Following upGrad’s acquisition of Unacademy at a $206 million valuation, expert Saikat Neogi breaks down the impact on vested, unvested, and peak-valuation ESOPs and their tax implications.
Edtech startup Unacademy was acquired by upGrad on Sept 1 through a share swap at a valuation of $206 million, a huge drop from its August 2021 peak valuation of $3.4 billion. Saikat Neogi explains the impact on employee stock ownership plans (Esops) when a startup is sold at a much lower valuation
What are Esops?
EMPLOYEE STOCK OWNERSHIP plans or Esops are a type of benefit plan where employees get shares of the company at a low or no additional cost. These are given by companies to align employee incentives with company growth and conserve cash in the early stage of the business and help attract and retain talent.
The first stage is the grant stage, when the employee is offered the right to acquire a specified number of the startup’s shares in the future at a predetermined price, known as the exercise price. The second stage is vesting — the process through which the employee becomes eligible to exercise, i.e, buy, the Esops after certain conditions are met such as continued employment for a specified period (minimum one year as per Sebi regulations) or achievement of specified performance conditions.
Then comes the exercise period — often up to 5-10 years — when the employee can buy the vested options or shares at the predetermined price. The shares remain locked for a certain period to prevent immediate sale and to ensure commitment to the company. This is followed by the liquidity stage when the shares can be sold during an initial public offer, acquisition or secondary market sale.
In case of acquisition, what happens to the Esops?
FOR ESOP HOLDERS, the treatment depends on whether the options have been vested and the terms of the Esop and acquisition agreement. Employees who have already exercised their vested options will hold the shares of the target entity and these shares will be exchanged directly for acquirer shares under the transaction documents.
In case of vested but unexercised options — where the employee has the right to the shares by paying the exercise price but has not yet purchased the shares —the holders will not automatically receive the acquirer’s shares. Their treatment will be governed by the transaction agreement and Esop scheme rules resulting in an option rollover —existing stock options are replaced for new options or even cancellation.
What if Esops were bought at peak valuation?
THE ACQUISITION OF Unacademy by upGrad is structured as a share swap, with Unacademy shareholders receiving shares in upGrad. Where the current value attributable to the shares is lower than the exercise price paid by the employee, the employee would effectively be at a notional loss. Employees who exercised their Esops when Unacademy’s valuation was at its peak will thus see a significant decline in the value of their investment. It would become a realised loss when the shares are sold or exchanged against the shares of Upgrad at this valuation.
While the number of upGrad shares allotted per Unacademy share is not public, the outcome will depend on the terms of the transaction and the rights attached to the shares held by the employees. In case of a potential all-stock deal at a lower valuation, the to-be acquired firm may come up with a buyback offer and allow employees to convert their vested options into equity shares but this comes with tax and liquidity implications.
What happens to unvested Esops?
WHERE THE COMPANY has granted the stocks to the employee, but the latter does not yet own them because he has not fulfilled the vesting conditions, the Esops remain unvested. If the employee resigns or is terminated before the vesting conditions are met, the unvested options lapse. In case of an acquisition, like upGrad acquiring Unacademy, the treatment of unvested options will depend on the terms of the acquisition, the transaction and the relevant Esop plan of the acquirer. The unvested options may be cancelled or terminated as part of the acquisition.
Alternatively, the acquiring entity may replace the existing unvested options with new options. “In such cases, the acquiring entity may either provide a new vesting period to the employee or allow the existing vesting period to continue, subject to the terms agreed between the parties,” says Sandeep Sehgal, partner, Tax, AKM Global. Therefore, employees may continue to remain vested based on their original service period, or they may be required to fulfil a revised or new vesting schedule following the acquisition.
What are the taxation norms?
ESOPS ARE TAXED on exercise of option and subsequent sale of shares. Abheet Sachdeva, partner, M&A Tax, Nangia Global, says the value of specified securities is taxable as perquisite under the head ‘salaries. “The taxable value is the fair market value (FMV) on the date of exercise less the amount paid by the employee (exercise price),” he says. When the allotted shares are sold at a higher price, the profits are taxable as capital gains.
Gains from sale of unlisted shares held up to 24 months are treated as short-term capital gains (STCG) and are taxede at the slab rate. If held for more than 24 months, these are long-term capital gains (LTCG) and taxed at 12.5%. Gains from sale of listed shares when held for up to 12 months are treated as STCG and are taxable at 20%. When held for more than 12 months, gains are treated as LTCG and taxed at 12.5%.
Please click here to view the full story on FInancial Express.