlock their stock’s value. We offer non-recourse stock option exercise financing to help you reap the benefits of exercising your options early. We also offer financing alternatives that allow you to access the cash of your hard-earned equity prior to departure without selling your stock.