Understanding the hidden risks of pre-IPO ESOP exercises

Employee stock options are often presented as a simple equation:

Exercise your options → company goes public → shares become valuable.

But there is another scenario employees need to understand.

What happens when you exercise your ESOPs at a high valuation, pay tax based on that valuation, and the company's valuation falls before you actually get a chance to sell?

It isn't just a theoretical possibility.

A recent case involving a high-growth Indian startup brought this risk into focus. As the company moved towards a potential public listing, its valuation had reached around $7 billion. Its ESOP pool was expanded significantly, and an interest-free loan was made available to its ESOP trust to help employees exercise their options.

For employees exercising at that stage, the relevant FMV was tied to the company's valuation at the time of exercise. That meant the tax implications were based on a substantially higher value than the exercise price.

But the expected IPO timeline and valuation expectations later changed. Subsequent reports pointed towards discussions around a valuation closer to $3 billion.

The important lesson isn't about that particular company.

It is about what happens when the valuation used when you exercise and the valuation available when you eventually get liquidity are very different numbers.

And this is one of the less-discussed risks of pre-IPO ESOP exercise.

The tax event happens before the liquidity event

Under India's ESOP taxation framework, exercising an option can create a taxable perquisite.

Broadly, for an employee exercising ESOPs, the taxable perquisite is calculated based on the difference between the Fair Market Value (FMV) of the shares on the exercise date and the amount paid by the employee to exercise them.

So imagine an employee has options with an exercise price of ₹100 per share.

At the time they exercise, the FMV is ₹1,000.

The employee's taxable perquisite is broadly based on the ₹900 difference per share.

For 5,000 shares:

• Exercise cost: ₹5 lakh
• FMV at exercise: ₹50 lakh
• Taxable perquisite: ₹45 lakh

The employee hasn't necessarily received ₹50 lakh in cash.

They have simply acquired shares that are valued at ₹50 lakh at that point.

But the tax liability associated with the perquisite can still arise.

This is where the timing problem begins.

The employee has a real tax obligation today, while the potential financial benefit from the shares may remain entirely in the future.

Now imagine the valuation falls

Six months later, the company doesn't list at the expected valuation.

Perhaps market conditions have changed.

Perhaps the IPO is delayed.

Perhaps investors are no longer willing to value the business at the same level.

Perhaps the company raises its next round at a lower valuation.

Whatever the reason, the FMV eventually falls from ₹1,000 to ₹600.

The employee is now holding shares worth significantly less than the FMV that was used when they exercised.

But the earlier exercise doesn't simply get recalculated because the company's valuation has subsequently fallen.

That's the critical point.

The tax event at exercise and the eventual sale of the shares are separate events.

A lower valuation doesn't simply erase the earlier tax

The tax treatment becomes particularly important here.

At exercise, the difference between the applicable FMV and exercise price may be taxed as a salary perquisite.

Later, when the shares are sold, the employee may have a capital gain or capital loss depending on the sale price and applicable cost basis.

The subsequent fall in value does not simply mean that the original perquisite tax is recalculated at the lower valuation.

For example:

At exercise

FMV = ₹1,000
Exercise price = ₹100
Perquisite = ₹900 per share

At sale

Sale price = ₹600

The employee has suffered a ₹400 decline from the FMV at exercise.

That decline is relevant to the subsequent capital-gains calculation. But it doesn't automatically turn the original ₹900 per-share perquisite into ₹500 for salary-tax purposes.

This distinction is easy to miss.

And it is exactly why employees need to think beyond the headline value of their ESOPs.

The real problem: paper wealth versus real cash

This creates a situation that can be uncomfortable for employees.

They may have:

A real tax liability.

A real exercise cost.

An illiquid asset.

And only paper wealth.

The shares may look extremely valuable on paper, but the employee may not be able to sell them immediately.

If the company is still private, there may be no ready market for those shares.

And if the expected IPO is delayed or happens at a lower valuation, the employee may have to wait even longer for liquidity.

This is why an ESOP's value should never be viewed in isolation.

The more useful question is:

How much will it cost me to turn this paper value into actual ownership, and when can I realistically turn that ownership into cash?

An interest-free loan doesn't remove the risk

There is another layer to consider when employees are given access to financing to exercise their options.

An interest-free loan can make exercising more accessible.

But it doesn't eliminate the financial obligation.

The employee still needs to repay or settle the loan according to its terms.

Now consider the same scenario:

An employee exercises because they expect a near-term IPO at a high valuation.

They use financing to help fund the exercise.

The IPO is delayed.

The company's valuation falls.

The employee still owns the shares.

But the employee also still has a repayment obligation.

The result is very different from simply holding vested options.

The employee has converted an uncertain future opportunity into a real financial commitment.

That doesn't automatically make the decision wrong.

It simply means the decision needs to be evaluated much more carefully.

Why "the company is going public soon" isn't enough

An upcoming IPO can make exercising ESOPs feel like a relatively safe bet.

But an IPO isn't a guaranteed liquidity event at a guaranteed valuation.

Between exercising and actually selling shares, several things can change:

• The IPO can be delayed.
• Market conditions can deteriorate.
• The issue price can differ from private-market expectations.
• The company's valuation can be revised.
• The listing can happen at a lower valuation than employees anticipated.
• Lock-in restrictions can delay the employee's ability to sell.
• The employee may need to hold the shares longer than expected.

So the decision shouldn't simply be:

"Is the company going public?"

It should be:

"What valuation am I exercising at, what will this cost me today, and what needs to happen for me to actually realise the expected value?"

Three numbers employees should understand before exercising

Before exercising pre-IPO ESOPs, employees should look at three things together.

1. The FMV at exercise

The company's valuation matters because FMV can directly affect the taxable perquisite created at exercise.

A higher FMV can mean a larger tax liability.

And importantly, a high current valuation isn't necessarily a guarantee of the future sale price.

2. The cash required today

Employees should calculate the total cash requirement, not just the exercise price.

That can include:

• Exercise cost
• Tax arising from the ESOP perquisite
• Any applicable transaction costs
• Potential financing costs or repayment obligations

An employee might have ₹50 lakh worth of ESOPs on paper but still need substantial cash today to actually exercise them.

3. The realistic liquidity timeline

When can the shares actually be sold?

An IPO may be one route, but it isn't the only one. Depending on the company and its arrangements, liquidity could eventually come through a buyback, acquisition, secondary transaction or public listing.

The key is to understand when and how liquidity might actually happen, rather than assuming that an IPO will automatically solve the problem.

So, should employees avoid exercising before an IPO?

Not necessarily.

There can be good reasons to exercise before a liquidity event.

An employee may have strong conviction in the company's long-term prospects. They may have sufficient liquidity to fund the exercise and tax. The exercise terms may be favourable. They may also have a long enough investment horizon to tolerate valuation fluctuations.

The point isn't that employees should never exercise early.

The point is that pre-IPO exercise is not a risk-free shortcut to wealth.

It is a financial decision that involves taxation, valuation, liquidity and timing.

And those variables don't always move in the same direction.

The ESOP decision is really three bets

When an employee exercises before an IPO, they're effectively making three bets at once.

What companies should do differently

This isn't only an employee education issue. Companies also have a role to play in helping employees understand the economics of their equity. An ESOP communication shouldn't stop at "You have been granted X options worth ₹X." Employees should understand:

The bigger lesson

The most attractive number in an ESOP plan is often the current valuation.

But that number is only a snapshot.

A company's FMV can rise.

It can also fall.

An IPO can happen.

It can also be delayed.

And an employee can exercise at one valuation and eventually sell at another.

That's why the question shouldn't simply be:

"How much are my ESOPs worth today?"

It should be:

"What am I paying today, what tax am I triggering, how long might my money remain locked in, and what happens if the valuation changes before I can sell?"

ESOPs can create meaningful wealth. But understanding how valuation, taxation and liquidity interact is what helps employees make better decisions about when — and whether — to exercise.

This article is for informational purposes only and does not constitute tax, legal or financial advice. ESOP taxation depends on individual circumstances, the nature of the employer and the applicable tax rules. Employees should consult a qualified tax or financial adviser before making an exercise decision.