Start-up India’s sob story

FOUNDERS SHOULD BE PERMITTED ESOPs, SUBJECT TO SHAREHOLDER APPROVAL

- 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 startup 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 startups, as it is neither fair nor there is a market, and the value is hard to realise.

Startups are valued based on future performance, with investors negotiating special rights such as valuation read adjustment (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 boards, auditors, and advisors fail to permit any FMV reduction, fearing scrutiny notices and prolonged litigation.