In a webinar with MyStartupEquity, Siddarth Pai (Founding Partner & CFO of 3one4 Capital) spoke about the importance of equity grants in startups. Siddarth believes that Indian startups should consider the mechanism of “Phantom Stocks” or “Stock Appreciation Rights” or SARs to help employees with the exercise tax on their equity shares. Explaining SARs, he says, “Instead of paying your taxes from your personal bank account, SARs enable you to pay taxes at the time when the sale happens just like in a listed company. In a listed company, for example, when you exercise your shares, you immediately sell them, realize the cash of that, and pay your taxes. It becomes easier as it is in the form of cashless management.”
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In my opinion, startup founders should avoid “vanilla” ESOP schemes. This is a cookie-cutter ESOP scheme that one gets from an acquaintance and it often proves to be detrimental & costly in the long run. What founders can do instead is reach out to a proper law firm or company secretaries, or reach out to companies like LetsVenture’s MyStartupEquity and use good standard templates put out by them.
They can also architect something like the SAR scheme or the Stock Appreciation Rights scheme. A SAR scheme is similar to what people call “phantom stocks” in the US, wherein one can actually realize liquidity from a particular stock, and then use that liquidity to pay particular taxes. Instead of paying taxes from personal bank accounts, employees can pay taxes at the time when the sale happens just like in a listed company. In a listed company, for example, when one exercises shares, they immediately sell them, realize the cash of that, and pay taxes. It becomes easier as it is in the form of cashless management.
The problem that India has with its ESOP taxation policy is that there is a cash flow mismatch. One ends up paying taxes and then waits for a long period of time before actually realizing the cash value of those shares. Because shares in a startup are not listed in any stock exchange, there is no ready liquidity for that and by virtue of being equity shares, the appetite for these shares (unless the company is doing really well) is comparatively lower. I personally know employees who borrowed money to exercise their ESOPs and waited for 6 years to sell their shares. The tax they pay can prove to be a dead loss in their hands. By formulating and following a SAR kind of policy, employees are not penalized by paying the tax as they do not end up losing money on this particular transaction, but in vanilla ESOP schemes, the employee might end up losing a significant amount of money (close to 30%).
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