Companies grant ESOPs to employees with three major objectives, sharing wealth, rewarding performance and making them think like a shareholder (owner). Giving Equity as a part of compensation is a very costly proposition because cost of equity is far higher than cash pay-out. More and more companies are granting ESOPs, in spite of knowing this. While on one hand Shareholders and the Board feels that they are giving significant value to employees, the later do not necessarily share the same feeling. If this is true then we have a serious perception gap which needs to be addressed. This article to help understand and address this gap.
The perceived Value Gap
The gap is in the perception of what Value is granted by the Company and what is perceived as received by the employee.
The Issuer of Options (the Company) believes that since the cost of equity is high, the value is also high for the employee. This logic may not necessarily be true. Value of Equity could be higher for the employee if he is willing to take the risk (instruments with high risk usually have a potential to give high returns) over a longer time horizon (increase in stock prices in the range 30-40% annually is not unusual). The Issuer expects the receiver to view ESOPs the same way.
However, the employee does not share the same outlook. He has no risk appetite and more over he neither understands the stock markets nor does he have any control over its fluctuations. Usually, employees also do not have patience to receive a reward over a long term. They need to see cash in hand in a shorter term.
In order to bridge this gap, the issuer has to communicate “the Value” to employees.
Employees will see value in Options, if they understand the instrument well. They need to be made aware about the long-term nature of reward, about the linkage it has to the overall value appreciation (market cap), about the uncertainty linked to its realization.
Demonstrating emotional value
ESOP is not only a financial reward. It also has a strong emotional value. The issuer needs to demonstrate this value by treating Option holders as shareholders. Even though legally an Option holder is not entitled to Dividend on the Options, it will be a good way to demonstrate this emotional value by passing on the dividend to employees in some way (this is possible if a Trust is holding underlying shares). Another way could be by sharing all the information that is shared with shareholders with them, inviting them to Shareholder meetings even though they may not have any voting rights.
Often ESOPs are perceived as a tool that is used at the whims of the management. The process of granting, eligibility, frequency of grant, need to be communicated transparently rather than being seen as black box. Even simple things such as handing over Grant letters, communicating finer option terms, handholding them during the entire process, help them understand tax and liquidity related issues, if handled well, will help building the confidence.
Fairness in Option terms
Options are governed by the Grant agreement between the employer and employee. Terms of the Offer should be fair and reasonable for the employee. Clauses related to Tag along, impact of termination without cause are often worded one sided. There have been cases when, on acquisition while Promoters and Investors have encashed, the employee options were not allowed to be encashed. Though far and few, there have been instances where CEOs have been terminated without cause just before the vesting date.
Beyond all these factors, it is obvious that employees have to see cash in hand to get the taste of value. Growth in the company’s valuation will ensure this but as an Issuer, the company can also facilitate this process, by enabling funding of Options, Cashless exercise, providing liquidity to the shares (in case of unlisted companies).