As the clock ticks on your ESOPs, the decision of whether to exercise or hold on to them can feel like a high-stakes game. But if you play your cards right, chances are, you will be setting yourself up for financial success.

While the process itself is relatively straightforward – you are paying your company to buy shares at a predetermined price – there are a few things to consider to avoid a barrage of implications later.

The first step is to figure out WHEN you can exercise your ESOPs

There are two key things to understand here: first, the time it takes before you can exercise your ESOPs. This is determined by the vesting period, which, typically, happens over a period of four years.

The second is the exercise period or the time during which you can choose to buy the shares at the predefined price. This is when you can actually buy the stock at a fixed price.

In an ideal scenario, the vesting period will be quite low while the exercise period is as long as possible. You can get early access to the shares at a predetermined exercise price. Then, you can wait for the company to grow before you sell the shares.

In a perfect world, the value of your options could double or triple, or provide a multifold return!

Can you imagine being an early employee at Facebook or Apple? There are so many stories all over the world of employees who have made killings from their ESOPs. You can as well!

In reality, however, things are not always as rosy.

The second step is to see WHO you can sell to

One disadvantage with ESOPs is that they are illiquid in nature.

There are two main scenarios that can happen. You remain invested until the company goes to IPO and gets listed on the stock exchange. Or, the company buys back shares from its employees periodically.

The second scenario is far more likely, for obvious reasons.

For starters, it takes a while before a startup goes the IPO way. There are several rounds of private investment that take place before that. Also, there are many companies that never apply for an IPO.

ESOP buybacks have become quite popular over the past couple of years. In 2022 alone, Indian employees made $196.5 Mn through buyback programmes, according to an Inc42 report. Razorpay bought back shares worth $75 million from its employees, while Ninjacart and Pine Labs spent about $13 million each on their buyback plans!

ESOP buybacks have a two-fold benefit. Firstly, of course, the employees get an exit and make a profit. Apart from that, the company, too, gets the chance to increase its own holding.

It’s a win-win situation.

The third step involves figuring out HOW MUCH tax you have to pay

Financial assets in India are all subject to capital gains tax. This applies to ESOPs as well. Depending on how much profit you make from the sale of the investment, you may have to pay capital gains tax.

However, when it comes to ESOPs, there is one more complication. You also have to pay tax when you exercise the option, i.e., you buy the shares.

Perquisite refers to the difference between the current fair market value (FMV) and the exercise price. This means if you buy the shares at the predetermined exercise price of ₹1,000 and the current fair market value of the shares is ₹1,200, the difference is the perquisite. You’ll have to pay a tax on ₹200. For each share!

But don’t fret.

Based on the amendments introduced in the 2020 Budget, you can actually defer the payment of this perquisite tax for five years or till you sell the ESOP or leave the job, if your company is registered as a startup with the Department for Promotion of Industry and Internal Trade (DPIIT), whichever is earlier.

This taxation method (perquisite plus capital gains) that ESOPs are subject to can be an issue, especially if you compare them to normal equity shares.

There are inherent advantages to an ESOP though. Primarily, the discounted buying price!

Should you exercise your ESOPs?

Only you can answer this question.

If your startup succeeds, you will end up with a winning hand. If your startup does not succeed, you will end up with nothing, in addition to having already paid the exercise cost and associated taxes. There isn’t really a thumb rule that you can apply here, it all depends on your conviction and belief in the growth prospects of the company.