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ESOP - Paper or Money?

In this week's FinMail we understand what are ESOPs and how it is used by companies to keep their employees hooked.

The Story:

On Friday, Nithin Kamath, founder of India's largest Stockbroker - Zerodha, announced that it will conduct an ESOP buyback from its employees worth $25 Million (₹180 crore). This is the second time in less than 2 years that Zerodha has conducted its buyback program. With this buyback, Zerodha has valued itself at $2 Billion.

Announcing this, Nithin Kamath also said that the valuation of $2 Billion is still conservative considering the risk in their business.

Last year too Zerodha had conducted a buyback of around ₹60 Crores which helped Zerodha reach a valuation of $1 Billion, making Zerodha India's first Bootstrapped Startup on the Unicorn List. Bootstrapped Startups are Startups that don't raise funds from outside investors but utilize their own profits and funds to source capital and grow their business.

ESOPs are becoming a go-to tool for employee retention techniques and many startups have started giving ESOPs as well. In this week's FinMail we are simplifying ESOPs and everything around it.

Before we understand ESOPs let us for a moment understand why ESOPs are important and how they are used.

Why ESOPs?

Employee Retention is a job on which every HR wants to win. Employee Retention is one of the biggest challenges for companies and reducing the employee turnover rate is on every company's wishlist. A company that has frequently changing employees has higher retention costs, a lower sense of bond between employees and ultimately less potential to grow. According to a report, consistent staff changes make it hard to develop the type of long-lasting friendships that can make a job that much more pleasant. In fact, employee happiness is 23.3% more correlated to connections with coworkers than direct supervisors. Hence, companies try to keep their employees as involved as they can be in the company.

You might be aware of the concept to give the employees of the company some portion of ownership to give them a sense of responsibility and ownership so that to make them feel more involved in the growth of the company and ESOPs is just another fancy way to do this.

What are ESOPs?

Employee Stock Ownership Plans or ESOPs as we call them are Employee Benefit/Retention Tool that is used by Companies to give employees a sense of involvement and ownership which helps to align the goals of employees with that of the company.

ESOPs are essentially a contract/stock option that gives the receiver of ESOPs (the employees) an "option" to convert those ESOPs into actual stocks of the company. These ESOPs are given to the employees without any cost or at a very low cost which means ESOPs are a kind of bonus that is given to the employee for their loyalty and dedication towards the company. The underlying reason behind issuing ESOPs is that if the employees that work for the growth of the company are given a chance to own that company, they would work in the best possible interest as they themselves are the owner.

How are ESOPs issued?

As mentioned earlier, ESOPs are given to the employees usually at zero cost to them or if charged, they are given at a very low cost. Now, as far as the value of ESOPs is concerned they are given a monetary value. To understand the value of ESOPs, let us understand them by a simple example.

Natukaka is an employee of Gada Electronics for a long time and Jethalal is aware of his loyalty and dedication towards Gada Electronics. He wants to reward Natukaka but not in the form of a salary hike. So he gives Natukaka 5 ESOPs of Gada Electronics. Let's say Gada Electronics is valued at ₹1 Crore and the number of shares of Gada Electronics is 1000. So each share has a book value of ₹10,000. It means if Natukaka holds 5 ESOPs of Gada Electronics he essentially has a bonus of ₹50,000 in his hand. But the reward is not limited to ₹50,000.

Let's say Natukaka holds the ESOPs for 5 years and then decides to execute the ESOPs to buy shares of Gada Electronics. Now after 5 years, the valuation of Gada Electronics might have increased. Let's say to ₹2 Crores, so if Natukaka holds 5 ESOPs and the total number of shares is still 1000, it means Natukaka's bonus has now increased to ₹1,00,000.

This is what ESOPs do. If a company's valuation grows, the value of the ESOPs also rises thus an employee gets benefited more if it rises more. Hence, it helps a company in the alignment of the best interests between the employee and the company, but are ESOPs really free?

Taxability of ESOPs:

ESOPs are a kind of bonus income for the employees and hence they are taxed as perquisites in the Income Tax. Whenever an employee exercises ESOP to convert them into shares, it is considered as an additional income and so it is taxed. Note here that the employee has not actually received any monetary compensation when he/she exercises ESOP. It has just been converted into shares that's all. The employee has to pay taxes on exercising the ESOPs plus capital gain taxes whenever they sell those shares at gains.

The taxability on exercising the ESOPs is the reason why many employees choose not to exercise them as it will increase their taxable income and they will have to pay taxes on it even if they have not actually received any monetary compensation. Many employees choose not to exercise their ESOPs until a window of the event arrives where they can sell them.

This is the major limitation why employees consider ESOP as just a piece of paper. But, the FM in the budget 2020-21 has announced that employees who have received ESOPs from eligible startups can defer their perquisite tax deduction up to 5 yearsor till they sell them or till they leave the organisation whichever is earlier.

Are ESOPs just a Piece of paper?

ESOPs if left unexercised, are just a piece of paper. Because it gives employees an option and it is not a compulsion to exercise ESOPs and buy shares. So it is totally is in the hands of the employee whether to exercise or not. In practice, normally every ESOP receiver would want to convert their ESOPs into shares but due to the limitation of taxation, it can lead to a change in the mind of the employee.

How ESOPs are converted into hard cash?

Well, the first option is that ESOPs can be exercised to convert them into stocks. Once they have been converted into stocks, the employee needs to sell the stock for them to able to convert the stock into real cash. Now, this is where many employees face difficulties. If a company is listed, it is well and good for the employee as they can sell the stocks freely in the market. But in the case of private companies or most of the startups, converting ESOPs into real cash is a headache.

As the startups are not listed, their shares can't be sold in the actual market. There needs to be a buyer of the stock for the employee to be able to sell it. Hence this is where the company's management steps in. There are 2 ways to convert such ESOPs. One is that the company buybacks the ESOPs from the employees, which Zerodha is doing currently. The company pays the value of the ESOPs to its employee at their most recent valuation. For example, if someone holds 20 ESOPs and if they are valued at ₹1000 each, the company pays the ESOP holder ₹20,000.

The second way to give ESOP holders an exit option is to sell their ESOPs to outside investors. In the case of startup companies, most of them are not profitable and are short of liquidity to successfully conduct the ESOP buyback. Thus, in such a case company raises funds from the investors, which in turn are used for buying back the ESOPs i.e. the company sells the employee's share to the investor in exchange for funds and gives the fund to the Employee. Hence a win-win-win for all. This is similar to what Cred did to their ESOP holders back in February. Alternatively, an employee can also exit the stock at the time of listing of the company.

What does an ESOP buyback convey?

A company that conducts ESOP buybacks is a company that sends a message that it cares for its employees. More than that, it shows the belief of the company's board in themselves. Whenever a company buybacks ESOPs, it means they gave ESOPs for free and are paying back to get back the free stuff. It means the company board believes in itself and thus wants to own as much stake as it can in the company. The employees too can earn real cash with such buybacks and as a result, employee retention has a positive impact on the same. In and all, it is a win-win for everybody.

So that is it for this week's FinMail. Keep learning and stay safe.


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