This is the third post in the series, you can read the earlier post here –

What is ESOP (Employee Stock Ownership) ? – https://financegrail.com/what-is-esop-employee-stock-ownership/

ESOPs – Grant, Vesting, Exercise, Cliff ?? – https://financegrail.com/esops—grant-vesting-exercise-cliff/

Now, Exercise of the ESOP is very interesting topic and there are two things which you should know (As always, it will be simple and straight forward with no Jargons etc!

1. ESOP Policy – When the ESOPs are offered to you, it is very important to understand that by when you can exercise the ESOPs after vesting. There can be two far end i.e.

i) Vested ESOP should be exercise as soon as it is vested or it will lapse in next 30 days

ii) Vested ESOP can be exercised anytime by the employees whenever they want, even after they have left the company.

Most of the companies are in-between of these two ends. Earlier the standard was the employee can exercise the vested ESOP till his last day of the employment. Now, to make the ESOP policy more attractive and to be more employee friendly, companies are allowing the employees to exercise the ESOPs within 5 years from the last day of the employment.

Reason why this is important because when you exercise the ESOP, you have to pay cash in two ways-

a) Employee needs to pay the exercise price of the ESOP i.e. the amount employee needs to pay to the company to get the shares registered in his/her name. Generally, that is small amount but in companies which are mature this amount can be material.

b) Tax to be paid by the employees on the date of exercise of the shares, even if employee does not sell those shares, which takes us to point 2.

2. Tax on exercise of shares – This has been the sore point for employees who had to exercise the shares before they had an opportunity to sell the shares because when you exercise the shares, you need pay tax on the extra value you received in the form of the shares i.e. Fair market value of the shares – (less) Exercise price of the shares.

To put things in perspective, lets say you exercised the ESOP for Rs 10 per share and on the date of exercise the Fair market value was Rs 200 per share, So you will have to pay tax on Rs 190 i.e. 200 -10.

It is painful because at the date of exercise you do not get any cash but you have pay tax to the government.

Now, that does not mean that you will not have to pay tax when the shares are actually sold. In the above example, lets assume you sold the share for Rs 500, so on the time for sale you will have to pay tax on the gain of Rs 300 i.e. 500 – 200.

In summary, if the ESOP policy of the company allows you to exercise the shares even after employment then you can choose to exercise when you have ability to sell the share, that means you will get sale price from the buyer and with that cash you can pay exercise price to company and tax to the government.

But, if your company ESOP policy does not allow you to exercise after employment, then you will be pay exercise price to company and tax to the government on the shares for which you may or may not get any buyer in the future.

Now, that you know that how the taxation works on the ESOP, lets also look at the exit options of the ESOPs which you may be holding, refer – https://financegrail.com/sale-options-for-esops-cash-and-wealth/