How Risky Are ESOP Shares Of An Unlisted Company & How To Redeem Them?

Imagine you’ve been offered your dream job at an Indian startup, and the company is asking if you would be willing to take an Employee Stock Option Plan (ESOP) for a slightly less salary. Most startups are now offering ESOP as a bonus to lure top talent. Even the employees happily accept it as they become part owners of the company and believe they’re contributing to their own growth journey.

Some employees even ask for ESOP in exchange for a reduced salary if not provided during the hiring process. But, taking an ESOP and earning a return from your stock holding is not all roses. You should be willing to take a bumpy stock market ride before accepting ESOP. You should consider various factors to determine if your stock investments in an unlisted company would be worth the risk. Therefore, you should take time and gauge the risks and benefits of the ESOP.

An ESOP is a method in which an unlisted or listed company offers a certain amount of shares at a value lower than the company's fair market value (FMV). It is given as an option to buy a certain amount of equities after completing a specific period. 
 
Allotment

When an employee signs the joining contract with an ESOP benefit, they will not receive the share or shares immediately; instead, they will be transferred to the employee's name in the accounting books after a certain period called the vesting period. The employee will also receive the ownership documents for the share allotment. "An employee must complete a certain period of service in the company before ESOPs are offered. Also, immediate liquidity is a concern," said Lovaii Navlakhi, CEO of International Money Matters, an investment advisory firm.

After the vesting period, the employee can exercise the ESOP option and buy shares agreed upon in the initial contract. "When you exercise the option, which means you have agreed to buy, the difference between the fair market value (on exercise date) and the exercise price allotted to you will be taxed as perquisite. Your employer deducts TDS (tax deducted at source) on this perquisite and will be shown in Form 16," Lovaii added.

Exit Options

After every two to three years or during funding raising, companies usually provide employees with the stock buyback option. The company offers to repurchase the shares from the employee either to increase the share of the promoters or to sell them to venture capitalists and other investors at a higher price to generate working capital. The amount the employee receives from the share sale is at a fair market value or higher when sold to outside investors. 
 
What Happens When You Exit The Company?

The employee has no option to sell the stock if the company is unlisted other than to wait for a buyback offer from the firm, a funding round, or an initial public offering (IPO).

If your shares are vested with the company, and you haven't exercised your right to purchase the shares, you will leave behind the vested shares. But suppose you've exercised your right to buy the shares, and you have ownership of the shares. In such a case, if the company goes public, it will mention the shareholders in the red herring of the IPO filed at the Securities and Exchange Commission of India (Sebi) and receive the shares in their Demat account.

Many companies require you to sell your exercised shares back to the company within 30 to 90 days after leaving the company.

Unlike promoters’ equity, shares provided under ESOP do not have a one-year lock-in period, and the employee can sell them after the IPO. Revenue generated through the sale of ESOP is counted as income and taxed per your income slab.

Risks Involved

When an employee receives shares of an unlisted company, he gets the ownership of shares in that particular firm, as the business is not listed on any exchange. However, the employee may face risk if the company doesn’t come up with a buyback offer or cannot raise money through funding rounds where institutional and private investors buy a company or employee shares. In this case, the ESOP shares cannot generate any return for the employee until the company goes for a public listing.

So, the employees should research the company’s buyback track record during the vesting period and whether the company will raise capital through a funding round.

If you leave a company, you won’t be able to participate in the buyback offers and sell your shares during a funding round. However, you’ll still have the ownership, but you can only sell them after the company gets listed on any stock exchange. Otherwise, you won’t be able to sell the shares. You can apply for a buyback offer when you leave a company if the firm doesn’t already provide it.

“The risk of holding single company ESOPs in a portfolio is the same as holding a single stock. Hence, the allocation should not exceed 10-15% on the overall portfolio to avoid concentration risk,” added Lovaii.