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Employee stock options today form an integral part of the compensation structure in small and large startups. As a rule of thumb, startups allocate between 5% — 10% shares to the ESOP pool, and it keeps on getting topped up in each funding round. On average, unicorn startups have between 4% — 7% of their total valuation locked in ESOP pools, allocated to employees over a period of time.
As a consequence of the spurt in startup valuations and a large number of IPOs in the last two years, a large number of ESOP holders have become millionaires in the past few years, and many more are in line. Recently, with the IPO of Freshworks, more than 500 employees who were offered ESOPs have turned crorepatis ($125,000). Freshworks founder Girish Mathrubootham said that more than 76% of employees have been issued ESOPs in Freshworks.
Unfortunately, two key issues have also emerged from the growing pool of ESOP holders.
· Lack of understanding about ESOP structure, when to exercise, tax implications on exercise, and several other factors
· Lack of funding available for ESOP holders to be able to exercise their ESOPs and participate in the growth of their companies. This is especially applicable to employees who are leaving a startup after having worked for a long number of years and need to exercise their options before leaving the organization.
As per our estimates, between 70% — 80% of vested ESOPs in unicorn and soonicorn companies go unexercised every year, leading to billions of dollars of lost value for startup employees. There are four primary reasons why startup employees are unable to exercise their ESOPs:
· Lack of faith and unwillingness to take a big risk with own capital
· High tax obligations that employees are in most cases even not aware of
· Lack of funding required to exercise the ESOPs
· Lack of understanding, delay in approvals, and transparent communication from their companies
We at Torre Capital have seen more than 2,000+ shareholders in the past 12 months who are paper rich and cash poor and have made several wrong decisions when it comes to their private shares ownership.
Hence, we created structured financing products that enable startup employees and other shareholders to gain access to necessary funding required to either exercise their options, pay tax obligations, or get liquidity by partially selling their shares.
This article is written to help startup employees to understand their ESOPs better, and also how they can secure the necessary capital for their needs.
Problem at hand
Employees in late-stage companies typically wait till IPO to exercise their options face exorbitantly high exercise costs as well as large tax bills. If you join a startup and receive ESOPs as part of the compensation plan, your first step should be to understand all the terms clearly, understand how exercise works, how much will you need to pay for exercising your ESOPs, how much tax do you have to pay on exercise and how does it change with company valuation, and what kind of returns you can expect in different exit scenarios. Understanding all these points in detail helps you evaluate your ESOP grant correctly and plan in a manner that you do not end up missing out on benefits at the end of your employment period. We have seen employees working for startups for 5–7 years, and then not be able to benefit from their hard work when they move to another employer.
There are a few key concerns to address:
When to exercise? Of your total ESOPs allocated, you are vested a certain percentage every year, likely between 20% — 25%. You have the option to exercise as soon as your shares vest, or you can wait as long as you are employed with the company to exercise your options. Most employees do not exercise their shares as they vest, and instead wait for confirmation of an exit event before they look at exercising their options. The problem with this approach is the increasing tax burden upon exercise keeps on increasing as you defer your exercise to a future date.
Tax obligation is calculated as a factor of the total notional profit (Current Fair Market Value of a startup — Exercise Price) and charged at your personal income tax rate. Look at the following hypothetical example to understand your tax obligations.
Total Options granted: $100,000
Per-share price of option grant: $1
Vesting period: 4 years, 25% per year
Employee tax bracket: 30%
At year 5, your shares are worth a cool $2 Mn, for which you have paid a total of $340,000 in exercise price + taxes.
However, let’s say you exercise everything on 31 Dec 2024 at a company share price of $20. Your tax obligation in that case would be $592,500 instead of $240,000. Your total cost of exercise increases to $6,92,500 instead of $340,000. This is 2X of what you would have paid if you exercised your options as they vest instead of waiting till Year 5. Not only that, but you will also need to have this amount of cash at hand, which is not always readily available. In case you leave a company at the end of 4–5 years, you also have the additional time limit of 60–90 days in which you need to exercise your ESOPs or they expire.
Should I exercise? Exercising the company’s stock options has the potential to significantly boost your earnings, however, you also run the danger of losing the money you put in. Should you even exercise the shares of your startup, or let it go? This depends on multiple factors:
· Your belief in the company’s growth story and its potential to return significant returns in the near future
· Your intent to stay with the company and for how long?
· Time to an exit event — is there a visible exit event on the horizon in the next 2–3 years?
· Company’s track record of ESOP buyback
· Your liquidity situation
At the end of the day, you should run multiple scenarios to understand what is your opportunity cost, and what potentially could be the positive outcome if things go well for your organization.
Through this article, we seek to help startup employees understand the benefits and pitfalls of ESOP programs and how to handle them correctly. We will also talk a little bit about structured liquidity solutions that Torre Capital can offer you and your organization to make exercising ESOPs a simpler, risk-free strategy.
Why are ESOPs 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, 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, you do not pay anything on Day 1. However, you need to understand that ESOPs are options that provide you an opportunity to buy your company shares at a fixed price at a point in time. As the company’s valuation grows, its share price increases, and you have an incentive to buy the shares of the company at historical prices. Important to note that ESOPs are not free, you do need to pay an exercise price and applicable taxes to get your shares. You can also opt to not exercise and let your options lapse; in which case you are not given shares of the company. 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.
What is ESOP vesting?
ESOPs are given to the employee as an incentive to perform well and stay with the company. Vesting enables the employee to exercise the portion of the shares that become eligible to be bought by the employee at the agreed exercise price. The length of time that an employee must wait to be able to exercise his ESOPs is called the vesting period. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. A common schedule is vesting over 4 years, with a 1-year cliff. Vesting cliff means the employee gets 0% vesting rights for the first year. 25% vesting rights at the end of the first year and so on. After the vesting cliff (generally 1 year) expires, ESOPs are eligible to be bought by the employee at the agreed-upon exercise price. The “vesting date” is the date on which an employee becomes eligible to exercise his right to purchase shares. The rights may vest fully or partially over the vesting period depending on the company policy.
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% at completion of the second year, and 50% on completion of the third year from the date of the grant. So, in this scenario, the vesting date for 200 options is 1 April 2018; for 300 options is 31 March 2020, and for the remaining 500 options is 31 March 2021.
Depending upon the company, the plan may specify the same or a different exercise price for each year. The exercise price, or the price at which an employee can purchase a share from the company, is usually set at beginning of employment and is significantly lower than the current market price of the shares.
The employee has no obligation to exercise the option and can let it lapse. If the current price of the shares is lower than the exercise price, the employee can choose to exercise the option or let it lapse. The employee is granted a certain amount of time to exercise his option, after which his vesting rights may lapse. Typically, you can hold on to your options indefinitely till you are inactive employment. If you leave the company, all unexercised shares expire at the end of 90 days or any other deadline specified by the company. 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. It is only when you wish to exercise during employment or exercise post-resignation that you need to worry about exercise and tax obligations.
Exercising options: why, how much, and when?
You pay to exercise options today so that you can participate in the future growth of the company by acquiring shares at historical valuations. You stand to benefit significantly if the company does well, however you can lose your entire investment if the company fails.
After an employee’s options are vested, he does need to exercise them immediately. The employee has a set amount of time in which he can exercise his options. From a financial and taxation standpoint, knowing when an employee should exercise his options is critical.
When the employee exercises the option, he must pay the agreed-upon price for the shares as per his ESOP agreement, 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 through buyback. Furthermore, because tax obligations keep on increasing as your company’s valuation increases, the later you exercise, the higher taxes you have to pay.
Surprisingly, taxes can make up to 50% — 80% of stock option exercise cost. Exercising options have two fees associated with them:
· The cost of obtaining vested shares (the strike price multiplied by the number of shares)
· The costs of the accompanying taxes. Taxes are frequently the determining factor in the cost of options. In some circumstances, there is no tax liability. Taxes, on the other hand, drive up exercise costs up to 6.6x the starting price for the average late-stage unicorn employee. This is because the difference between striking price and fair market value (also known as 409A valuation) is taxed, which can be significant for high-growth firms. We call this the surprise element since most people are unaware of their tax liability.
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).
The exercise of stock options becomes more expensive as a company grows. This is because the tax bill from exercising climbs in tandem with the company’s 409A valuation.
Case in point, Nykaa (Indian E-Commerce Platform) — As the valuation increases, so does the share price. Had an employee exercised the share price at an earlier date, the lesser his tax liability, and vice versa.
Your company exits — finally!
When a business goes for an IPO or a strategic sale, one of two things can happen:
· It is acquired, which means that another firm buys it. Microsoft purchased GitHub, Amazon purchased Twitch, and Facebook purchased WhatsApp. In case a company gets acquired, the acquiring entity can opt to continue with the ESOP program, or create a new program for existing employees of the acquiree company. The acquiring company can also opt to buy all ESOP shares and provide an exit to employees.
· 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. When an IPO happens, your shares convert to public shares and you can sell them through your broker whenever you desire. 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 greater than your exercise price. Unfortunately, the exit value is an unpredictable 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, your profitability will increase.
When should you sell the shares?
Selling an ESOP stock is equivalent to selling any other type of investment. When making a decision, you must consider the capital gains implications as well as the necessity for liquidity. The decision will also be influenced by the company’s long-term prospects.
It’s also possible that the ESOP shares you bought 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 might or might not be in very favorable circumstances. In this case, it would be prudent to wait until the shares are listed on a stock exchange or any other liquidation event.
Tax implications when exercising your options or at the time of exit
ESOPs are generally subjected to two levels of taxation. The employee’s option to exercise shares at the exercise price is the first stage. The eventual sale of shares is 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 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 the 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) are tax-free up to Rs 1,00,000, however, short-term capital gains are taxed at 15% as of FY 21–22.
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 then the amount in excess of Rs 100,000 shall be chargeable to tax at 10% without indexation (plus health 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 a 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 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 perquisites of the options, rather than the amount 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 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 ESOP Financing: How does it help startup employees exercise their ESOPs with a risk-free, non-recourse solution
Torre Capital is the world’s first commission-free tokenized shares platform that gives investors access to exclusive opportunities in pre-IPO companies. We also offer ESOP Funding solutions to startup employees. Exercise your startup stock options without paying out of pocket. You can earn up to 80% more due to potential tax savings at the time of exit. Exercising your stock options early can reduce your tax burden and also exercise price in certain cases.
Employees seeking ESOP funding can register on our platform to secure funding for their ESOP exercise obligations. The product has the following features as listed below:
· Get 100% of ESOP funding + tax obligations required to exercise your shares
· No personal guarantees, no credit checks
· 30%-70% of equity participation in profits in the case of early or late-stage growth startups
The advantages of our ESOP funding program are as follows:
· You continue to benefit if the value of your company stock rises.
· You take zero risk on personal capital when exercising your ESOPs
· Reduced tax obligations from exercising early than late
· Make room in your budget to invest in other opportunities
· Maintain the advantages of owning Qualified Small Business Stock
For example, if the loan is non-recourse, Torre Capital accepts the risk and the shareholder (employee) is 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 ESOP funding is useful in the first place.
It’s usually better to exercise 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 does it work?
Torre Capital delivers you the funds you need to exercise your stock options and pay your taxes. There are no recurring monthly interest payments, unlike a traditional loan.
You wait for your company to have a liquidation event. If your firm has a successful exit (such as an IPO), you repay the money you borrowed plus any fees. The employee gets nothing if your company has an exit lower than the exercise price or shuts down completely. Your other personal assets are never at risk because it is a non-recourse finance.
This is how it all works:
· Submit your financing request in minutes to find out how much you qualify for.
· Once your ESOP funding request is approved, you sign an Option Funding Agreement (OFA) with the investors. The Options Funding agreement covers key elements of the funding solution including profit share in future cash flows, exercise events, exit events, etc.
· You exercise your ESOPs and provide proof to Torre Capital.
· Sit back and watch your shares grow in value
· As and when your company goes for a liquidity event (IPO or company sale), you liquidate your shares and pay the principal along with a certain percentage of upside (ranging between 30% to 70%, depending upon the stage of the growth startup) back to your investors.
· On the flip side, we bear all risks related to performance issues with the investee company, delays in IPO/other liquidation events, or closure/bankruptcy scenarios.
· We do not conduct credit checks, and our funding has no effect on your credit score.
How does the funding work in different scenarios?
As described earlier, our non-recourse ESOP funding does not put your assets at risk, and the investors bear all of the adverse risk. These are the different exit scenarios
Case 1: The company exits successfully at a multiple of option funding agreement exercise price
The investor participates in the success of your startup. The more effective the exit, the better for everyone. In the end, the amount you get is determined by your equity participation percentage. For example, if you have $100,000 worth of ESOPs on the date of funding, the equity participation with the investors is 50%, and the ultimate exit price is 3X of exercise price. Post exit, the investor receives ($ 300,000 — $ 100,000 principal and $ 200,000 in 50% profit share), and the employee receives $ 200,000 in profits. The amount you owe to the investor will be determined by your equity value at the exit event and the profit participation.
Case 2: The company exits but at a lower price than the initial options funding agreement exercise price.
Torre Capital investors will receive all cash flows till the time their principal is paid back, and bear the loss if entire principal is not returned. Carrying forward the previous example of $100,000 worth of ESOPs. Suppose, the exit value of the ESOP shares position is $90,000. The entire $ 90,000 will go to investors who take a loss of $ 10,000 on their initial investment, and the employee takes no loss whatsoever.
Case 3: The company doesn’t exit at all and shuts down.
In case of a total loss, Torre Capital investors bear the risk. Our ESOP funding arrangements provide value to both employees as well as investors to make sure both parties have an equitable share in future growth of promising companies.
The same cases have been presented in the table provided below:
We at Torre Capital are on a mission to assist start-up employees and shareholders to understand, maximize, and unlock their stock’s value. Torre Capital offers 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 before departure without selling your stock. Reach out to us at [email protected] if you wish to know more about Pre-IPO investing or other related services.
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This article has been co-authored by Sargam Palod and Sayan Mitra, who is in the Research and Insights team of Torre Capital.