Though employees and associates have been offered shares in company for
a very long time, it is only for last 20 years that companies are
offering their employees options to buy shares as part of compensation
packages. The trend perhaps started by young tech firms of US around
1980’s when many of these firms were pursuing excellent ideas and had
nothing to offer to their employees. Some of these firms went on to
create stupendous shareholder values and many of the employee
shareholders found themselves extremely wealthy at an extremely young
age. It was soon caught on by many well capitalized firms that could
afford to pay cash compensation to their employees. It has been argued
that this (equity related compensation package)helps align the
interests of the shareholders and the employees.



That the interests of shareholders and of management are not always the
same needs little elaboration. Managements detest distribution of
surplus cash to the shareholders, preferring to carry it for some
investment / acquisition that may or may not be in the best interests
of the shareholders but would go toward increasing the management’s
sphere of influence. This has been subject to detailed analysis by
researchers since 1970’s and is referred to as manifestation of the
“agency problem”, management being agents of the shareholders – the
actual owners of a firm. Seminal work in this field was done by M C
Jensen and W H Meckling in 1976. (Theory of the firm: Managerial
behavior, agency costs and ownership structure. Journal of Financial
Economics 3, 305-360.)



Influenced by such thoughts, many large firms had been linking the
compensation of the top management with the stock prices. This
inevitably led to the managements sacrificing the long term goals of
the company for the immediate agenda of taking the share prices to a
certain level within the year or the quarter. Thus instead of aligning
the shareholders' and managements’ interests this seems to have led to
their further alienation.



Performance rewards by issuing new equity, free or at concessional
price, never really caught on as it was seen that the employee could
immediately dispose off the shares so acquired in the market and issue
of such shares could hardly compel an employee to develop long term
interest (like that of shareholders). What came about as a prevalent
practice was issue of restricted shares – i.e. shares that could not be
traded for a given period. Shareholders of restricted shares enjoy all
rewards of ownership and are exposed to all risks of ownership;
additionally their holding also suffers from illiquidity for the period
of restriction. Issue of restricted shares may buy medium term loyalty
of the employees. Issue of stock options achieves the same without
immediate dilution of existing shareholders’ holdings. Stock options
consequently became more popular with each passing year.



During 1990s the popularity of stock options raised concerns among
equity analysts and serious investors. The concern was centered around
the issue that though stock options detracted from the wealth of the
shareholders, this detraction was escaping the conventional accounting
treatment of income and expenses. Warren Buffet, the noted investor
observed in 1993 “If options aren't a form of compensation, what are
they? If compensation isn't an expense, what is it? And if expenses
shouldn't go into the calculation of earnings, where in the world
should they go?” (Berkshire Hathaway Annual Report for 1992, Chairman’s
Letter; was again quoted in Chairman’s Letter in Annual Report for 1998)



I attempt to explore here the ramifications of existing accounting and
taxation principles on employee stock options. I shall start by
defining employee stock option and sweat equity, then examine the
prevailing trend in issue of stock options, then turn to US, European
and Indian accounting practices governing treatment of ESOP, then
consider the taxation implications of employee stock options and
finally the examine the corporate governance issues in grant of stock
options.



Employee stock options are options granted to employees to purchase
equity shares of the company at a pre-determined price over a
pre-determined time. The options can be granted free or can be sold at
a price, normally they are granted free. Typically, an employee cannot
exercise these options immediately on being granted. The options become
operative after some time. This is called vesting. Vesting period
(widely) varies from company to company. Usual condition is that the
employee must continue with the company for a certain period else the
options granted are not vested. It is uncommon to see very long vesting
periods. However, it is quite common to see options with maturities
going up to 10 years from the date of grant. Even in the 80’s some US
companies had issued options that could be exercised over 10 years
period. Stock options are almost always granted as part of compensation
to performing employees.



On the other hand, shares known as Sweat Equity (SE) are granted
usually as a one time affair to some one who brings to the company some
organizational capital i.e. some information assets that enhance
productivity of a firm, such assets as firms in the normal course
usually take a long time to accumulate; e.g. patents, know-how, skill
and expertise. By granting of SE someone who brings organizational
capital is recognized as a contributor to the company’s equity and is
often accepted as part of the promoter group.



Grant of stock options as part of compensation package has of late
become a contentious issue. (Indeed, there are other equity related
compensation programmes too. A company may allot shares to its
employees, under say a share purchase scheme, against payment of an
offer price that is less than market price; may even be less than the
face value of the share. Another may grant its employees stock
appreciation rights, where it pays them the appreciation in the market
price of the shares from the time of the grant till a certain future
date. Yet another company can compensate by writing an option contract
of a different type – a bonus if the market price touches a certain
level.)Many companies have employee share option schemes, many others
do not have. The proponents, i.e. those who propound desirability of
such compensation usually put forward the following three reasons:



1. Aligning manager and owner interests

2. Better management of scarce cash resources

3. Motivating and retaining employees



What they do not put forward and many (among the shareholders at least)
feel is a major factor for considering stock options as part of
compensation package is biased accounting and tax treatment of these
options. Accounting standards have historically treated companies using
stock option as part of executive compensation much more generously
than firms that use cash based compensation. Traditionally stock
options did not appear on the expenses account of the firm issuing
those options to its employees; hence the three poignant questions
posed by Buffet in 1993. Interestingly, even the Council of
Institutional Investors (of US) had observed in nineties that options
should not be viewed as a cost because they "aren't dollars out of a
company's coffers."



Accounting treatment of stock options in US veered around two themes.
First is treating the intrinsic value of the option as the fair value
of the option . A word about fair value. Fair value of any asset, at
least in financial theory, equals the present value of the expected
cashflows from that asset. “Intrinsic value” is a term frequently used
in analysis of option contracts. Typically an option contract entitles
the option buyer (also called option holder) to buy within the
contract’s maturity (in case of American Options) or at the end of the
contract period (in case of European Options) the underlying security
from the option seller (also called option writer) at a pre-determined
price, called exercise price. Obviously if the option is American (i.e.
can be exercised anytime till maturity), the option holder can realize
some value as soon as the underlying security’s market price exceeds
exercise price; the value being the difference between the market price
and the exercise price. This value is called intrinsic value of the
option. An option which has positive intrinsic value is said to be
in-the-money and one with nil intrinsic value is said to be
at-the-money and one where exercise price exceeds the market price is
called out-of-money. Does an option become valueless if it has no
intrinsic value? Certainly not, in fact traders do commit hard cash to
buy out-of-money options everyday and expect to gain by rise in the
market price of the underlying security. Regular trade of these options
proves that an out-of-money or an at-the-money option has some “value”.
Economists have developed models to price options; most famous model is
Black-Scholes model. These model give value of options, also called
“fair value”.



Thus if a company grants option that can be exercised to purchase
shares at price equal to or below the prevailing market price on the
date of grant, such options will have no value! The argument is that
since the option entitles the option holder to do something (buy the
share at market price) which he could have done even without holding
the option, therefore the option is not bringing any value to the
holder. The second view emphasizes that options when granted do not
affect anything till they are exercised. Therefore options should be
accounted for only when they are exercised. The first view is
encapsulated in the Accounting Principles Board (of US) opinion number
25, referred to as APB 25. Almost all US corporations granting options
have taken shelter behind APB 25 one time or other. Companies granted
options with the strike price set equal to the prevailing stock price
and did not account for it as its value was zero as per APB 25.



This accounting treatment has interesting tax implications. In the year
of grant the option granting company or option receiving employee faced
no tax consequences as they had given and received something of nil
value. At the time of exercise (say after four years) the option holder
would get one share of the company at the exercise price and the
company would get a tax deductible expenditure amounting to market
price (the value of the share given to the employee exercising the
option) less the exercise price (the value received by the company from
the employee). It was tailor-made for young companies who retained
employees at no cash outgo and later, when presumably they would become
taxable, save on cash flow by claiming tax deductions . But does the
tax department suffer in the process? It seems no. As the young company
was making losses there would have been no tax incidence in the year
the option was granted. If the company had paid cash compensation to
its employees, the tax credit (loss) would have got carried forward and
the company would have claimed deductions in the year it had taxable
income.



No wonder most US firms historically have used APB 25, to account for
options. It is interesting to note here that Financial Accounting
Standards Board (FASB) (of US) recognized as early as 1994 that this
was incorrect and proposed a new standard (FAS 123) where options would
be valued and expensed at the time of the grant. (When Institutional
investors were saying that options need not be expensed as there was no
dollar outgo.) FASB, however, permitted continuation of the old rule.
In 2002, FASB 148 was issued as a stopgap rule, laying out the two new
transition methods for firms that wanted to voluntarily shift to
value-based accounting for options. In 2003, the final version of the
rule (FASB 123R) laid out the following rules:



 Options must be valued using an option pricing model (binomial
lattice models, Black Scholes and Monte Carlo simulations) at the time
of grant. Thus the option value which was considered the intrinsic
value in APB 25 now became a function of the current market price of
the share, the strike price, the expected life of the option, the
variance in the stock price, the risk-less rate and expected dividends.
The expected life of the options would depend on the option maturity
and the vesting period. Since all options that are granted may not get
vested as employees may still choose to jump ships the option value
should be adjusted for expected forfeiture. Forfeiture rate will depend
on the options not getting vested and a higher forfeiture rate would
reduce the value of options granted.



 The value of the options so calculated can be amortized over the
vesting period, starting with the year of the grant. Companies are free
to choose between accelerated or straight line amortization. Thus the
stock option expense item in the Profit & Loss account of a firm
would reflect not only the effect of options granted in that year but
also those granted in earlier years, till they are all vested.



New rule also provided for change of forfeiture rate on the basis of
actual behavior. The change in option value because of such change in
forfeiture rate is required to be accounted for in the year in which
the forfeiture rate is re-estimated. This rule permits companies to go
for a value based accounting treatment of stock options and is a far
cry from the earlier APB 25.



It will be interesting to examine the international accounting
standards for employee stock options. The International Financial
Reporting Standards Board in early 2004 released IFRS 2. IFRS 2 too
requires that if stock options are used as compensation these options
must be valued at the time of the grant. IFRS 2 is more or less on line
of FAS 123R. IFRS 2 applies the same rules about option valuation to
both public and private companies. As share price volatility is
impossible to calculate in private companies, it is permitted to use
industry average variances as proxy in valuing private company options
and it even allows the use of intrinsic value (exercise value) when
option valuation is difficult to do.



In such tax jurisdictions (e.g. the US) where only the exercise value
of the option is tax deductible, IFRS 2 requires that a deferred tax
asset be recognized if (and when) the options have exercise value that
can be deductible for tax purposes. Thus options issued at-the-money
will not create deferred tax assets. FAS 123R, on the other hand,
requires recognition of a deferred tax asset based on the grant-date
fair value of the award. The effects of subsequent decreases in the
share price (or lack of an increase) are not reflected in accounting
for the deferred tax asset until the related compensation cost is
recognized for tax purposes. The effects of subsequent stock price
increases that generate excess tax benefits are recognized when they
affect taxes payable. We now turn to the practice prevailing in India.



Securities and Exchange Board of India ESOP Guidelines, 1999, (SEBI
ESOP Guidelines) prescribe that the ‘value’ of a stock option would be
the difference between the market price on the date of grant and the
exercise price of the option, or the fair value of stock options,
arrived at using the Black-Scholes Formula or such other binomial
function. Listed companies are required to expense this value over the
period of vesting of the stock options. Thus SEBI’s prescription has
elements of both ABS 25 and FAS 123R. Currently, there is no expensing
requirement for unlisted companies. We find that some of the most
reputed Indian companies sheltering behind intrinsic value is value
approach. We are considering two banks, both active in derivative
markets and better qualified than most corporates to value options.



First ICICI Bank, because it is perhaps the most innovative company,
having successfully rewritten the rules of the banking game in the
country. ICICI Bank (ICICI) instituted an Employee Stock Option Scheme
(ESOS) in the FY 1999-2000. The objective of the scheme was / is “to
enable the employees and Directors of ICICI Bank and its subsidiaries
to participate in the future growth and financial success of the Bank”.
The maximum number of options that can be granted to any
employee/director in a year, as per the scheme, is limited to 0.05% of
ICICI Bank’s issued equity shares at the time of the grant. The
aggregate of all such options (in any one financial year) cannot exceed
5% of the bank’s issued equity shares on the date of the grant. (SEBI
ESOP Guidelines, 1999 has prescribed 5% limit for grant of options.)



Options granted by ICICI get vested, in a graded manner, over four
years from the date of the grant – 20% each at the end of the first two
years and 30% each at the end of the third and the fourth year. Options
are exercisable till ten years from the date of the grant or five years
from the date of vesting, whichever is later. The price of the options
is set at the closing price of the bank’s shares on the stock exchange,
which recorded the highest trading volume preceding the date of grant
of options. ICICI has changed its pricing formula for options three
times over the last seven years in line with the SEBI guidelines, as
amended from time to time.



Annual Report of ICICI for the year 2005-06 states that since the
exercise price options was the last closing price on the stock exchange
which recorded the highest trading volume preceding the date of grant
of options, there was no compensation cost based on the intrinsic value
of options. However, if fair value of options based on the
Black-Scholes model were considered, employee compensation cost in FY
2005-06 would have been higher by Rs.5.24 crores and profit before tax
would have been less by that amount.



It appears that ICICI is giving full particulars about the value lost
by shareholders due to grant of options to the managers. But this may
not be so. It is not clear whether Rs 5.24 crores is the value of the
options granted during 2005-06 or it includes the increase in the value
of still outstanding options granted in earlier years due to rise in
price of the company’s shares. As mentioned earlier in option pricing
models value of an option is a function of, among other things, the
current market price of the underlying security.



We next consider another new private sector bank namely UTI Bank. UTI
Bank, as per its Annual Report for 2004-05 has an employee stock option
scheme in accordance with the SEBI ESOP Guidelines. The eligibility and
number of options to be granted to an employee is determined on the
basis of the employee’s work performance. The exercise price under
options granted till FY 2004-05 has been at the average daily high-low
price of the Bank’s equity shares traded during the 52 weeks preceding
the date of grant at the Stock Exchange which has had the maximum
trading volume of the Bank’s equity shares during that period
(presently the NSE). The options vest at the rate of 30%, 30% and 40%
on each of three successive anniversaries following the granting and
must be exercised within three years of the date of vesting.



It is interesting to contrast the pricing formula of UTI Bank (UB) with
that of ICICI . The latter’s options have exercise price set equal to
the closing price on the date preceding the date of grant. Thus these
options are at-the-money. Since intrinsic value of such options is
considered zero, in terms of the earlier US norm i.e. APB 25 IB grants
and its managers supposedly receive something of nil value and thus
grant of option need not be expensed at all. Not so in the case of UB,
which sets the exercise price equal to average daily high-low for past
52 weeks. In this case the options can be in-the-money, out–of-money
and even (rarely though) at-the-money. Even as per APB 25 an
in-the-money option has some value – equal to the difference between
current market price, (closing price on the date preceding the date of
grant), and exercise price. UB recognizes this as a deferred
compensation cost and amortizes on a straight-line basis over the
vesting period of such options. For instance on 29 April 2004, UB
granted 3,809,830 stock options (each option representing entitlement
to one equity share of the Bank) to its employees, the Chairman &
Managing Director and the Executive Director. These options could be
exercised at a price of Rs. 97.62 per option. The closing market price
of the underlying equity share on the date of the grant was Rs. 161.11.
Since these options were in-the-money UB recorded a compensation cost
of Rs. 24.21 crores on the options granted. The annual report for
2004-05 does not refer to the value of the options granted using any of
the standard option pricing models.



Another major difference in the options granted by ICICI & UB is
the maturity. IB’s options have ten year life from the date of grant.
UB’s have 5 years from the date of vesting. Since options get vested in
a graded manner over three years, 30% of options have 6 years life, 30%
have 7 years life and remaining 40% have eight years life. Average
maturity works out to 7.1 years against ICICI’ 10 years. Other things
being same, (of course other things will never be the same), ICICI’s
options would normally be more valuable.



The third case we are considering is Infosys Technologies (IT),
arguably the first Indian brand to command attention and respect in
advanced economies. IT takes pride in the fact that “the first large
scale experiment in democratization of wealth using stock options took
place at Infosys” (Annual report for 2005-06). In 1994, Infosys became
the first company in India to conceive and implement Employee Stock
Option Plans (ESOPs). IT had introduced various stock option plans for
our employees. However, the grant of stock options to employees at IT
has been suspended for some years. It is still instructive to have a
look at its 1998 and 1999 stock option plans. There have been however
exercise of options granted earlier. An interesting item in its balance
sheet as at the 31st March 2006 is the amount of Rs. 72 crore credited
to the share premium account. This represents the tax benefits during
the year in overseas jurisdiction of deductions earned on exercise of
employees stock options in excess of compensation charged to the profit
and loss account. IT has clarified that it has always granted option at
fair market price and hence had never had to expense the options at the
time of grant.



This credit of Rs 72 crores on account of permitted deductions was
possible in the overseas jurisdiction because it presumably enforced
expensing of grant of options. SEBI ESOP Guidelines, as mentioned,
require expensing but leave it to the company to choose between
intrinsic value and fair value as the cost of grant. This expensing,
however, does not affect the taxable income of the company; why,
perhaps because they "aren't dollars out of a company's coffers." Thus
a company compensating its employees through ESOPs ends up paying more
taxes than what it would have paid if it had stuck to cash compensation
for its employees.



If a company is viewed as a common vehicle for the shareholders it is
easy to see the double whammy poor shareholders are getting because of
ESOPs. Stock options are granted to the executives, who get the reward
of benefiting from a rise in share price just like the shareholders but
do not share the risk of downfall in share prices to which the
shareholders are exposed. Ironically, for placing the executives in
this privileged position the tax department charges the shareholders –
as it is the cash belonging to the shareholders which goes for taxes,
which are higher because the options are considered worthless at the
time of grant. Let us recount the objectives of ESOP as enunciated in
ICICI Bank’s annual report: “to enable the employees and Directors of
ICICI Bank and its subsidiaries to participate in the future growth and
financial success of the Bank”. UTI Bank solemnly states “employee
compensation is structured in terms of fixed pay, variable pay and
stock options”. Let us consider what these banks would have paid in
cash to retain the same set of talent. ICICI Bank’s Board approved a
grant of approximately 63 lac options for fiscal 2006 on April 29,
2006. Each option conferred on the employee a right to apply for one
equity share of face value of Rs. 10 of ICICI Bank at Rs. 576.80, which
was the last closing price on the stock exchange which recorded the
highest trading volume in ICICI Bank shares on April 28, 2006. As per
the bank’s own calculations if it had used the fair value of options
based on the Black-Scholes model, compensation cost in fiscal 2006
would have been higher by Rs.524.4. This sets the fair value of each
option at approximately Rs 832. If instead of granting options the bank
had given Rs 832 for each option to the eligible employees, the taxable
income would have come down by Rs 524.4 crores and as the effective
income tax rate for the Bank in 2005-06 was 27%, revenue loss for the
Tax department would have been over Rs 136 crores, less what it would
have collected from the grantees. These 136 crores obviously went out
of the shareholders’ funds.



Admittedly, if cash Rs. 524.4 crores were paid in compensation, even
after tax savings, the cashflow coming by the shareholders way would
have been reduced by Rs 388 crores. However there would have been no
dilution of their equity holdings, which with the grant of option had
become exposed to potential 0.71% dilution.



The question now arises if ESOP are so detrimental to the shareholders’
wealth how come we see so much of it. It is easily answered, ESOPs
emerge only when owners are not managers. We do not see a Premji or a
Rahul Bajaj granting ESOPs. Perhaps because, in terms of the Central
Government Notification No. 323/2001 (R.No. 142/48/2001-TPL) dated
October 11, 2001, a person holding more than 10% of the shares in a
company would not be eligible to participate in employee stock option
plan or scheme of the company. ESOP at Bajaj Auto would systematically
reduce Rahul Bajaj’s percent holding. It is interesting to note that in
case of Infosys the “management” consisting of Narayan Murthy and
others control only 16% of equity and no person holds more than 10% to
become ineligible under SEBI Guidelines; still the top management at
Infosys are excluded from ESOPs. (We do not really expect such sense of
probity and fairness from everyone.)



It is interesting that Income Tax Department in India is considering
ESOP as a fringe (i.e. indirect) benefit and taxes the assessee (i.e.
the company, which is in effect taxing the shareholders) FBT on issue
of ESOP. In all fairness,

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