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What you need to know when you exercise your stock option plan

What you need to know when you exercise your stock option plan
  • In case of listed companies where the market value of the share is lower than the predetermined price in ESOP, the employee should not exercise the option.
  • It is crucial to consider the company's financial health and growth prospects when assessing the worth of ESOPs.
  • You can sell a portion of the shares obtained through exercising your ESOPs right away to cover the costs associated with exercising, including any taxes owed.
A few days ago, Infosys offered 5.11 lakh shares to its employees under Employee Stock Ownership Plans (ESOPs). ESOPs are extensively employed by corporations worldwide to incentivize employees to become stakeholders in the company. By offering employees the opportunity to own equity in the company, ESOPs aim to align their performance and dedication with the organization's success.

In recent years, ESOPs have gained significant popularity, particularly among startups, as an effective tool for attracting and retaining top talent. Startups leverage ESOPs to not only reward employees but also to create a sense of ownership and motivation, driving their commitment and contribution to the company's growth.We take a look at what you need to keep in mind when exercising your stock options.

“Under ESOP, employers grant options to its employees which are exercisable against company’s shares at future date, on fulfillment of defined vesting conditions. For this purpose, the employee pays the exercise price (set as zero or less than fair market value (FMV)) at the time of exercise of shares in future. Therefore, no upfront costs are associated with ESOPs at the time of grant,” says Akhil Chandna, Partner, Tax, Grant Thornton Bharat, a professional services firm.
Understanding exercise options
“Most reputed companies have a vesting period of four years, with 25% of the ESOPs becoming eligible for exercise each year after the initial one-year cliff. This means that after the first year, employees can exercise 25% of their ESOPs and subsequently exercise 25% over the following three years on a monthly pro-rata basis,” says Ajinkya Kulkarni, Co-Founder, and CEO, Wint Wealth, an online investment platform focussed on fixed income products.

There are two common types of approaches when it comes to exercise prices. The first approach sets the exercise price as the face value of the shares. Thus it is significantly cheaper for employees to purchase the shares. The second approach involves the employee paying the market value of the shares at the time of exercising the option, where the exercise price would be higher.

Employee-friendly companies may offer an exercise period of up to 10 years after the employee leaves the organization, providing greater liquidity opportunities for employees. “A sufficient exercise window is crucial since the notional gains from exercising an option are immediately taxable for employees, even though the actual wealth is realized upon liquidation of the shares,” says Kulkarni.
What to keep in mind when exercising options
When exercising an option see if there is a condition that the option will lapse if you do not exercise. “Then you should exercise. But if there is an option that it will be carried forward, there is no need to exercise immediately,” says BM Singh, ESOP Expert & Managing Partner, BMSA Consultancy.

The actual value of ESOPs in a company is closely tied to its future performance and market valuations. Even if ESOPs hold a significant monetary value on paper, if the company's performance is poor, their true benefits may be limited. It is crucial to consider the company's financial health and growth prospects when assessing the worth of ESOPs.

Ultimately, ESOPs are most advantageous when granted by companies with strong performance and promising future prospects.Therefore, employees should conduct thorough background research before accepting an offer that includes a substantial ESOP component.

Chandna says that in the case of listed companies where the market value of the share is lower than the predetermined price in ESOP, the employee should not exercise the option. For unlisted companies, the employee should also research the company’s buyback track record during the vesting period and whether the company will raise capital through a funding round etc, to know the exit possibilities.
Tax implications at the time of exercise
Taxability of ESOPs first occurs at the time of exercising the options, where the perquisite value of the ESOPs is deemed taxable under the category of 'salary' in the hands of the employees. When employees exercise their ESOPs, the difference between the fair market value of the shares at the time of exercise and the exercise price is treated as a taxable perquisite.

This value is added to the employee's salary and subject to applicable income tax regulations. “Please note that the taxable value of perquisite would be computed basis the date of exercise of options /units, however, the same would be taxable in the year in which shares are actually allotted/ transferred to the employees,” says Chandna.

Name of employee

A

Grant date of ESOP

1 April 2023

Vesting date of ESOP

1 April 2024, 1 April 2025 (50% at each date)

Exercise date of ESOP/date of allotment of shares

1 April 2026

FMV as on Exercise date i.e. 1 April 2026

₹1,000

Exercise price

₹100


In the above illustration, the taxability would arise in the hands of Mr. A on exercise date i.e. 1 April 2026 (FY 2026-27). The taxable value would be ₹900 (i.e. ₹1000 as reduced by ₹00) on 1 share.

Source: Grant Thornton

How to minimize out of pocket expenses when exercising ESOPs
“To minimize the duration between tax obligations on notional gains and the actual gains, it is advisable to exercise ESOPs closer to liquidity events,” says Kulkarni.

You can sell a portion of the shares obtained through exercising your ESOPs right away. The proceeds from the sale can be used to cover the costs associated with exercising, including any taxes owed. This strategy effectively lowers your out-of-pocket expenses by utilizing the funds generated from selling the shares. “Let us say that you are entitled to exercise 50 shares. If you get a chance to sell 10 shares in the secondary market, then you can sell the shares and cover the expenses from the proceeds,” says Singh.

By creating a budget and developing a financial plan, you can ensure that you have the necessary funds for exercising ESOPs while minimizing your out-of-pocket expenses. Through careful financial management, such as setting aside money in advance or reallocating your financial resources, you can mitigate the impact on your personal expenses when it comes time to exercise your ESOPs.

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