May We Help You? - All about ESOPs

Ever got a letter from your company saying that you're eligible for ESOPs? Wondering what to make of it? Here's giving you an idea.

What, When, How?

ESOPs expand into Employee Stock Option Plans. They grant employees the right, but not obligation to buy a specific number of shares of the company, at a pre-determined rate (the exercise price) after a specific time period (vesting period).

Say for instance, you company offers you the option to buy its shares one year from now at a price of Rs 100. Here, the vesting period would be one year and the exercise price would be Rs 100. The exercise price may or may not be at a discount to market price.

The option to buy the shares is may be staggered over a time-period, known as ‘vesting percentage'. ESOPs are a tool for long-term retention strategy and vest from periods ranging from 1-9 years for employees staying on with companies. Once you resign, you would lose the entitlement to the ESOPs becoming due in the years after your resignation date.

You need to exercise your choice to buy within a certain specified period (the exercise period), failing which the option lapses. But an ESOP is not an obligation to buy. If, at the end of the vesting period and before the end of the exercise period, the market value of the share is lower than the exercise price, it hardly makes sense to exercise the option. Sometimes, there is also a lock-in period, post exercise of the option, in which case, you are required to hold the shares for a specified period after exercise.

The tax angle

Taxation happens in two stages - at the time of exercise of the option and when the shares are sold. Exercise of options is considered as a perquisite for employees in the first stage. You are liable to pay perquisite tax on the difference between the fair market value on the date of exercise and the exercise price.

Capital gains tax applies in the second stage, with the excess of sale price over the fair market value on the date of ESOP exercise being considered as gain. But don't sigh in annoyance just yet. If you hold the ESOP for more than one year after allotment, gains would be long-term in nature, and exempt from tax.

Desirable or not?

When the going is good and markets are on a roll, ESOPs can be highly rewarding and generate a lot of wealth for employees across the hierarchy ladder. However, a January 2011 analysis by Business Line shows that it is the method of determining exercise price that makes or breaks returns.

Companies such as IDFC, ACC and HDFC Bank, which have been running ESOP programmes for several years, have kept the exercise price constant across multiple years, even as the market prices zoomed, allowing triple-digit returns. Truly exponential returns come from those ESOPs that have been offered at par value.

However, caution needs to be exercised before exercising options. ESOPs may increase concentration risk you bear, since both your regular income (salary) and investment income would hinge on the fortunes of the company you work in. Make ESOPs just a part of your portfolio, and, like any other investment, go for it only after you study and are confident about your company's prospects.

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