What is Exercise Price in ESOPs and How is it Calculated

It’s raining ESOPs in the Indian economy recently, thanks to the Zomato IPO clearing the path for other Indian firms to explore listing. Ten firms, including Paytm, Oyo, Zomato, Nykaa, and Pharmeasy, have raised over $5.2 billion for their employees through ESOPs this year or are planning to do so.

Flipkart, a Walmart-owned ecommerce website, has created an INR 17,000 crore ESOP pool, propelling it to the top of the list of Indian technology companies that have granted stock options to employees. In the run-up to its IPO, Ola, the ride-hailing company, announced an increase in its ESOP pool to $30 billion in August 2021.

Employee stock option plans (ESOPs) allow employees to purchase shares of their company at a predetermined price at a later date. ESOPs are given to employees as part of their remuneration package.

ESOPs come with an exercise price as well as an exercise and vesting period. The exercise price in ESOP is the price at which a stock option holder has the right, but not the responsibility, to buy vested options during the term period.

What is an Exercise Price in ESOP?

The exercise price in ESOP is when stock option holders have the right but not the obligation to purchase vested options during the term period. Under ESOP, the company is free to set the exercise price as long as it follows accounting policies and regulations.

On the grant date, an employer and employee agree on ESOP terms. ESOPs are vested whenever the employee has met the requirements or the applicable time period. Now the employee has the choice to exercise or purchase these options. The employee is granted a certain amount of time to exercise his or her options within that time frame.

Stock options are frequently issued at an exercise price that is lower than the stock’s Fair Market Value. The difference between the fixed exercise price and the FMV of the underlying securities gives an equity option its value.

If the stock price rises, the employee will profit by exercising the option at the strike price, which is lower than the current stock price. However, if the stock falls in value, the option will be worthless, and the employee will not suffer a notional loss as with typical stock ownership.

In other words, if the stock price increases, the employee profits, but if the company fails, the employee loses nothing.

How is Exercise Price in ESOP Calculated?

ESOPs come with an exercise price and an exercise and vesting period. Assume the company offers ESOPs or the option to purchase its shares for INR 500 per share, starting a year from now and lasting 2 years.

The vesting period is the one-year interval between when an employee gains the right to buy shares and when the employee gets it. The exercise term is a two-year period during which employees can buy them at any moment. However, employees lose the right to buy the shares after the exercise time expires.

Some companies may provide ESOPs with a staggered vesting time. An ESOP can be phased over three years. From the date of issuance, the employee can exercise 20, 35, or 45 percent of the ESOPs at the end of each year.

The employee can choose not to buy the shares because ESOPs allow the employee to do so. If the option’s exercise price is higher than the current market price of the shares at the time of exercise, it may make sense to do so. After the employee has exercised the option, he or she can sell his or her shares at any time or after the company’s stipulated lock-in period expires.

Because ESOPs are considered part of an employee’s pay, they are taxed when the employee exercises the option to buy and when the employee sells it for a profit.

1. Taxes and Exercise

To begin with, the exercise price in ESOP is used to determine the amount required to exercise the options and the tax ramifications of doing so. In return for the shares, the employee must pay the strike price multiplied by the number of vested options the employee desires to exercise.

The difference between the stock’s current Fair Market Value (FMV) and the strike price is used to compute taxes. Taxes are calculated depending on the type of ESOPs given to the employee.

2. The Value of Options

The next step is determining the exercise price, which determines where the employee is in the money. The options have positive value if the current stock price is higher than the exercise price.

The options are under-water if the current price is less than the exercise price. In the stock market, the exercise price is when shares are purchased with the expectation that they could be sold for a much higher price.

Example:

Assume that in Company B, an employee has 100,000 vested options with a strike price of INR 10.

The current fair market value (FMV) of Company B stock is INR 40.

To exercise the option, the employee must pay INR 100,000 (100,000 shares x INR 10 per share).

At the exercise time, the taxable gain will be INR 300,000 (100,000 shares x INR 30 or INR 40 – INR 10). Keep in mind that this gain will be taxed differently depending on the type of options the employee is given.

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