What is an ESOP Surrender Program?

An ESOP Surrender Program allows employees to voluntarily surrender or sell back their allotted options to the company. It is a company effort or choice within an Employee Stock Ownership Plan (ESOP). An ESOP Surrender Program allows employees to sell their ownership stake in the business. By participating in this program, employees have the option to voluntarily surrender or sell back their allotted options to the company. This allows them to liquidate their ownership share and receive cash in return.

ESOPs are options that are given to the employees. The terms and conditions of ESOPs such as the number of options, exercise price, vesting period, lock-in period, etc. are highlighted in the “Grant Letter”. The company first decides to allocate a certain percentage of the company to the employees. After the board approves the decision, employees are given options under an ESOP Plan. Options give the employees a right to own shares in the company. They can either “exercise” this right or “surrender” them. Surrendering options would mean that in exchange for financial compensation, the employees give up their right to own shares in the company.

Can employees who have exited the company also surrender their options?

Usually employees can surrender/exercise their vested options. Once an employee is terminated or chooses to leave the company, employee ESOPs stop vesting. In case they have vested options, companies usually specify a post-termination exercise (PTE) period before which employees can surrender or exercise. This is usually highlighted in the grant letter. ESOPs are voided if the PTE period is crossed.

How are the proceeds from the surrender program calculated?

Companies running a liquidity event are usually valued first to understand how much each option would be worth if converted to shares, this is the Fair market value of the company share. This is usually done by an independent valuator. The value minus the exercise price and perquisite tax gives the net proceeds for each employee. The net proceeds from the company are given as the Fair Market Value minus the exercise amount and the perquisite tax.

What is Fair Market Value and how is it calculated?

For a listed company, the Fair Market Value is simply the stock price that is available on the market. For an unlisted company, the Fair Market Value is calculated by an independent valuator using option pricing models such as the Black Scholes or the binomial method.  If you are an employee working for a company headquartered in India, this value can only be given by SEBI Registered Cat 1 Merchant Banker.

What is Exercise Price and Exercise Amount?

Exercise Price is the price that is agreed upon by the employee and the company when ESOPs are issued. This is the price that the employee must pay to buy one share in the company. This is also known as the strike price. Exercise Amount is the total amount that the employee must pay for exercising or surrendering their options which is calculated as the number of options x exercise price.

What is Perquisite Tax?

Perquisite Tax is the tax that is levied upon the net gain that you get from your surrendering your options, i.e., the fair market value – exercise price. The tax percentage depends on the country you're in. For Indian employees, this tax rate depends on the income slab that you fall into.

The Grant Letter highlights the exercise price, the number of options, and the vesting schedule. The company also has a cliff (a certain time period before the vesting starts), post which options start to vest. In India, it is compulsory to have at least 12 months of cliff. Let’s see an example in which the options are vested immediately after the cliff.

Assume that an employee has been granted 100 options as a part of the ESOP 2023 Plan.

2023 – Options are given to the employee at the exercise price of 10.

2024 – At the end of year 1, all the options are vested.

Now the company can open a liquidity event asking the employees to surrender. Let’s assume she wants to surrender her options. This is an unlisted private company and the FMV is ₹5000.

So, the total value of the options when the employee surrenders is ₹5000 x 100 = ₹5,00,000

Exercise Price is ₹10 for each option. Exercise Amount is ₹10 x 100 = ₹1000

Perquisite Tax

Perquisite tax is calculated by taking a percentage of the difference in the Fair Market Value and the Exercise Amount. For Indian tax-paying employees, this is dependent on the income slab that they fall under and the tax regime. Assume that this employee earns 15 LPA, so the perquisite tax rate is 30%.

Therefore, the Perquisite Tax Amount is calculated by 0.30 x (₹5,00,000 – ₹1,000) = ₹1,49,700

Thus, the net value to the employee will be ₹5,00,000 –₹1000 – ₹1,49,700 = ₹ 3,49,300

*Note that the tax rate shown above does not include the cess.

Is it better for the employee to exercise the options or surrender them?

This depends on what the employee wants. If the employee believes the company can reach higher valuations, he can choose to exercise and hold his shares. And wait for future growth in the company. Surrendering options would mean that the employee will cash in early and will not be benefitting from the future growth of the company. Either case there are tax implications, in earlier case there is the Long-Term Capital Gains (LTCG) tax based on the number of years the employee holds the shares and, in the latter, there is the Income Tax as Surrendering the options is treated as regular income and taxed based on Income tax slabs.

How are the employees given the proceeds from a surrender program?

Employees get their proceeds from the surrender program, like any other bonus in his/her pay slip.  In case of Indian Company, employer withholds the perquisite tax and the exercise amount and gives the net proceeds.