Quick Guide to ESOPs

DARE / Vol. 2/ Issue 06/ March 08


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 Technologies.

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 ESOPs?
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%.

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