One of the key concerns of existing Investors, including Promoters is dilution. Dilution occurs when a company allots new primary Shares. In case of ESOPs, dilution can occur in two ways:
- In the % shareholding of existing Investors, at the time of issue of new equity shares on exercise of Options; and
- In the form of total value of Investors’ holding, in case new Shares are issued at a discount to the prevailing market price.
However, companies can protect its Investors from dilution on both counts by appropriately structuring their ESOP Plans. Some of the approaches companies can evaluate are:
- Protection against dilution in % holding:
Dilution in existing % holding can be protected in two ways:
- Implementing the cash settled stock options plan (“Phantom Plan”); or
- Use of secondary Shares acquired from the secondary market or existing shareholders.
In the Phantom Plan, no shares are issued to employees. All vested Options are settled by paying cash. Since no new shares are issued, the existing shareholding % does not change and dilution is avoided.
Another way to avoid dilution is to implement the ESOP scheme using secondary Shares. In this mechanism, a company can procure existing shares from the market (in case of listed companies) or from existing shareholders (say the non-Promoter shareholders) and use them to transfer to employees when they exercise Options. In this case also dilution is avoided as no fresh shares are created but the existing non-promoter shareholding gets reshuffled. This route can be implemented by setting up a Trust to facilitate buying and transfer of shares.
- Protection against value dilution:
Dilution in value in the hands of the Investors can be avoided by adopting either of the following ways:
- Issuing ESOPs at Fair Market Value (“FMV”); and
- Issuing ESOPs having Performance linked vesting conditions
When a company issues ESOPs at FMV, the Company is receiving same amount of cash as it would have received had the shares been issued to any investor or public. Consequently, no dilution occurs in the existing value.
Similarly, if the Options are granted with a Performance condition, no Options would vest unless the given performance is achieved. If the Performance condition is in the nature of increased profitability or market capitalization, then the dilution impact is more than compensated by increase in the overall value of the Company. In other words, if the vesting conditions are such that ensure future value of 95% of shares is more than the existing 100% holding, the Investors would not mind diluting 5% to employees. Some examples of Performance conditions could be growth in Topline, EBITDA, Market Capitalisation or FMV.
To conclude, while implementing the ESOP scheme, companies can address the dilution constraint through appropriate mechanism. If the Promoters believe that growth of the company cannot be achieved without retaining its critical employees, the choice with them is whether they want to own 100% of a low growth company or 95% of a high growth company.