BUSINESSWORLD dated October 29, 2001
Is your employer hoping the underwater stock options problem will just go away? He's not the only one it seems

What goes up must come down. Stand this cliche on its head, and what do you get? The standard policy most Indian corporates are adopting to deal with underwater stock options. They... hey, hang on a minute! What are underwater options? Okay, let's tarry a bit and deal with the jargon first. Underwater Esops are options with an exercise price much higher than the share price. Net result: they are worth their weight in, well, paper. Exercising them is not a good idea unless you want to bankroll your company's latest dotcom plans.

If you got any stock options in the last couple of years, they are likely to be underwater by now. Employees in tech companies have been the worst hit: the Computer Software Large ASA Index is off almost 75% since the beginning of last year. Now, we don't know about your employer, but most companies seem to be going by the assumption that what goes down must come up. And if the options are going to resurface on their own sooner or later, why bother with a salvage operation? According to a survey conducted in April by Pune-based ESOP Direct -- a company which designs Esop plans -- over 90% of the companies did not want to change the conditions of their schemes. It sure helps that the general economic outlook is depressing. Employees are likely to be more worried about hanging on to their job than about rescuing battered stock options.

There is also the issue of shareholder-employee conflict. There are quite a few ways of burnishing Esops (see 'The Employers' Options'), but most of them involve a trade-off between the rights of existing shareholders and those of employees looking for a chance to encash their options. Repricing of options can be especially tricky. If the repriced options are given at a discount to current market price, shareholders would be justifiably peeved. Nobody's protecting their downside, after all. "It is against the shareholders' interest to frequently reprice the options. It is also against the shareholders' interest to let options remain underwater for a very long while and lose the alignment between shareholder interests and employee interests. Managements will have to strike a fine balance between dilution and incentivisation," says T.R. Santhanakrishnan, CFO, Satyam Infoway, India's first ISP to list abroad. Any repricing could also send a signal that the company is losing faith in its ability to create value. In that case, the market might just decide to punish the stock further.

The Employers' Options

Harshu Ghate
Managing director
ESOP direct

After the bull rampage of 1999 and early 2000, when Esops were liberally issued by companies, it's time to take stock of the wreckage. And it's not a pretty sight. Indian employees have seen the value of their Esops erode faster than you can say 'tough luck'. The trouble is,employers are clueless about how to respond.

Act they must, though. Many Esop schemes were designed to reward past and future performance.If share prices fall purely because of market conditions, underwater Esops act like an involuntary pay cut.

Some companies have started thinking about alternatives. For instance, one of our clients is considering cancelling the old options and designing a new scheme. Another client has already made a larger grant at current prices, so that employees can average out their cost. An unlisted company, which had to defer its IPO, has provided a facility to enable trading in its shares amongst the employees,so that those in need of cash can exit.

Here are some of the ways your employer can address this issue:

Repricing without cancellation: The exercise price of the underwater options is changed to a new exercise price that is equal to the current market price or is at a discount to the current market price, after getting shareholder approval. Surprisingly, Sebi guidelines do not mention the accounting impact of repricing.

Cancel and reissue at market price: Another method is to cancel all the existing options and grant an equal or fewer number of options at lower exercise price. The company can reverse the accounting entry for the amount, equivalent to the discount given at the time of the first grant. If the new grant is made at the market price, there is no adverse accounting impact .Shareholders also may not mind this as options are granted at market price and there is no additional dilution.

Grant larger number at current prices: Granting of additional options at a high discount that would result in averaging the cost to the employees. A small increase in the market price would make all the options in-the-money. The accounting impact of the new grant will be very significant.

This alternative is likely to be accepted only in unusual circumstances.

Selective Repricing: Instead of complete re-pricing, companies can re-price only those options granted to middle and junior level employees. The logic here is that part of the blame for the fall in the prices has to be shared by the senior team and that they should strive to increase the market valuation. As senior management usually gets the bulk of the options, the shareholder may not object to such a re-pricing.
Of course, there is no standard solution to the problem as firms will have different priorities when it comes to factors like accounting impact and shareholder reaction.

But for most firms, it is perhaps as much the lack of pressure from employees as concern for shareholders that is keeping them from tinkering with Esop schemes. We decided to run this by Santhanakrishnan. "There was no pressure to change the terms of the option programmer," he says. "Despite the pressure on the option value, Sify has been able to retain its employees reasonably well."

Raymond Arogyaswamy, vice-president of Polaris, agrees that there is "no problem in the short-term. I don't think Esops are an attraction or retention factor anymore. They are a hygiene factor. They have not helped us retain or attract people." His own options, granted under the Esop 2000 scheme, are underwater. What does he think about that?

"Of course, I would have been much happier if the share price had been
Rs. 3000. But I am not thinking about that at all. In any case, the exercise period is five years." Not all employees will take such a long-term view. And any company which doles out Esops as a reward for past performance, or to retain talent, knows that it can't afford to short-change employees.

Especially key employees. That could be why, when Polaris came out with a new scheme -- Esop 2001 -- in April, the grant was given to 300 employees at current market price.

A few other companies are also getting worried. "In the last six or seven months I have seen some desire to relook at the Esops," says K. Pandiarajan, managing director of HR services provider Ma Foi. In fact, Ma Foi is one of the companies that is actually doing something about its underwater Esops.It granted more options to employees at a 20% discount to book value in July. "We always wanted a broad-based Esop scheme: 38% employees have Esops now.And if a person leaves, he can actually surrender the shares at the price bought," says Pandiarajan. Ma Foi is an unlisted company -- like most dotcoms in India. Didn't Pandiarajan face any opposition from the VCs (venture capitalists are known to vehemently oppose any change in Esop terms that could affect the earnings per share)? "We did face some opposition from our VCs initially, though they came around when they realized how important the change was for retention," says Pandiarajan.

Even some MNC employers are working out ways to boost the value of their options. Buybacks announced by companies like Cisco could shore up share prices abroad and make the options granted to Indian employers more attractive.

Whether a company has to change the terms of its scheme finally depends on just how well designed it is. A multi-year plan where at-the-money (market price equals exercise price) options are granted in tranches does not usually need fixing. There is also an incentive for employees to perform, since a stock price increase today increases the value of future options as well. So there you have it. While we are unlikely to see the kind of repricing that NIIT went in for last April -- the company had lowered the exercise price of its options from Rs 2,476 to Rs 1,593 less than three months after shareholders approved its Esop plan -- there could be some more recovery operations in the offing. Particularly in cases where top-drawer talent was attracted by dangling the options carrot. According to sources, there are companies that have decided to mount a selective salvage operation for key employees, but are chary of going public with the move.

Can't blame them. It's bad enough that employees who had compromised on their fixed compensation to take Esops might be getting restless. Finding out that their employer is now playing favourites might not go down too well.


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