Hi Rodinhooders,
This is a practical post a bit different from the philosophical ones, perhaps because we are at the ground floor (one of Alok’s previous posts)! Let me introduce myself. I am the founder of Value Edge, a 2 year old start up that does business analytics outsourcing for global bio-pharma companies. We have been reasonably successful, are self funded and profitable. We have got great talent on board and I want to develop an ESOP plan that is “best in class” and genuinely creates wealth.
It would be good to learn from others who have gone this way. My few questions are:
(1) if we do an ESOP then what are the tax implications for the company and for employees? If employees now have to pay a tax on something which may later be worth toliet paper then it becomes less attractive to them and they be not exercise their option.
(2) Also how does one decide what is the offer price? It may be par for now but it should keep increasing
(3) What are some of the do’s and don’ts. For example, I have been advised to have an ESOP trust that administers the ESOP.
Thanks a lot in advance. If anyone wants to connect directly with me please send me a mail at rohit.anand@valuedgeindia.com. All advice will be greatfully appreciated.
Rohit Anand
Alok Rodinhood Kejriwal
Rohit, my CFO Satish should answer this quite easily. Have sent him a mail.
satish v iyer
Hi Rohit,
Happy to answer your query.
Before answering your query i will write below some basics Terms in the ESOP scheme of things.You may be aware of the same. I am explaining the same as these terms may be referred in my answer to your query.
GRANT:- when you issue a letter to the employee that he got 300 ( example amount) number of ESOP over a period of 3 years. ( Period is at discretion of management and as aged in the ESOP plan)
VESTING:- When the above grants get eligible to be owned by the employee. 300 shares can VEST over a period of 3 years from the GRANT date, so at end of every 1 year 100 shares can VEST (vested shares).
EXERCISE of Grant:- When an employee agrees to exercise his option to BUY the Vested shares.
In the example employee can EXERCISE the 100 shares every year by paying for the same OR he can have the option not to exercise the shares but just let the shares VEST and get accumulated for himto be exercised at later stage.
To ANSWER your QUESTION (1)
If the employee chooses to exercise the 100 shares at end of every year then the company has to deduct TDS from his salary for the Perquisite Value of shares exercised.
The company has no TAX implication but it has liability to deduct tax from the employee salary.
If PVT LTD company is giving shares at Rs 10 (face value) to employee then the TDS will be difference between the Value of 100 exercised shares as per valuation report given by CATEGORY 1 MERCHANT BANKER , take at Rs 500 per share. Then perquisite Value will be Rs 50000 (Rs 500 X 100 SHARES) LESS 1000 (Rs 10 x 100 shares) = Rs 49000. Rs 49000 will be considered as perquisite ( notional) salary in hands of employee. So tax for employee will be Rs 49000 x 30% tax bracket.
Cost for PVT company will the cost of getting CATEGORY 1 MERCHANT BANKER report which may vary from Rs 50000 to Rs 150000 per year. For LISTED company value is as per closing price at BSE.
AS YOU say employee may not exercise every year. Then he has to exercise when he resigns as compulsion OR
If employee continues to work he may not VEST till occurrence of event like IPO or liquidation event a MERGER or ACQUISITION. During the event the employee will have to exercise before acquisition.
Example if the employee has 100 shares vested and not exercised and he has to do so when the event happens:- TDS has to be deducted as explained earlier by me. AND the period of exercise and the acquisition will be within 1 YEAR and EMPLOYEE has to PAY SHORT TERM CAPITAL GAIN TAX (30%) instead of LONG TERM CAPITAL GAIN TAX (20%) if he had exercised every year. THIS difference TAX 10% may be HIGH depending on VALUATION of company shares.
To ANSWER your QUESTION (2)
The OFFER PRICE to employee is at DISCRETION of BOARD/MANAGEMENT. Giving at PAR, FACE VALUE will make it attractive to employee as for PVT companies and START UPS the realization of value doesn’t happen until occurrence of event. Keeping at PAR will be good practice for rewarding.
To ANSWER your QUESTION (3)
DO’s – Give ESOP to deserving employees| Its also necessary to make the employee understand the importance of ESOP , how they benefit in future|
CREATING TRUST:- It wont be advisable to create such for a small company keeping in mind of additional administrative costs, compliance for TRUST etc.. In case of big companies, listed with many employees being given grants TRUST can be formed.
Hope I have been able to answer your queries. Happy to answer further queries.
regards
Satish V Iyer
Rohit Anand
Hi Satish,
Many many thanks for your reply. Its been like daylight for a zombie searching in the dark (despite paying a modest law firm). Thanks for your offer – round 2 is perhaps even more challenging like a typical c2w game:
(1) Lets take a situation with some numbers. Suppose there is an employee who gets 2,000 options. He has to pay par of Rs. 10 – so he pays Rs. 20,000 to the company. But the employee’s 2,000 options are actually worth 20 lacs – so he has a profit of some 19 lacs and pays 30% tax TDS or about 5.7 lacs. The 5.7 lacs “pains” the employee and the company. He cannot liquidate these shares in the open market as its a private unlisted company. As management, I understand where the employee is coming from. How do we resolve this?
(2) Related to the above, if the employee makes a profit of Rs. 19 lacs then doesn’t the company make a “loss” of Rs. 19 lacs because its given something worth Rs. 20 lacs just for Rs. 20,000. This “loss” – shouldn’t it be a tax credit to the company? If so, cannot the company take the “tax credit” from the loss and “pay” the tax amount so that both company and employee are neutral?
(3) Now take the case of “buyback”. “Buyback” could make it attractive so that employees who have shares and leave, can sell their shares back to the company. For this reason, perhaps a trust can become attractive as it maintains an arms length from the company. Do you agree? Also if we do a buyback we would like to offer employees who excercised their option and also buy the shares at par. This means employees don’t have any cash outflow from their side. Your thoughts?
(4) Now imagine some years have gone and an investor has come in. There is already a value per share. How can we offer employees ESOP at par when an investor has paid several times that value?
Hope round 2 is not confounding – we just set off to do something simple but found ourselves entangled and more entangled…especially since we also wanted to give ALL employees ESOP (howsoever small). Many,many thanks once again, Rohit