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How ESOPs make millionaires

ESOPs as a component of one’s salary can suddenly turn her/him into a millionaire if the valuation of the company goes up

Imagine a sudden windfall that allows you to repay your home loan at one swoop, fulfil that long-cherished dream of vacationing in an exotic foreign locale in the lap of luxury or own a premium car without having to worry about saving for your future.

Well, more than 100 current and former employees of Indian ecommerce giant Flipkart, soon to be acquired by its much larger international counterpart Walmart seeking to make solid inroads into the lucrative Indian market, are set to see such dreams come true with a cool million dollars landing in their bank accounts. This is result of S500 million earmarked for liquidating employee stocks as part of the entire deal through a process called employee stock option plan (ESOP).

Cut to the point now: What is this magic genie called ESOP that can turn you into a dollar millionaire overnight?

Here you go…

How does an ESOP work?

Under ESOP employees are offered a certain number of shares of the company they work for at discounted prices within a certain period of time. They remain in the ESOP trust fund till they become exercisable. An employee can then exercise those even if he has quit the company or has been sacked or has retired.

Confused? We elaborate further.

An ESOP basically offers an option to an employee to purchase company shares after a stipulated period of time at a predetermined price which is known as the strike price. The strike price could either be equal to the prevailing market prices or less than that. The time over which employees have to wait to purchase the shares, known as exercising the option, is the vesting period.

So, say, you were given 100 ESOPs while joining at a discount price of Rs.80 from the prevailing market price of Rs.100 and while exercising the option after a certain period of time if the share price shoots up to Rs.120, you simply pocket a neat Rs.400 (difference between buying price of Rs.800 and selling price of Rs.1200). But one does have to pay capital gains taxes on them.

However, if the share value comes down you have the option to not buy the shares.

While in some cases employees can claim only a certain percentage of shares, in others they can claim the entire amount at one go. In case of Flipkart, for example, the current employees have been allowed to vest up to 50 percent of their stock options now. Next year they would be allowed to vest up to 25 percent, and the rest the year after.

ESOPs form a component of one’s salary and one either has the option to take it or opt for cash.

Goals of ESOPs

ESOPs are primarily aimed at compensating and retaining employees and at drawing new ones. They also help align the interests of a company’s employees with that of its owners. This is because such plans induce productivity in employees who can benefit from a share price appreciation only if the company’s performance improves. Hence, those in higher echelons, having greater control over performance, are offered more number of options.

ESOPs are also used by cash-strapped companies to hire talent they otherwise can’t afford in senior levels.

How often does it churn out millionaires?

ESOPs have enabled many in innovative, unlisted companies in the Silicon Valley to make a killing. In India, with the startup culture picking up pace, stories of employees laughing their way to the banks on account of such employee stock options are becoming common too: besides Flipkart’s employees, a few from online wallet Paytm have been able to strike gold too thanks to ESOP earlier this year (around 25 employees of the private company became dollar millionaires after they were allowed to sell their Employee Stock Options).

However, this is not always the case. During the dotcom burst that left many stocks devalued beyond measure, employees couldn’t cash in on ESOPs. In short, it is a high-risk gamble.