More and more companies are now
bullish on issuing stock options to their employees. Here is what you
need to know while contemplating ESOPs.
When Lotus Mutual Fund decided to
offer its employees stock options last month, it joined the list of
asset management companies willing to share a pie of their equity to
retain their best r brains. Another fund house, UTI Mutual Fund,
also allocated stock options to its employees recently. Fund houses
are now catching up with companies in other sectors offering stock
options. The IT sector made ESOPs quite popular in the early part of
this decade. ESOPs have emerged as an important tool to keep talent
from spilling over, thanks mainly to this sector. Our ESOP scheme
has been a tremendous success, both in terms of human resource
organizational growth. Today, we are one of those rare IT companies
where the attrition rate is very low at 2%. In fact, we are probably
one of its kind in the industry with 22.32% of the company being
held by employees," says C K Shastri, Managing Director, Intense
What is an ESOP?
Employee stock option plan (ESOP) is aimed at offering shares to
the employees of a company, wherein promoters decide to dilute their
stake. The shares are offered to either a select group of employees
or all employees in general at a price, which could be the same as
the market price or less than that. In case the company is yet to
come out with an IPO, the promoter decides the price of a share.
Why and when do companies offer
Talent crunch has forced companies to think of innovative ways
to retain employees. While established companies use ESOP as a
retention tool, startups could offer ESOPs to hire people with
complementary skills and setup a key management team. ESOPs act as a
big motivator. As the company's performance and earnings go up, the
value of its share also increases, thus making the employees richer.
There is no right time to go for ESOP. All it requires is the
willingness of the promoters to dilute their equity in the company.
The terms and conditions may vary because ESOP is a legal contract
between the company and its employees.
Harshu Ghate has 22 years of professional experience in Accounting,
Corporate Finance and Benefits Consulting. ESOP Direct provides
end-to-end solutions in equity-based compensation. Apart from
consulting companies on designing of ESOP plans, ESOP Direct
provides ESOP administration with expertise in UK / US based plans.
What does structuring ESOP mean
and what is the best way to do it?
There are a couple of angles to structuring ESOP. There is an HR
side, which deals with whom to give how much (of shares). Then there
is a legal angle, because ESOP is ultimately a contract between the
company and its employees. There are legal issues about what should
go in the contract. Then there is a taxation issue, because under
the prevailing law there could be a situation where an employee and
the company would be required to pay tax. There is also an
accounting angle because as per the Indian GAAP (generally accepted
accounting principles), any discount that you give to the market
price has to expensed in the books. There is also a company law
angle because there are shareholders' approval, board approval
and SEBI guidelines that have to be complied with.
Is ESOP a mere retention policy
or more than that?
Retention is the pre-dominant objective. The ESOP trend started
somewhere in the late 1990s, when we also saw the emergence of new
entrepreneurs and many venture-funded companies. In many cases,
there were also management buyouts. Essentially, the investors hired
key executives and in order to get them equity in the company, ESOP
was the ideal way, wherein they did not put in money initially but
they did get options that were at a discount. So they could get
shares in the company at a lower price than the investors. For
established companies, retention is the main objective and for
start-ups it is a way to get a management team in place. It is also
something like a joining bonus in case the employee who joins had
stock options in his previous company. You have to compensate him,
because he foregoes the gains he made there. Just like you match the
salary, you also match the stock options. Typically, retention works
where the unvested options are more than the vested options.
Employees should have something to look forward to. If ESOP is like
a one-time grant, after two years when the options vest, there is
nothing that the employee will look forward to.
What are financial implications
of ESOP for companies and for employees?
For a company there are no financial implications as such. There
is a net inflow, because it gets the price for its shares. For all
the gains an employee gets, there is no payout for the company as he
makes money from the market. For an employee, ESOPs are linked
directly to market situations. ESOPs are long-term instruments. Thus
the value of the option should not be calculated on a day-to-day
basis. This is because in any case if the options have not vested
whether the market price goes up or goes down, it is a notional loss
or gain. Even if the market price were to double, the employee
cannot sell his shares because it has not vested. Typically every
company has a period within which employees can exercise their
option. Even if the market is going through a low and the stock
options are vested, the employee would not sell his shares as the
prices are down. In a growing company, prices will bounce back and
options will win the money.
What major decisions do
companies have to take while considering ESOPs?
On the company's side, there are a couple of major decisions
that need to be taken. Since ESOP is about equity, there is an
element of dilution. Therefore, key shareholders will have to dilute
to the extent of ESOPs. To what extent they can dilute, to what
extent should they dilute is something that promoters have to
decide. Legally there is not bar on it, so it could even be 1%.
Second thing is about pricing. If you issue shares at a
discount-to-market price, it adds to the dilution apart from the
percentage dilution. The value of the remaining shares also
relatively goes down. The core thinking behind ESOPs is 'if the
price today is Rs 100, I'll give you at Rs 100, you can buy over the
next 2-3 years but you should gain only if the price goes to Rs
300'. That is the basic concept. Particularly at senior level, we do
not advice companies giving options at a discount, because there the
whole story is about taking the company forward. So such are the
decisions that companies have to take. From an HR angle, ESOP is
about coverage. Do we cover only senior management or key employees?
That is something very important to decide. Another important action
from the company's side is about communication to the employees.
Unfortunately, ESOPs have been projected as an easy way of
becoming a millionaire. Thus, it is important to keep the
expectations realistic because otherwise if the prices dip for a
day, employees start complaining. There have been cases where we
have seen companies wanting to offer ESOPs just because some other
company has been doing it.
What are the tax implications
of ESOP, now that it is in the ambit of the Fringe Benefi t Tax (FBT)?
FBT as a tax is on the company, so the responsibility is on the
company to pay but specific with ESOPs, the law also gives
authority to the company to pass it on. So in our experience almost
100% of the companies have passed on the tax impact to their
employees. Before FBT came in, the ESOP gains were virtually
tax-free. The kind of gains employees were making was very
noticeable, so the tax was long overdue. But the real impact of FBT
is much less than 33%.