By TV Mohandas Pai & Siddarth Pai

Employee stock option plans (Esops) symbolise “skin in the game”, marrying employee economics with shareholder value to democratise start-up success. It converts labour into equity, kickstarting a participative and prosperous virtuous cycle. India’s archaic laws on Esops are counterintuitive for the world’s third largest start-up ecosystem.

India has the aspiration of a $10-trillion economy with the regulations of a $0.5-trillion economy. The policy mindset is extractive, not expansive. Some aspects of tax laws and practices would make even the colonial British blush. India’s laws on Esops suffer from two fatal flaws: fair market value fallacy; and the promoter prohibition.

The taxation of Esops worldwide is similar. Esops are granted at a nominal price (grant price). When Esops are exercised, the fair market value (FMV) and grant price differential is taxed as “salary income”. When the shares are sold, sale price and FMV differential are taxed as capital gains.

Yet this is broken in India. Fair market value fallacy. The phrase “fair market value” is a misnomer for start-ups, as it is neither fair nor there is a market, and the value is hard to realise.

Start-ups are valued based on future performance, with investors negotiating special rights such as valuation readjustment (anti-dilution rights) and priority during exits (liquidation preference). This merits the prices they pay for their shares.

This same price forms the FMV for Esops, despite employees not getting the same rights. Private companies offer differential rights, unlike listed companies. Yet........

© The Financial Express