Employee
stock options (Esops) have steadily gained acceptance and popularity in
India, not only amongst the corporate management but also among the
beneficiaries, the employees. Though their initial usage was in the IT
industry, Esops are now a given component of compensation in almost all
employee-centric organisations.
The success of Esops is critical because they are a costly tool.
When companies issue shares to employees, it dilutes the value in the
hands of other shareholders. Higher the discount to market price,
higher is the dilution and hence higher the associated cost. The
management will have to face the shareholders� wrath if the Esop pool
is not effectively utilised.
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Effective utilisation of the Esop pool not only means judicious
distribution of the available shares but also ensuring that grant of
Esops lead to higher motivation levels, better operational performance,
appreciation in stock prices, higher Esop gains and hence satisfied
employees.
When do we say that a company has a successful Esop
implementation? From the employees� perspective, the most tangible
indication is when the employees make money.
From the management�s perspective, the success of Esops is manifested
in higher motivation levels, higher retention and realignment of the
employees� interest with shareholders�.
How can Esops be made successful?
Well, it starts right from how you have designed the options.
Higher discounts to market price are not the be all and end all. Giving
shares cheap to employees will make monetary gains a certainty, which
is not good for the spirit of Esops. On the contrary, giving options at
the marke t price and motivating the employees to help in making the
price grow will go a long way in not only increasing the shareholder
value but also giving a deep sense of satisfaction to the employee of
having achieved something. Satisfaction is always high and long lasting
when you have earned something through effort and not as gratis.
Whom to grant and how much?
Given the limited pool, one needs to be selective on the
coverage and quantum. The choice is between covering a larger employee
base with smaller allocation and a smaller base with a sizeable
allocation to each. How much is adequate is a critical question. An
effective strategy could be to grant large chunks to a fewer employees
where the potential gains are too high to forego. Often, these are more
than 100% (annualised) of the cash compensation. This also goes well
with the universal perception that employees at junior levels are not
necessarily attracted by a long-term incentive such as a stock option.
They would rather have a cash incentive that, though lesser in amount,
is received yearly and is cash and not an option, which they do not
understand and takes years to realise.
Frequency of grants
Here, the choice is between granting the whole entitlement once
a year and granting the same quantum, but quarterly. Frequent grants
have the advantage of pricing the options in line with the market
swings. In case of the yearly grant, if the grant date coincides with
the peak stock price, the entire grant is locked at the highest price.
On the contrary, if the grants are made quarterly or even monthly, the
pricing is close to market movements. It works the same way as the
systematic investment plan of a mutual fund.
Vesting conditions
Vesting of options can be time-based or performance-based.
Performance-based vesting, which is now gaining popularity, will ensure
that equity
dilution happens only on the demonstrated performance. In a time-based
vesting scenario, vesting happens irrespective of the post-grant
performance. Practically, it may not be possible to link vesting to
performance for employees at all levels. However, the allocation to the
senior management can be of such a category.
Communication
The key to ensuring that employees are not de-motivated when the
chips are down is a very strong communication link with them. It starts
right when you grant.
They need to be educated that Esop is a
long-term instrument giving benefits over a 3-7-year period. It is not
about a one-time spurt in stock price but about sustained growth over a
longer time.
When the performance is down, the communication needs to focus
on why the performance is below expectations, what the management is
doing about it, what the employees can do about it and so on.
Communication is also essential in making the employees aware
of their Esop entitlements and benefits. Globally, more than 30% of the
granted options lapse, the bulk of them because the employees forget
that they hold some vested options. Having a well-thought-out
communication plan with adequate budget allocation is essential to make
Esops successful.
Communication can be in several forms � pre-grant orientation,
grant documentation, help manuals, quarterly half-yearly performance
reporting, periodical bulletins, vesting alerts, email campaigns,
workshops, presentations and so on.
Understanding expectations and designing solutions
One vital way of ensuring the success of Esop is to understand
in advance the expectations of the stakeholders and designing solutions
to address them. Key stakeholders here are the beneficiaries (eligible
employees), management (usually CEO) and the shareholders (promoters,
strategic partners, institutional investors, potential partners).
The option design should ideally be tailor-made for the
different hierarchy levels. Usually, the differentiation in levels is
made in terms of the quantum of the grant. It will help if the option
design is itself different for different levels. One of the variations
could be in the vesting condition as mentioned above. The others could
be different vesting periods (longer for higher levels), different
pricing (premium to market price can be considered for key senior
employees like the CEO or key business leaders).
From the shareholders� perspective, the expectation is to
achieve high corporate performance with minimum dilution. This can be
achieved through judicious use of the available pool and linking
vesting to corporate performance.
FBT dimension
A new facet to the attractiveness of Esops is the fringe benefit
tax (FBT) levied on Esop gains in the hands of the employer. Now, the
difference in the market price on the date of vesting and the exercise
price will be taxed at 34% on the date of exercise. FBT will obviously
reduce gains in the hands of the employees, though the impact will not
be as high as initially perceived.
The impact of FBT can be minimised if the vesting periods are
shorter (minimum one year is mandatory). For instance, if the options
have 100% vesting after one year and if one keeps granting quarterly or
half-yearly (which is ideal as mentioned above), the FBT impact could
be minimised. It would also be interesting to evaluate if instruments
like restricted stock units will make more sense to mitigate FBT.
Esops will not work if there is no buy-in of all the
stakeholders. Shareholders have to approve of them whole-heartedly.
Management should design and roll them out ingeniously, by being
transparent about the process, by being responsive to the expectations,
by periodically evaluating the plan performance and correcting the
course if required.
Employees have to understand the motive behind Esops, and
understand that option certificate is not a lottery ticket that will
fructify by fluke or a government bond that will give returns even if
the heavens fall. Rather, they are an instrument, which makes them
part-owners of the organisation they work for. It is for them to
maximise the returns for themselves and for other shareholders who are
relying on their skills and abilities.
The human resource team has a decisive role in making Esops successful in their organisation.
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