Make the most of ESOP opportunities during meltdown



The sooner a company grants Esops, the better for its shareholders and employees.

The current meltdown in the stock markets has had a devastating impact on the value of stock options companies have issued to their employees. Most of the options issued at market prices 12 to 15 months ago are underwater. Needless to say, there is no excitement among either the option holders or the issuers regarding these.

However, given the enormous success employee stock option plans (Esops) have met with in the last three to five years, this time no one is writing them off as a useful tool in fostering motivation, retention and attraction of talent.

Contrary to popular belief, the most appropriate time to grant Esops is when the markets have hit the bottom. The option holders get shares at the lowest possible price, with no downside risk and higher potential upside. The shareholders can do with lower dilution, since you will need fewer shares to give the same amount of benefit.

Table shows how companies will have to issue 20% more shares if they delay the grants by a year and 73% more shares if one delays the grant by two years.

However, not many companies seem to view the current downturn as an opportunity. Employees also seem to give preference to cash incentives over Esops.

Among the top reasons for this lack of interest among the companies is their belief that the current meltdown is not restricted to the stock market and rather reflects an all-pervasive recession which is expected to run well into 2010. Given this timeframe, they are not sure if share prices would appreciate significantly enough to make a difference to the value of Esops in the coming 18-24 months.

The fact, however, is this itself is an opportunity. Esops by their very nature are a medium to long term instrument. The legal stipulation is for a minimum one year vesting, but typically, the vesting spreads over 3-4 years. A company with a sound business model is bound to bounce back in terms of performance and market pricing in the next 2-3 years. All global analysts are unanimous that countries like India will be faster off the ground in overcoming the recessionary impact than the US and Europeans.

As the table shows, the earlier the companies grant Esops, the better it is for the shareholders and for the employees.

Some promoters are of the opinion that the current valuation is not a true reflection of the companyís inherent value and issuing options at that value would mean acceptance of the valuation. The point is well taken. Many companies are quoting at less than book value, which certainly is not a correct reflection. However, it is possible to structure options wherein the exercise price is decided on the date of vesting with a look back/ look forward feature. This will give adequate time for the true valuation to show up in the market prices.

Many unlisted companies would want to link their Esop rollouts to the IPO plans. This will ensure certainty of liquidity for the employees and eliminate cash payouts by the company. In the current situation, all IPO plans and hence ESOP rollouts are deferred.

It is possible in such cases to link the exercise to the IPO. Here, the options will vest but are exercisable on IPO. The employees need to be educated adequately about these terms. They would not mind this since they are not required to invest till the IPO materialises. The exercise period could be kept appropriately longer.

The other reason commonly heard is that in the current situation, retention is less of a challenge. There are fewer jobs in the market to lure them and those available will not offer aggressive salaries. While it can be argued that retention at junior levels of management could be less of a challenge in the next couple of years, the same is not true for the managerial staff. Management skills are still in short supply and these resources could seek greener pastures even in the current scenario. Esops are essentially meant for the managerial staff and not for junior staff, who usually prefer cash incentives. In fact, if the company has in the past spread the options thin with a large number of employees, this is an ideal opportunity to amend the allocation and to focus only on those who would be critical to tide over the current recessionary phase.

Lack of employee interest is also cited as a reason for companies to defer their Esop initiatives. Employee awareness about Esops has been quite low the world over. Just as the small investor flocks to the market to buy in the booming market and sells desperately in the slump, employees also believe that Esops make sense when the prices are already high and rising fast. Firstly, the employees need to be educated that Esops are not shares where you book profits or losses on a daily basis. It would be worth the effort to create this awareness among the employees in order to align their goals with those of the promoters.

To be fair to the employees, their dejection is understandable. No one would want to have an option which has potential to go underwater. It is possible to structure an option which will ensure that they are always in the money at the time of vesting.

Quite a few companies, which have granted options earlier, are under water. If for some reason they find that re-pricing is not the solution, they could use the timing to grant options at a lower price so that the employees can average out their cost and still be in-the-money at an aggregate level.

Any option design will have to work within the four corners of dilution, benefit, employee coverage and accounting charge. It is possible that if you give more weight to one parameter, the other will get impacted. While itís important to prioritise the parameters, it is necessary and possible to optimise them to achieve buy-in of all the stakeholders.

Indian Inc has always responded commendably to all the business challenges, be it globalisation, rupee valuation or the current meltdown. Here is an opportunity to handle the situation equally ingeniously to ensure they maintain the edge with a motivated workforce.

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