Employee Stock Ownership Plans (ESOPs) are often marketed as a golden ticket for startup employees, offering a chance to own a piece of the company and potentially reap significant financial rewards. Success stories of ESOP millionaires from India’s startup boom fuel this narrative. Yet, for every success, there are tales of employees left with worthless shares due to restrictive clauses, unmet promises, or unexpected tax burdens. Are ESOPs a wealth-building opportunity or a risky gamble? Here’s a closer look at the pitfalls and precautions to consider before banking on ESOPs.
1. Verbal Promises Are Worthless
A marketing manager at a Bengaluru-based fintech startup was promised ESOPs to match a competing job offer during negotiations. Excited by the verbal assurance, she joined the company, only to learn later that the board had “deferred” the ESOP allocation indefinitely. Without written documentation, she had no recourse.
What You Should Do
- Insist on ESOP details in writing, ideally within an offer letter or through a formal ESOP portal.
- Verbal commitments have no legal weight. If it’s not documented, assume it doesn’t exist.
2. Restrictive Exercise Windows Can Drain Your Wallet
ESOPs often come with a catch: a limited window (typically 3–6 months after leaving the company) to exercise vested shares. For example, an employee with 1,000 vested ESOPs at a strike price of ₹1,500 per share must pay ₹15 lakh to buy the shares upon resignation. If they can’t afford it, the shares lapse. Additionally, India’s tax laws impose up to a 42.7% tax on the difference between the fair market value and strike price at exercise, even if the shares aren’t sold—a hefty upfront cost.
What You Should Do
- Review the ESOP agreement for the exercise period. Look for plans with extended or unlimited windows.
- Assess your liquidity. Factor in the cost of exercising shares and potential tax liabilities before relying on ESOPs as part of your compensation.
3. Performance-Linked ESOPs: A Subjective Trap?
Some startups tie ESOP vesting to performance metrics, which sounds reasonable until vague or subjective evaluations come into play. A software engineer shared on social media how their ESOPs were withheld due to “underperformance,” despite meeting all project deadlines. Another clause allowed revocation of vested shares for “misconduct,” a term left undefined, giving employers unchecked power.
What You Should Do
- Demand clear, objective performance criteria in the ESOP agreement.
- Ensure “misconduct” or similar terms are explicitly defined to avoid arbitrary revocations.
4. No Accelerated Vesting During Exits
Many ESOPs follow a 4-year vesting schedule, but what happens if the company is acquired or goes public before your shares fully vest? Without an accelerated vesting clause, you could lose out. For instance, an employee who joined a startup in 2022 saw it acquired in 2024, but with only 50% of their ESOPs vested, they missed out on the windfall despite their contributions.
What You Should Do
- Check for an accelerated vesting clause in the ESOP agreement, especially for events like mergers, acquisitions, or IPOs.
- Negotiate for partial or full vesting in such scenarios to protect your stake.
Real-World Example
In 2023, a logistics startup’s employees faced a harsh reality when the company was acquired. Those with unvested ESOPs received nothing, while others struggled to exercise shares due to high strike prices and short windows. Meanwhile, a competitor with employee-friendly ESOP terms—longer exercise periods and accelerated vesting—saw its team benefit significantly from a similar exit.
Key Questions to Ask Before Accepting ESOPs
To avoid being blindsided, ask:
- What is the vesting schedule, and is accelerated vesting included for exits?
- What is the exercise price, and how long is the exercise window post-employment?
- Are there performance conditions, and are they clearly defined?
- What are the tax implications of exercising and selling shares?
- Is the company’s valuation realistic, and is there a clear path to liquidity (e.g., IPO or acquisition)?
Conclusion
ESOPs can be a powerful tool for wealth creation, but they’re not a guaranteed jackpot. Opaque terms, tight exercise windows, subjective performance clauses, and tax burdens can turn a promising perk into a financial burden. Before factoring ESOPs into your compensation, scrutinize the fine print and consult a financial advisor to assess their true value. In India’s fast-evolving startup ecosystem, due diligence is your best defense against the risks of ESOPs.
Disclaimer: The views expressed are the author’s and aim to educate. This article does not recommend specific products or investments.