Importance of the Exercise Period of an ESOP grant

Termed PTEP (Post Termination Exercise Period), this is one of the most important evaluation criteria of an ESOP grant. Let me explain why, but let's start with a very short summary of how ESOPs work.

Startups are generally low (or frugal or both) on cash, and require the best talent to help them achieve (w/ low probability) product market fit & scale. ESOP grants allow startups to attract great talent by promising them exceptional returns if the startup does well eventually. With an ESOP, a company gives you the right to "exercise" the option(s) you receive and convert them into shares in future. Stock option is only an option to purchase shares in the company in the future - ESOP does not automatically give an employee shares in a company. Options are usually vested over few years ensuring that you commit to the company long term and earn your right to be a shareholder & only the options that are vested can be exercised. These options once exercised become shares that can be liquidated at an IPO or other liquidation events (like secondary sale or buy back etc). If the liquidation event doesn't happen during your tenure at a startup, the PTEP factor comes into play.

PTEP is the period (post exit from a startup) during which you have to "exercise" your options and convert them into shares. If you fail to exercise them, you basically forfeit them. You are no longer a shareholder in the company. But, what's the fuss? Why can't you just exercise them always?

It's because exercising options requires you to pay the "exercise price" (basically money) upfront to convert them into shares & then pay perquisite tax to the government. Note that the liquidation may still a few years ahead and you are basically taking out money from your pocket to become a shareholder in the company. Let's understand this with a simple example.

Say you join a startup that grants you options equivalent to about 10000 shares of the company vested over 4 years (25% every year). These are offered to you at the Fair Market Value (FMV) of Rs. 1000 per share (based on the latest valuation). 3 years hence you decide to move on from this startup. You've vested 75% of your options (equivalent of 7500 shares) and according to the latest valuation, the FMV of the share is Rs. 5000 (nice!). Since the PTEP at this startup is 90 days (common), in 90 days of your exit you will have to "exercise" them by paying 7500*1000(FMV @ joining) to the company & additionally 7500*(5000-1000)*0.30 (assuming perquisite tax of 30%) to the govt that year. That's a dent of about 1.65Cr on your personal wallet. Now assume that the liquidation event happens a few years later when the FMV of the share is Rs. 10000, you will get 7500*10000 (7.5Cr) and pay Rs. 7500*(10000-5000)*0.30 (assuming 30% tax on gains over the sale price & FMV at exercise time) or 1.125 Cr as tax. Your total net earnings from the ESOP stint is then Rs. 4.725 Cr.

The earning is great eventually in this case, but is subject to liquidation and the startup doing well after your exit. In case a startup folds up post your exit, you will not make anything at all but will actually be at a loss of about 1.65Cr. This huge upfront liability of Rs 1.65 Cr is what makes exercising options very challenging for a lot of early employees of a startup.

Typically, employee friendly startups (like Quora, Uber, Pinterest & Flipkart, Myntra closer home) keep the PTEP very long (about 10 years). With such a long PTEP, you don't have to pay upfront immediately post exit and if a liquidation event occurs within 10 years of your exit, the "exercising", "sale" & "taxation" are adjusted in a single transaction ensuring that you always end up making money without having to pay anything from your pocket.

I hope that when you join a startup, you make sure you discuss the terms of the ESOP very carefully and pay due attention to the PTEP as that can basically make or break the incentive for you to stick around and slog it out. Let me know through comments if the post was helpful and do share the post to help spread the knowledge.