A Stock option (“ESOP”) is a derivative of the underlying equity share and hence any change in the value of the share has a direct impact on the value of the ESOP.   In any corporate restructuring event such as merger, amalgamation, demerger, acquisition, etc. (“M&A”), the shareholders of a participating company are compensated through a share swap in a ratio that will equate the pre- event and post event value for the shareholder.   The ESOP holders also need to be treated in a similar way. This also is a legal and logical requirement.


Whereas, the share swap ratio is based on the comparative “value” of the shares, the fair and reasonable (“FAR”) adjustment for ESOPs (prompted by legal provisions) requires adjustment in the number and exercise price of ESOPs without extending the vesting period and life of ESOPs. The underlying principle of equating the pre and post value is the same as in shares.


The moot question is how does one define or calculate “the Value” that has to be equated. In case of shares, it is relatively simple, in case of listed shares it is the price at which shares are traded, in case of unlisted companies it the Fair Market value of the shares estimated using established Valuation methods. The share swap is done using intrinsic values. Most of the companies (at least in India) have been following the same basis (intrinsic value) for arriving at Option swap (the ratio is same as share swap).  For example, Co-A merges into Co-B. Shareholders of Co-A shall get 2 shares of Co-B for 1 share held in Co-A. Applying this principle, ESOP holders of Co-A are given following FAR adjustment on the basis of intrinsic value method:


Particulars Pre M&A details Post M&A revised details
Number of ESOPs 1000 ESOPs of Co A 2000 ESOPs of Co B
Exercise price Rs. 50 Rs. 25
Other terms as to remaining vesting period/ exercise period As originally prescribed No change (as originally prescribed)


Another way of equating the value is on the basis of Option Fair value (using Black & Sholes or similar binomial model) method. As SEBI is silent on which method has to be followed for restoration of value of ESOPs, as a matter of prudence, caution and record, few companies check both the methods to apply the one more beneficial to the ESOP holders.


Change-in-control (“CIC”) in a company happens necessarily by ceding more than fifty percent of controlling interest directly or indirectly with mostly change in the Board of Directors (“Board”) with or without change in the Top Management. The company stays as it is with the same equity shares even though the market value may fluctuate on perception after the CIC. Thus, any FAR adjustment to ESOPs is not warranted legally. However, CIC may trigger other adjustments such as accelerated vesting, invocation of Tag along or Drag along provisions as per the ESOP scheme terms. In such case the employees become shareholders with similar rights as other shareholders and participate in the transaction triggering CIC.


In case, the ESOP scheme does not provide for any acceleration or Tag / Drag along, employees continue to hold their ESOPs with the same terms as earlier unless an offer is made to take part in the CIC transaction.


In a nutshell, it can be said that the fate of ESOPs in M&A situations remains intact due to FAR adjustment mandated by law. Whereas that in case of CIC is dependent on the ESOP scheme terms.


Uma Shankar is a member of the Institute of Company Secretaries of India and Bar Council of India.
Uma Shankar heads the legal, Tax and compliance function at ESOP Direct.
During his association with us for more than 10 years, Uma has advised more than 200 mandates in Plan design, legal documentation and complex local and international Tax advisory.