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Home > Business > Special


ESOPs and how best to invest them

Dhvani Desai, Outlook Money | February 07, 2007

In Bangalore, they say, each perfectly fluffed cushion in every plush apartment has an ESOP story to tell. If you have been wondering how your techie friends manage to upgrade their cars and houses even before you have finished writing down the numbers, the answer usually would be employee stock option plans, or ESOPs, as they are called.

What are ESOPs? ESOPs are stocks of a company offered to an employee either at the time of joining, or when such a plan is introduced. The offer, or option to buy, is usually valid for a fixed period, known as the vesting period, and can either be exercised in phases during the period, or at the end of it. The price the employee has to pay is usually less than the market price. That is what makes an ESOP attractive.

Why ESOPs? The scorching progress of the stockmarkets in the last couple of years has thrown up several stories of regular blokes becoming millionaires overnight through ESOPs, but one needs to be cautious while treading that path to wealth. While tech companies were the early starters of ESOPs, now several industries have embraced this practice. But should you always go for them? The answer is, no. We seek to hold your hand as you walk down the ESOP and vesting lanes.

What to do? ESOPs are usually used to control attrition. At the time the offer is made, you only have to agree to the schedule and the price and usually don't have to buy anything. Depending on the schedule, a part of your stock option actually becomes yours�whether it is every year or once in a couple of years.

On the date when the vesting period for your stock options expires, you can decide whether you want to buy it or not. If the stockmarkets are on an upswing and the prospects of your are good, its share price would be higher than the price at which your options were offered. So, if things are looking up, you can take the benefit and purchase the shares after the vesting period is over. And if the market goes down, you can simply refuse to purchase them.

After vesting, what? What should you do with your options once they have vested? You have a few options.

First, you could pay cash to your employer and buy the shares. Second, you could raise a loan and buy your options. Third, you could buy them and sell them immediately. Fourth, you could choose not to exercise any of these options at all. Your choice should be made after considering a variety of factors, say financial planners.

Ask yourself - what is your cash requirement at this point in time. Mumbai-based certified financial planner Gaurav Mashruwala insists that the fundamental factor that should influence your decision is your need at that particular time and your future goals. If you need cash urgently, then the best thing to do is sell the shares immediately after purchasing. And treat this as a bonus.

Analyse your company and the industry objectively. How much potential does the business hold? What are the prospects of the industry? "If your company is doing well then it would be quite foolish to sell the shares. There is more sense in holding the shares," says Mumbai-based CFP Kartik Jhaveri.

"I have gained immensely out of this option. And, at least for us, there is nothing to lose since the ESOPs were offered to us at face value," says Shailendra Masaldan, general manager, Wipro BPO, who was offered shares in his company at its face value of Rs 2 in 2004. "Whether the market goes up or down, we will stand to gain. I certainly plan to hold on to the shares for some more time."

Do you hold equity in any other company? Jayant Pai, vice president, Parag Parikh Financial Advisory Services, says it's not safe to put all your eggs in the same basket. If any employee is investing in his company he should have investments in other companies and instruments as well. "If your company fails, then your job is at stake and so is your investment."

However, T J Mohan, finance manager, Air Deccan, who has been offered ESOPs, says that he has no interest in investing in any other company, but would most willingly exercise his stock options. "I have full faith in my company and will be responsible for its growth," he explains.

When markets fall. What to do with ESOPs is a no-brainer when markets are rising. But the difficult decision is whether to buy your options or not in a falling market. Sometimes companies revalue the price at which options can be exercised. If the new offer makes the deal attractive, you could choose to buy. If not, evaluate the potential of the company and its valuations in the stockmarket for a specific period of time and make your decision.

Says Jhaveri: "The best person to judge is yourself. If you think your company is functioning well and has immense opportunity to grow, then your company will do well and its market price is bound to increase."

Element of taxation. "In case you are planning to encash your options, then waiting for a year from the date of allotment of your shares can exempt you from paying any tax," says Ameet Patel, chartered accountant, Kanu Doshi and Associates.

What to do with the cash? Once you cash in on your ESOP, the next step is to invest and spend it prudently. Most financial planners ask one simple question - what is your need? Do you need to fund your new business in the next three years, or fulfill your child's higher education dream? Well, then think short term. Else you can invest in long-term instruments or assets.

Reinvest. While there are various asset options you can pick for your new funds, paying off debts should be your first goal. Try and retire as much of your liabilities as you can, including home loans and credit card dues.

The rest of the money can go to one of the many investment avenues. Equity holding in other companies is one of the avenues. According to Pai, if you are in your early 30s, it would make sense to invest in equity. "If the industry that you are working in is doing well, then you may invest in another company of a similar caliber," says Pai.

"If that is not the case, then an entirely new sector is also a good idea." Diversified mutual funds and real estate are relatively higher-risk but higher-return products. If you want a safer option, look at PPF or National Savings Certificates.

Stock options for employees

Different companies have different reasons for offering ESOPs, says Tarun Gulati, vice-president of consultancy ESOP Direct. The number of, or discount on shares may be bigger for those who are more valuable. If the company wants to reward employees for achievements, the vesting period could be short. The following are some of the common ways in which listed companies reward their employees with stock.

If you are being offered ESOPs by an unlisted company, it could be a risk. So be sure to get an exact stock valuation first.

Graded vesting: This is annual vesting over a period and is the most common way of giving ESOPs. For instance, Air Deccan has offered ESOPs with vestments of 15 per cent, 15 per cent, 30 per cent and 40 per cent over four years. "Even if someone leaves before the end of the vesting period, he can still exercise part of the option," says Mohan Kumar, director (finance), Air Deccan. This is usually done to retain employees.

Performance-linked graded vesting: This is the route taken by companies that not only want employees to stay, but to work better. Here, the percentage of shares allotted depends on the performance of the employee.

Bullet vesting: In this case, the entire allotment is made at the end of the vesting period.

Employee stock purchase schemes: Employees are offered their company's stock, usually at market price, by paying for it out of his salary over a three- to 27-month 'offering period'. This could be risky if the stock price tanks.

Taxation of ESOPs

Stock options can be taxed in two stages

Pre-sales

 

Not applicable to listed companies selling shares according to Sebi guidelines. Stock options are taxed in unlisted companies. It applies from the date the company allots shares to its employees.

Pre-sale tax

Prevailing share price:

Rs 2,000

Exercise share price:

Rs 1,800

Perquisite:

Rs 200

Perquisites added to income, tax deducted at source

This is when an employee sells the stocks bought through an ESOP. The date of allotment of shares, after the employee buys it, is important. If a company goes for a public offer after an ESOP, for taxation, the status at the time of sale of ESOPs will be taken.

Post-sales
Post-sale tax

This is when an employee sells the stocks bought through an ESOP. The date of allotment of shares, after the employee buys it, is important. If a company goes for a public offer after an ESOP, for taxation, the status at the time of sale of ESOPs will be taken.

 

Shares sold on
 recognised|
 
stock exchanges

Other shares (private limited /unlisted firms;off-market deals)

Holding period

 

More than 12 months

LTCG tax=0

20%

12 months or less

10% STCG tax+

Normal rate

 

sur.1 + EC

LTCG: Long-term capital gains; STCG: Short-term capital gains; EC: Education cess; 1sur.: Surcharge; applicable if total income is more than Rs 10 lakh;  Normal Rate: Profit from sale added to total income and taxed as per slab


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