NO MORE THE HONEY
DATAQUEST dated October 15, 2001   
 
Once carrots that attracted talent, ESOPs are now well and truly dead. However, even though it’s been a while since stock prices fell, a survey shows that 92% of companies are yet to rethink their ESOP policies
My team and I work nearly 60 hours a week to finish my project in time. The exercise saves a good Rs 2 lakh for the company and what do I get? A five-figure salary that I would have got irrespective of any extra work…

It was this angst that IT companies addressed when they started offering employee stock options a few years ago. During the heady days, when a smattering of IT job openings greeted every techie, the system worked beautifully. Employers used ESOPs as an effective tool not just to attract the best talent but also to cut down attrition rates.

But after the stock market crash, most of these options have slipped underwater. Yet, companies have not found it necessary to address the situation. Among 28 of India’s larger IT companies surveyed, only 23% offer ESOPs to more than 90% its employees.The number is as high as 60% in the case of smaller companies. A significant 54% of larger companies offer ESOPs to under 25% employees.

A report 'ESOP Design Practices 2001' based on a survey of 40 companies across the country shows that a whopping 92% of these companies, both IT and non-IT have not changed their policies regarding ESOPs despite the fall in stock prices. Of this, 55% have not addressed the situation in case of an acquisition and 50% have not catered for rights issues and consequent diminution in the value of stock options.

The report by ESOP Direct, a subsidiary of Pune based Kirtane Pandit ESOP Consulting, covers 12 non-IT companies and 28 IT companies. ESOP Direct is an end-to-end solutions provider. "The survey was sought information on the trends and practice of ESOPs," says Harshu Ghate, managing director, ESOP Direct. Ghate admits that while ESOPs are fairly new in India, there is data available from the US where stock options are part of a well-accepted practice.

Says Ghate, "More than 95% of ESOPs in India were given as an additional benefit apart from the salary. So the ESOP recipients have not lost out on their salary to that extent.It is only those who exercised their options and held on to them in anticipation of prices going up, who would have lost out. If employees consider ESOPs as an incentive, they should sell them off immediately.

ESOP Survey: A Snapshot
>> 60% of companies implemented ESOPs in 2000 (post-SEBI guidelines)
>> 55% companies used services of a consultant to design the ESOP plan
>> 55% of plans do not address the situation arising out of change in control of the company
>> 50% of plans do not address the situation arising out of rights issues made by the company
>> 92% of companies have not altered the plan in view of the fall in stock market prices
>> 85% of companies do not use software to administer the stock plan
>> 60% of companies do not provide for any specific mechanism for financing the exercise of stock options
>> 20% of companies provide for a broker assisted cashless exercise

If they hold on to them, they become investors and it means taking all the market risks that come with an investment. There is no point in blaming the companies and giving ESOPs a bad name. This is the first time Indian IT professionals have witnessed the industry facing a slump and thus the despair in prices going down."

It is true that with the current slump in the stock markets, many of the options issued by the companies are underwater i.e. market price is lower than the exercise price. However, the slump is a blessing in disguise for companies as the current prices are the lowest at which the options could be issued. Therefore if options are issued at current market prices, there would be no accounting charge for the company and no downside risk to the employees.


Ghate points out that companies often create the impression that their employees will gain substantially from their stock options. This is misleading for employees. In fact, the whole objective of ESOPs is to integrate the goals and fortunes of employees and shareholders.

Once the employees become part owners of the company, they cannot say that they want only the up side of the ownership (appreciation in value) and not the downside (fall in the value). Unfortunately, ESOP benefits have been marketed in India as a sure way of making mega bucks.

The survey reveals that Indian recipients of ESOPs have not yet realized that ESOPs are actually incentives.

NUMBERS GAME: 35% of companies considered 50-200 employees for ESOPs, while 25% offered options to between 500 and 1,000 employees. But compared to enterprises, IT companies were way ahead in handing out the ESOP carrot to employees
Instead of encashing them on the day of allotment, they hang on. If they hold on, they take an investment decision, exposing themselves to market risk. Ghate explains that in the US, ESOPs are usually encashed the very same day.

Far more important is the fact that companies who have offered ESOPs have not paid attention to important issues like what happens when the company gets acquired, or when (as is happening now) markets are down and so are prices. Another situation that is not addressed is of companies going in for a rights issue. "Change in control through takeovers, mergers and de-mergers, are no longer stray incidences. It is the same with companies issuing rights and bonus shares. It appears that Indian companies leave it to the compensation committees to decide on the impact as and when such situations arise. Over 30% high-tech companies have re-priced their options in the US," says Ghate. He feels that when market conditions are down, as they currently are, ESOPs should either be re-priced or increased.

What has also emerged in India is that there is no difference between how IT and non-IT companies view ESOPs. While retention, rewarding performance and facilitating employee ownership were the objectives of the ESOP plan, the survey found no differences between sectors or in the categories of target employees.

The survey found that 42.5% Indian companies, across the IT and non-IT spectrum, offered ESOPs at a fair market price, 22.5% offered these at below market prices. This compares favorably with the global trend of 99.7% offering at equal to fair market price and 2.3% below fair market price. "Global trends reveal that there is a segment which offers at above fair market price but this could be attributed to mature markets. When the markets were rising rapidly (at say 40%), companies could offer options 20% above the market price and still stay ahead", Ghate points out.

What emerges is a strong need to inform employees about the downside of holding stock options just as they are told about the benefits. Options should be looked upon as an instrument that gives part ownership of the company to the employees, as it carries responsibilities and risks alike.


Methodology

The survey on ESOPs was carried out in 40 Indian companies. These included 28 IT companies and 12 non-IT companies across the country. These companies were shortlisted from a base of 150 companies who have implemented ESOPs.

These 40 companies were classified on the basis of—status (listed or unlisted), sector (IT or non- IT), company size (large or small) and year of ESOP implementation (before or after 2000).

IT companies encompass all those involved in IT services, manufacturing and products. The distinction between large and small IT companies were on the basis of turnover and overall size of operations. For small companies, the turnover was cut off at Rs 200 crore. The turnover for large companies is Rs 500.

Companies like Infosys Technologies, Aptech Limited, KPIT Systems, Mahindra British Telecom, Mascot Systems, Mastek, Onward Technologies, Onward Technologies, Persistent Systems, Rolta India and Tata Infotech participated in the survey.
THE 2000 CRAZE: It was in FY 2000 that IT companies went overboard with their ESOP offerings. While 53.6% of the IT firms surveyed issued ESOPs in 2000, a mere 17.9% walked the stock options route in 1999

Case Study

Here’s an example of a software company that has granted options to its employees.

With its prime focus on Embedded Designs, Company X is a single source provider of software design expertise from concept to end product. It has clients across Europe, the United Sates and the South-East Asian countries.

The company was in its start up stage and the management wanted to use ESOPs to enhance employee performance, retain good performers as well as attract new talent. All employees in the company were eligible for stock options. Junior level employees would be entitled to receive options if their performance fell into a particular category predefined by the management.

These options were granted to them at almost 50% of the fair market value. Senior and middle-level employees were granted different types of options at close to 25% of the fair market value.

Of the 40 companies surveyed by ESOP Direct, 90% chose ESOPs to retain valuable employees. Of these companies,a high 80% offered stock options in return for good on-job performance
 
There were different options granted to attract new talent at the senior level. At 25% of the fair market value, the benefits passed on to employees through these options were almost twice the gross annual salary. However, in order to retain these senior employees, the period set to vest these options was comparatively longer than the period of the options granted to other employees. The benefits to be passed on from the options granted to senior, middle and junior employees, were close to a year’s gross annual salary.

As compared to other companies, this company had diluted a larger portion of its equity base to be granted as options. It was close to 20% of the total share capital. As an exit route the company also provided for Intra Employee trading as one mode, where the company would announce the floor price at regular intervals.

However, as has happened with several infotech companies as a result of the slowdown, the company has postponed its IPO indefinitely and is not currently listed on the stock exchanges. The name of the company has been withheld due to its agreement on confidentiality with ESOP Direct.

- Nanda Kasabe

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