ESOPs for Startups: How to Create Wealth with Employee Stock Options

Cash is scarce. Talent is expensive. That's why startups use Employee Stock Option Plans (ESOPs). They offer employees a slice of the company's future success in exchange for hard work today.

From Flipkart to Swiggy, ESOPs have created thousands of "crorepati" employees in India. But how exactly do they work?

1. Key Terms You Must Know

• Grant Date: The day options are offered to you.
• Vesting Period: The waiting period before you earn the right to the shares. Typical structure: 4 years with a 1-year cliff.
• Cliff Period: A minimum period (usually 1 year) where 0% vests. If you leave before 1 year, you get nothing.
• Exercise Price (Strike Price): The price you pay to convert options into shares. Usually lower than market value.
• Exercise Period: The time window you have to buy the shares after vesting (or after leaving the company).

2. How Vesting Works (Example)

Imagine you get 1,000 options with a 4-year vesting schedule and 1-year cliff (25% per year).

• Year 1: Cliff ends. You unlock 250 options (25%).
• Year 2: You unlock another 250 options (50% total).
• Year 3: You unlock another 250 options (75% total).
• Year 4: You unlock the final 250 options (100% total).

3. Taxation of ESOPs in India

ESOPs are taxed twice:

1. At Exercise (Perquisite Tax): When you buy the shares. Taxed as salary income.
   (Fair Market Value - Exercise Price) is added to your income.
2. At Sale (Capital Gains Tax): When you sell the shares.
   (Sale Price - Fair Market Value) is taxed as Capital Gains (LTCG/STCG).

4. Startups vs Listed Companies

For eligible startups (DPIIT recognized), the government allows deferring the Perquisite Tax payment by 5 years or until the employee leaves/sells shares, easing the cash flow burden.

Frequently Asked Questions (FAQ)