Understanding ESOP

Introduction

Employee Stock Ownership/option/equity Plans have a fairly long history in the Western market economies but are of a very recent origin in our country. Ever since Luis Keslo structured an employee ownership plan in 1957, acquiring external funds for employees to purchase new equity, Stock ownership and Option plans have come a long way in their variety as well as their intensity of application.

In the U.S. it is estimated that 9% of all stock is held in different forms of ESOP.  Stock Option and equity linked plans became fashionable in the UK during the seventies and have been steadily growing. Similar is the case with Belgium, France, Germany and other European countries. It is estimated that several transitional economies and the NICs have found Stock Options, if not the ownership plans, a useful instrument serving multiple objectives. Organizations in countries like Pakistan, China and those in the Middle East have also begun to examine the feasibility of such plans, even though the capital markets are not very active as yet.

In the USA, ESOP is not equivalent to the stock option plans that we, in India, normally refer to – the need for the distinction arises due to the tax concessions and funding possibilities associated with an ownership plan.

In that sense, we do not have “ESOP” schemes in India but only equivalents of

•        Executive stock options

•        Non-qualified stock options

•        Incentive stock option

•        Equity linked performance plans

•        Stock appreciation rights and the like

More recently, the SEBI guidelines have used terms Employee Share Option Scheme (ESOS) and Employee Share Purchase Scheme (ESPS) that in due course may gain ground replacing the mistaken acronym of ESOP. In USA the term ESOP stands for Employees Stock Ownership Plan.

These are the plans were employees own substantial part or the entire company. The Promoters of the company implement this plan with the objective of passing on the ownership to the employees.

Concept of ESOP in India

However, it is only during the last few years that there have been any publicly acknowledged and legally sound versions of equity-linked plans. Strictly speaking, all the plans, other than those that may have been initiated under the SEBI guidelines for the ESOS, are not option plans, as these do not involve “options” as instruments. There is a need to make this distinction - as all stock related plans are not necessarily option plans.

There have been several one-time offers to employees while raising equity or as preferential allotments, but these are mere precursors to more advanced and structured plans that we notice now.  Prominently quoted examples of such structured equity linked plans are those of Infosys Technologies, Global Trust Bank, Sat yam etc. There has been a discernible concentration of the I.T and Finance / Banking companies in this experimentation so far, due to the special manpower and compensation dynamics that they have been passing through.  However, several in the manufacturing, both in the private and the public sector are evaluating the merits of this instrument, which appears inevitability. Further, the reference to stock options in the last two Budget presentations by the Finance Minister has sparked a surge in the interest of corporate, both public and private.

The guidelines issued by the SEBI, despite several contentious issues, have come as a good step in the direction of promoting stock option plans.  The amendments to exchange control regulations of the RBI and guidelines in respect of stock options linked to ADR / GDR issues have also contributed to the swift progress in the spread of this knowledge and technique.

Why do we need such policy directions and regulations?

The stock option plans can have a great bearing not only on the employees but also on the control, governance, accounting, risk, disclosure / reporting and related issues. A one-time offer of shares to employees by which they accept or reject within a stipulated time-period is a simple method. It also would have very simple objectives. The more complex the objectives, the more complex would be the plans and more would be the legal and regulatory issues. Thus, a stock option can achieve several objectives than that of a simple one-time offer.

A stock option is an opportunity to buy stock at a set price, sometime in the future… The term ‘stock option’ means the right or privilege to buy stock under an offer continuing for a stated period of time.

Initial Hurdles

Companies in India, which had introduced employee stock plans and their variants during the period ‘94 till ‘99, had to innovate mechanisms for establishing them under fairly inhospitable legislative structures. In strict terms most of them cannot be called “option” plans because there are no options as such being given by the company, as the law did not facilitate the same. Consequently, these plans were ushered in through an intermediary trust and offered shares or warrants with a service lock-in mechanism. These plans have been called as:

• Equity Scheme,
• Offer Plans,
• Stock Participation Plans and the like

There have also been some instances of stock appreciation rights, shadow stock, or phantom stock being given, particularly where the company is listed in stock exchanges abroad and had to offer an incentive to local executives.

What are the shortcomings of these plans?

These plans in India, so far, have not issued stock options per se but shares, warrants or mere authorizations / promissory notes. Most such plans have also been restricted to a few employees, do not offer any tax advantages to any of the parties nor do they have leveraging possibilities.

They are relatively short term in focus with 3 -10 years as the frame and do not have any link with savings or retirement benefits - save the case of a Public Enterprise which has been operating a mutual benefit plan.

For discussion purposes, considering the schemes in vogue, stock plans may be fitted into a typology as follows:

• Options,
• Shares,
• Warrants.

One - off, Uniform: This will be an offer plan and decisions may be made whether the company would exclude non-performers, trainees and those with little service. Other than that it would be a one-time allotment of equal number of shares or warrants to all at the market value. The new SEBI guidelines in respect of Employee Stock Purchase Plans permit allotment of options below the market price for the shares, subject to accounting for the differential, in the books of the company.

One – off, Differential / Discretionary: While the earlier one can be administered easily, this version has some sensitive decision points. This also would be a one-off scheme but may differentiate allotments by grades, seniority or market value for special skills. If other factors like achievements, potential, loyalty, hard work and contribution to corporate performance are also considered, the discretionary element would go up commensurately.

On – Going Schemes: These serve multiple objectives. They can use a combination of uniform, differential and discretionary allotments dynamically. They may be warrants or shares and can be issued as a “sign-on” bonus, on confirmation, on promotion, on superannuating, on recognition of outstanding contribution, as performance pay, in lieu of compensation and other such conditions. Such award may be to some or all individuals. These types would have a combination of objectives in mind and hence are structured to enable flexibility. A special purpose vehicle like the Trust becomes preferable in such situations for many reasons.

Proxy Shares/Stock – appreciation Rights / Phantom Shares.

 

These are notional units apportioned to employees and are best described as productivity/contribution linked incentive programs than a stock option plan.

Typically, an employee is allotted notional units / shares of the company based on certain criteria at a set price.  The employee will be required to exercise his/her option within a given period, say two years.

The employee may exercise the option when the share price goes up fairly high and will be eligible to draw the differential or the whole in cash (as per the design), on deduction of tax. It is reported that some MNCs have been using this in India.

Also, if in a regular stock option plan, a provision is made to enable the employee to decline the shares and opt for the cash differential between cost of exercise and market price, it would have the effect of a stock appreciation rights / phantom share.

Objectives Of ESOP

The objectives of stock plans have been multiple and diverse. In some instances, while the initial objectives could have been one type there could be emergent objectives consequent to internal and external changes either replacing / modifying the initial objectives or adding to them. For instance, some plans were started as an incentive mechanism for the top team but slowly enlarged the scope to achieving commitment and loyalty among a large population in the company.

The objective of one-time preferential offers (like the 200 shares of the yesteryears) is primarily to:

• Pass on the benefit of possible capital appreciation on a firm basis to employees.

·         In the process, it widened the employee ownership of the company immediately on the one hand and possibly, saved costs in divesting this lot to general public.

The object of widened employee ownership, if that indeed is the case, is not necessarily achieved if the employees traded the stock through innovative mechanisms during the lock-in period or soon after its conclusion. It is in this context that some companies look to re-loading the employees every few years with fresh allotments. In sum, such type of offers which do not discriminate employees on the basis of job worth or performance or skill-premia do not achieve objectives which may be more central to the philosophy of stock options.

The philosophy behind stock plans:

• Aim at promoting the corporate performance on a sustainable basis
• Improve shareholder value through increased market rating of its shares.

In the absence of these, stock options may actually be substitutable by other types of instruments or methods.  The very fact that share prices are the locking mechanism for estimating the benefits underscores the predominant objective of increasing the shareholder value.

Even in the case of unlisted companies, the aim is to make the employees enhance the internal worth of the company in such a way that the valuation would be high when the company eventually goes for listing.

Most stock plans have one or a combination of the following as objectives:

• Employee commitment and a feeling of ownership
• Creating additional wealth for employees.
• To supplement retirement / social security benefits.
• To attract talented / highly valued professionals or scarce skills. Especially if it is the industry norm (i.e., to ensure that absence of stock option plan is not an entry barrier).
• To retain employees or specific skill groups among them, in the face of apprehended high turnover.
• To improve relations with Collectives and pursue common corporate targets.
• As a possible hedge against hostile controlling interests / takeovers (in future).

·         To introduce a Performance Management System without incurring full cash outflow and / or lessening possible individual differences in the immediate cash bonus.

Stock Plan

The objective of improving the employee commitment and ownership is a universal one though difficult to achieve as:

• A stock plan by itself cannot guarantee employee commitment, it can be stated that it would be a strong input in the process.
• There is hardly any substitute to this input and the decision here should be on the basis of the cost-benefits of such a plan than any misgivings about the objective itself.
• There are sufficient indications that employees who have stock options in the company evince greater concern than those without, for the company‘s performance in the stock markets and media.

The object of creating employee wealth has been achieved well in a few firms in the I.T. sector. In India, it is reported that Infosys, Wipro and ZEE have created dozens of millionaires through the stock plan route. However, the expectations connected with this objective also carry a serious threat of disenchantment under adverse conditions of capital markets and corporate recession.  It is known that most of these companies did not have the objective of creating a windfall for their employees as primary but appear to have stumbled into that prospect.

Objectives

• Stock plans can be fitted well as an additional retrial / social security measure in combination with other objectives.
• As most schemes have a vesting period and are also tied with grade levels and length of service, they serve similar purpose as social security benefits for those who are nearing retirement. The public sector companies have designed models that appear to have social security as an objective in addition to others.
• There are also schemes that link savings plans with acquisition of shares in the company. The scheme by the MUL, which has been advocated by the DPE, appears to be close to this objective.
• The fund created for the purpose from employee savings and employers’ contribution may be used for acquisition of the company shares or other shares.

Industry practices in compensation designs have been undergoing major changes and these are being aimed at attracting and retaining special talent.  In this context, insular / rigid policies will bring about a serious barrier for entry of important skills, in addition to the flight of current talent.

The sheer progress of stock option plans in other countries and the competitive sectors in the private fold in India must be seen as precursors.  It is a fact that certain skills are far higher in market value than the others.  This market differentiation has no connection with perspectives of internal equity or the traditional job evaluation.  Though markets may go through the cycles of valuing some skills unreasonably high at one time vis-à-vis others, this differentiation needs to be acknowledged by the corporate. Equity is a dynamic and relative concept and employee perceptions change depending on one’s current position / interest than by any specific logic.  Thus, several companies are establishing stock option plans both to attract highly valued skills as well as to retain the existing ones. The success of the plans in actually attracting or retaining talent is rather difficult to validate. The reason is that if all the competing companies have stock plans then the values implicit in the plans, become more important than the existence of the plan itself. At the same time, when several companies have stock plans, the existence of the plans become important as a hygiene factor.

Making ESOP successful

Some plans have the implicit objective of improved relations with collectives. It is intuitively felt that widely administered stock option plans would increase the areas of cooperation, focus on corporate performance in the long run and give other connected benefits.

The important caveat for the workability of this objective is the faith that can be evoked from the employees in this system.

If there are contentious issues ab initio, there could be possible adverse trades-off. There is, in fact, a fear of worker militancy at AGMs even where the employees in the market have bought stock. Mature companies, which have developed a good internal culture, may find no reason to fear this and would possibly find abundant benefits.  The prospect for this objective is rather doubtful in the private sector at this point in time. However, the Public Sector corporations may have to debate further the merit of this objective and the existence of other ambient conditions to achieve it in good measure. The voting rights become important in this context. Employees do not have voting rights till the shares are transferred in their names. In the case of Trusts as special purpose vehicles, the ”public trustee “comes into the picture as neither the trustees nor the beneficiaries have the right to vote.

In USA, the ESOP has been used to prevent hostile take-overs with the employees tending to support the existing managements. Though such a possibility in India is remote, it is nonetheless an important emerging objective for some. The role of the ““Public trustee” becomes important in such cases.

Factors leading to success

The set of objectives would obviously be different from one organization to the other. If research in the West shows diversity and occasionally unimpressive conclusions on stock option plans, it only points to the need for:

• Proper choice of objectives,
• Design of the plans,
• Their alignment with corporate strategies.

Stock option plans indeed increase the flexibility and repertoire of corporate tactics to meet the new economic compulsions and have little substitutability. It may be affirmed that stock options will soon be a norm in several progressive companies for differing sets of objectives. Concurrent with the above is the other aspect of equity pertaining to performance related payments. Stock option plans are a good mechanism for administering Performance Management Systems and several companies have this as an important reason for choosing the stock option route. The increasing differences in individual performances and acknowledgement of uneven returns from human resources to corporate competitiveness, result in commensurately increasing differentials in performance related pay. As huge differences in cash compensation are unwelcome and also are not necessarily tax-efficient, a good stock option plan may supplement the performance pay as also compensation per se.

Performance Payment

One of the popular objectives of stock option plans has been performance payment. The linkage has been most discernible in the case of senior management. It is reported that in some of the companies in USA, the payment for chief executives through stock options is over three times that of their normal salary. The trend has been to pay senior executives and critical employees for their performance increasingly through stocks. This move helps in several ways.

• Firstly, the cash out-flow for the company would be lower as the stock options would not entail immediate cash payments. The company pays in stock options or warrants for which there is no immediate cost to the company. In fact, eventually, it is the market, which pays for the stock when the employee sells the shares. (The only issue is the contingency of the company having to buy-back the options / shares in future at the fair market value.) However, if there is any concession from the fair market value, the same needs to be reckoned as an expense in the profit & loss accounts – this is as per the SEBI guidelines of June ‘99.

·         Secondly, hefty cash payments would create a feeling of extraordinary differentials between the lowest and the top – in fact, in the Western countries, employees have been vociferous about the growing differentials. The norm that has been accepted is that the ratio should be about 1 : 8 between the lowest paid and the highest. Some experts had even advocated a ratio of 1 : 5 as desirable in the long run.

However, the nineties have witnessed a reverse trend, justified or otherwise. The new thinking is that there need not be any caps to the differentials based on ill-conceived egalitarianism. Instead the need has been recognized for incentivizing top management on the basis of evident contribution to profits. Though huge bonuses to the top management may be justified, they create a sense of relative deprivation among the other employees. Consequently, some organizations have devised a way of awarding stock options to employee as deferred pay in kind and thus lowering the visible component of bonuses. However, the actual quantum of benefit can be realized by the employees only on selling the stock in the market and is subject to the developments at that time.

• Thirdly, such payments in stock reinforce the stake of the employee in the performance of the company and thus may reduce the problems associated with the principal-agent problems.
• Fourthly, the employee has better control over the choices he may make on when to en-cash, the size of the portfolio to be en-cashed and the like after reckoning the tax liabilities and the market movements for the stock prices.
• Fifthly, the options granted for the main purpose of performance reward will achieve other objectives as well – these additional objectives could be those related to retention (as a golden hand-cuff in case there is a service lock-in) and commitment.

Awarding Performance Payment

Performance pay may be awarded in cash or kind or both. This award may be deferred or immediate. Stock Options are typically deferred pay. The quantum of the reward cannot be determined so very accurately in the case of the stocks as is possible for cash payments. The reason for this difficulty arises due to the variable nature of the benefit, which is dependent on the market perceptions for the stock. Most schemes abroad do not envisage any concessions up front for the employees – i.e., the grant price would be the same as the market price.

The real incentives lie in the prospect for the shares. The higher the shares climb in the market the greater would be the benefit for them.

The difficulties in predicting the future benefits impinges on the calculations of the number of shares / options to be awarded. Consequently, the trade-off between the cash element and the stock options are difficult to calculate.

Issues Faced

Almost all organizations in India, which are operating a stock plan for the employees, reckon the need for performance linkage. They award stock / options / warrants on the basis of best guesses as to what would be the optimum for a given level in grade and performance.  The issue faced by most of these companies is not so much with the plan itself as much as the preference of employees for cash in hand as against deferred and uncertain payments.

Employees normally assume that the stock options with all the conditions have been awarded at the cost of bonus in cash. Employees may want to see the up-front concession being given vis-à-vis the market price and whether this is more than their expectation of the equivalent cash reward. This is so because the shares are normally not given free of cost. The challenge for the organizations lies in convincing the employees that there is no trade-off in reality or that such a trade-off is not likely to be adverse to their long-term interests.

Contemplating Stock Option

The SEBI guidelines for the stock option scheme allow for discount up front but this will be reflected in the financial statements as cost. In case a company is contemplating a stock option in lieu of a part of cash payment, the issue would be whether to calculate the number of options on the basis of such discount or whether some part of future increases have also to be reckoned. It may not be easy to give stock options at different rates for different people under the guidelines – primarily as shareholders approvals are necessary.

Further, the guidelines require that information on the award of stock options is reported. Most performance related pay is considered confidential. This requirement under the guidelines insists on greater transparency, which may not be appreciated by several Companies. However, where a company is operating a stock-plan under the trust route and not under the SEBI guidelines, secrecy can be pursued.

Stock options of some organizations:

• Stock appreciation rights and
• The phantom stocks.

Such organizations do not need to follow any guidelines, as such but will be reckoned for tax purposes as applicable. The schemes may be devised in such a way that the critical performance factors are determined in advance and the linkage to the stock prices is established. The employee may be given notional shares on the basis of his / her performance. These may be encashed during the defined exercise period.

The benefit for the employee would be the difference between the price at the time of allotment and the market price on the date of redemption, if the stock prices have gone up.

The money is taxable in the hands of the employee as income. The employee does not bear any cost, as the stock is notional.

Further innovations are possible in linking the performance of the individual with the strategic issues of the company and the share value. The underlying assumption would be that the performance of the individuals should be related to the shareholder value in some way or the other. That is, the organization expects the individual to enhance the shareholder value through his performance in the company.  The idea of linking individual performance to the shareholder value is powerful and is expected to expand in the years to come. The linkage between the two can be established either by a formal stock plan under the SEBI guidelines for ESOS or through preferential allotments to an intermediary trust, or through innovative schemes which may deal with notional instruments only. In any case, the connection itself is important whichever route may serve the company-specific conditions best.

Structure Of The Plans

In the absence of facilitative guidelines till June ‘99, the Indian practice so far has been to create Trusts (Special Purpose Vehicle) and issue either shares or convertible warrants. The warrants may have some perceived initial advantages due to the low cost of funding required for the trust. There are, however, some difficulties that need to be overcome such as the difficulty in apportioning the value of bonus, rights and dividends till such time as they are converted. Some proxy / indexed type of adjustments are envisaged in these cases.  Further, warrants have a problem of ‘roll ability’ as they are to be converted on the stipulated date. The share route has meant funding the trust to enable it to subscribe to the preferential allotment made by the company.

In either case, typically, a Trust is formed under the Indian Trust Act with:

• The company as the settler and
• Independent trustees.

Depending on the intended beneficiaries and volumes of allotment along with the time horizon, the financial needs of the Trust will be determined for administering the plan.  Though a company may give soft loans from its own funds to meet the entire requirement of the Trust, under some conditions, there are possible advantages of the Trust raising loans through other sources with the support of the company (company’s guarantee or back-to-back arrangements or a combination).

What role does the Trust play

• The Trust would typically make an offer to the employee concerned giving him/ her time for accepting the same.  Some schemes provide for exercise of the option within the stipulated exercise period (which could be a few months to two years or so).
• The Trust may have the provision for collecting part of the amount due on acceptance of offer. 
• The earmarked or allotted shares / warrants will be held by the Trust in the beneficial interest of the employee concerned.

There is a lock-in period of 3 to 5 years with the provision that if the employee separates from the service of the company (except in the case of death, medically certified disability or other discretionary conditions) the shares / warrants would be forfeited and reverted to the Trust.  As the shares are not physically transferred to the employee, there is no stamp duty at this stage. Even where the warrants / shares have been transferred in the name of the employee on exercise of option (which could be earlier than the lock-in), there could be a separate agreement / documentation to ensure that the lock-in period is fulfilled.

The Decisions of the Trust

The Trust decides how

• Bonus shares,
• Rights issued and
• Dividends will be passed on to the employee concerned.
• Rights issues for the unallotted portion of shares will require further funding of the Trust if the income accrued is not sufficient.

After the shares are transferred in favor of the employee on his/her fulfilling all terms and conditions, the employee may decide to sell the same in the market. Such sale will attract capital gains tax provision. Consequent to the Finance Act ‘99, the cost of acquisition will reckon the income tax paid by the employee for the difference, if any, between the exercise price and the market price.

The Indian experience is rather limited and yet presents innovate forays into establishing stock plans. There has been a general euphoria with the schemes so far and indications are that there will be great variety and wider usage in the coming years.  This is true of both public as well as the private sectors.

Company A

• Offers employees 1000 share each, at face value.
• Lock-in period of 3 years or 10 years of service.
• If employee leaves, he can sell shares at par value to individual nominated by the board.
• The proposal envisages a part of the shares for implementing general welfare schemes for employees. 
• The employees will have no right to the shares credited their account till superannuation or death.
• This proposal has not yet been implemented.

Company B

• Enables employees to purchase the stock offered by the company at the set price giving them a soft loan with an elongated repayment schedule and keeping the shares as security. 
• Lock-in period is of 3 years and separate documentation / agreements were entered into with such employees.
• A company with an initial grant to enable it to acquire shares contemplated Trust.

Company C

• The Trust was vested with the right to purchase stock from the market or employees if required in the future.
• The employees are required to remit a token sum while accepting the offer and keep the option alive.
• The major objective behind this scheme is to improve the shareholder value.

Company D

• A company in the private sector formed a plan allocating warrants to the freshly created welfare Trust.
• The major objective of the plan is to attract, retain and motivate the best talent.
• It also created an advisory Board with external members to choose employees and make recommendations to the Trust.
• On recommendation of the advisory board, the Trust would transfer warrants to the employees at a nominal sum. 
• The employee is entitled to one-equity share of face value of Rs.10/- each per warrant at an exercise price of Rs.100/- or such amount as may be decided from time to time.
• The exercise period is 12 months to 60 months from the date of issue of warrants. The exercise date has been specified within each year. 
• As a shareholder, the employee will be eligible for dividends, bonus and rights. During the lock-in, the shares registered in the name of the employee would be kept in the safe custody of the Trust.

This plan had the multiple objectives of attraction, retention and also performance management. Though it was initially meant for a limited number of people, it is gathered that the coverage has been growing.

How Does ESOP Work

A Company, which wants to set up an ESOP, can do so by the following ways:

• Create a Trust (Special Purpose Vehicle)
• Give options directly to employees

If it adopts the Trust route, it will have to issue shares or options to the trust, depending upon the number of Options to be given to the employees (as decided by the Compensation committee of the company).

The trust would need funds to buy these shares. For this, the company can either given soft loans from its own funds or the trust can raise loans through other sources to meet its financial requirement. The company can act as a guarantee to the lender to the trust.

With the funds so raised, the trust then acquires shares/options required. The trust can also purchase these shares from the market or employees, if required, in the future.

The trust repays its loans as and when: -

• The employees purchase the options offered and when
• They exercise their options by paying the exercise price.

The Compensation Committee determines the number of options allotted to each employee eligible employee, who would qualify under the plan. The selection of the employees can be based on performance of the employee-indicated by the annual performance appraisal, minimum period of service, present and potential contribution of the employees, and such other factors deemed to be relevant for the success of the company. Number of options per employee can be determined taking into consideration, the grade, level, years of service, salary, etc.

These selections would entirely depend upon the objective of the company for setting up the ESOP.

The options (i.e. a right not an obligation) are granted to the employees, to apply for shares of the company at a predetermine price (i.e. exercise price). The employee can exercise the option only on completion of the vesting period, which is determined by the Compensation Committee. The requirements of vesting would typically be that the employee work with the company for a minimum period till the options becomes exercisable. The employee can exercise the option during the exercise period after vesting, otherwise the options lapse.

The real advantage of ESOPs is because the exercise price remains fixed over the term of the option. So, the employee would exercise his option when the market price of the shares goes substantially high and he would gain on the difference between the market price and exercise price.

Exploring The ESOP Concept

The first step in the process of establishing an ESOP is to develop an idea of the type of plan that will best serve the company's interests. Companies have created ESOPs as an employee retirement plan, for purposes of business continuity, financing, enhanced employee motivation or as a combination. Normally, companies going in for ESOP go through the following process: -

1. Conceptualizing the Scheme

Designing The Specifics

• This is the most critical step in the entire ESOP process. At this stage the management lays down the broad policy and framework of ESOP. Critical issues, which need to be addressed in this phase, are:
• What do we want to achieve from ESOP?
• What kind of risk should the employees take when investing in shares of the Company?
• What should be the percentage holding earmarked for ESOP?
• Should the employees take the risk of investment or should they be issued cashless options?
• What should be the vesting period for option?
• How do we link the performance appraisal process to ESOP entitlement?

Once you have a general picture of the kind of ESOP you want, The actual feasibility of an ESOP needs to be established. Custom-tailored answers to the many questions need to be answered. Who will participate in the plan? How will stock be allocated to participants? What vesting schedule will be adopted and how will distributions of ESOP accounts be handled? How will voting rights is handled?

In the case of a privately held company, the feasibility and design phase of the process is not usually complete until three additional points have been addressed.

First, an independent appraiser must value the firm’s stock before shares are put into the ESOP. Initially, a careful estimate should be prepared for use as a working figure in the feasibility and design process.

Second, the ESOP's effect on existing stockholders should be estimated. Stockholders will want to know how the ESOP will affect the value of their stock and the company's financial condition. Often an ESOP will cause a dilution of their equity interest in the corporation.

Finally, while not a requirement for establishing an ESOP, a plan for meeting the private closely held company's obligations to repurchase the stock of departing employees should be projected. This "repurchase obligation" arises from the fact that in privately held companies, ESOP participants have a put option when leaving the company. Companies may plan for and meet their ESOP repurchase obligation in a variety of ways, including making substantial cash contributions on an annual basis, and buying insurance to cover the plan's obligations. If the likely growth of repurchase obligation over time is projected at the outset, however, the company is in the best possible position to plan for it and design the ESOP accordingly.

2. Financial Modeling

ESOPs have wide financial implications for the company. It has impact on the share capital, share holding pattern, accounting impact, financial commitment (in case of buy-back, cashless options or phantom options). In this phase all these issues are addressed.

3. Employees Interaction

To ensure the success of the scheme, it is necessary that the employees understand the scheme. Their concerns and views should be addressed in the scheme document. Thus it is necessary to interact with the employees to explain them the scheme, clarify their doubts and also incorporate their feedback in the structure of the scheme.

For ESOP to be effective, a regular communication with the employees and transparency in the allotment process is very critical.

4. Drafting of Legal Documents

Putting The ESOP In Place

Typical documents to be drafted are the ESOP scheme, Trust Deed, (in case a Trust is going to administer ESOP), Grant Agreement, Option Certificates, relevant Board and shareholders' resolutions etc.

When the process of analyzing and designing the ESOP is complete, the company will typically have an attorney prepare a formal plan document which will set forth the specific terms and features of the ESOP. An appraiser will then prepare a finished and formal evaluation report, based on data preferably no more than 60 days old at the date the ESOP is created.

Key Decisions

The plan document should include:

• Language addressing the plan's purpose and operation,
• Eligibility requirements,
• Participation requirements,
• Company contributions,
• Investment of plan assets,
• Account allocation formulas,
• Vesting and forfeitures,
• Voting rights and fiduciary responsibilities,
• Distribution rules and put options,
• Employee disclosures, and
• Provisions for plan amendments.

Other key decisions are who will serve as the ESOP's trustee and who will assume the functions of administering the ESOP?

The stock (as well as any other assets) held by the ESOP must actually be held in the name of the trustee, who usually has fiduciary responsibility for the plan's assets. Increasingly, plan sponsors are turning to professional trustees, such as a bank or trust company, although companies sponsoring an ESOP can and do handle this role in-house. The job of ESOP administration is likewise a function, which may be given to a professional administration firm or handled by the sponsor. The administrator is responsible for maintaining all the individual records of the plan in order to keep track of exactly who are the current participants in the plan, what percent is each participant vested, what is the content and value of each participant's account, etc.

On finalization of the legal documents, the company is ready to implement ESOP.

The Black and Scholes Model

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.

In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes Model

1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.

2) European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous Itô process. To understand what a continuous Itô process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An Itô process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.

6) Returns are lognormally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.

Black and Scholes Generalized Model

The Black Scholes Generalized model is suitable for evaluating European style options on instruments which assume to pay a continuous dividend yield during the life of the option. Since an option holder does not receive any cash flows paid from the underlying instrument, this should be reflected in a lower option price in the case of a call or a higher price in the case of a put. The Black Scholes Generalized model provides a solution by subtracting the present value of the continuous cash flow from the price of the underlying instrument. Assumptions under which the formula was derived include:

• the option can only be exercised on the expiry date (European style);
• the underlying instrument does not pay dividends;
• there are no taxes, margins or transaction costs;
• the risk free interest rate is constant;
• the price volatility of the underlying instrument is constant; and
• the price movements of the underlying instrument follow a lognormal distribution.

This Financial CAD function (which is based on the Black Scholes Generalized Model) can be used to work with the following types of instruments:

§  Options on instruments with a continuous dividend yield

§  Options on forwards or futures

§  Options on instruments with no yield

§  Options on spot foreign exchange

Advantages of Black and Scholes

The Black and Scholes option-pricing model presents a number of advantages. The most prevalent advantage is its ease of use. It tells the user what is important not what is important. In other words, it includes the very factors that market analysts look for. Secondly, it does not promise to produce the exact prices that show up in the market, but it does a remarkable job of pricing options that meet all of the assumptions

Rules & Regulations

Companies Act

Issue of stock options requires approval of shareholders by way of a special resolution as per section 81(1 a). This is not applicable for private companies who can issue stock options without shareholder approval but approval by the board of directors.

Income Tax Issues

For employees:

Till recently, the difference between the cost of the share to the employees and market value on the date on which an employee got the share would be taxed as perquisite in addition to capital gains tax payable by the employee on sale of those shares.

However with the recent announcement by the Finance Minister the perquisite tax has been removed. Tax is now payable only at time of sale of shares as capital gains.

Since perquisite tax has been removed employers are not liable for tax deduction at source, thus removing administrative inconvenience.

For the company:

As per SEBI guidelines listed companies have to account for ESOP by treating the same as an expense. As yet there is no clarity whether this expense will be allowed as deductible expense by the Income Tax authorities.

RBI Regulations

ESOP of Overseas Parent Company

Reserve Bank of India permits acquisition of shares of overseas parent Company by employees of the Indian Company subject to the following: -

• The overseas parent Company must hold at least 51% shares in the Indian Company
• The shares must be offered at a concessional rate. The discount can be from the parent or the Indian company.
• The maximum entitlement is US $ 10000 per employee in a block of 5 years. Permission for an individual employee is not required and the monetary limit of USD 10000 does not apply if shares are being offered to the employees in lieu of Bonus.
• In case of a cashless exercise of options the above guidelines do not apply provided gains made by the Indian employee are repatriated to him through normal banking channels immediately.

ADR / GDR Linked ESOPs

There is also a scheme for employees of software companies in India to have ADR/GDR linked stock option plans, which should satisfy the following criteria:

• Companies whose turnover from software activities is not less than 80% can grant stock options to non-resident and resident permanent employees (including Indian and overseas working directors) of the company as well as its subsidiary, but not to promoters and their relatives (as defined in the Companies Act).
• Employees can remit up to U.S. $ 50,000 in a block of five years for acquisition of ADR/GDR and on liquidation of the ADR/GDR holdings the proceed have to be repatriated to India unless permission from RBI is obtained for its retention or use abroad.
• The maximum limit is 10% of issued and paid up equity capital and the maximum discount is 10% to the market price prevailing at the time of issue of the stock option.

 

SEBI Guidelines

The SEBI guidelines are applicable only to companies listed in India and are as follows:

           

Who is covered?

Any employee except the promoter or director (holding more than 10% equity)

Requirements

• Setting up of Compensation Committee of the board, for administration and superintendence of ESOS - the majority being independent directors.
• Shareholder Approval – Any ESOS has to be approved by shareholders, through a special resolution in the general meeting, disclosing to them details about the ESOS like – the total number of options to be granted; identification of classes of employees entitled to participate in the ESOS; requirements of vesting and periods of vesting; the appraisal process for determining the eligibility of employees to the ESOS; maximum number of options to be issued per employee and in aggregate.
• Disclosure in the Director’s Report – The Board of Directors has to disclose all the details of the ESOS including employee-wise details in the Director’s report.
• Compliance with Accounting Policies
• Certificate from Auditors that the scheme has been implemented according to the guidelines and in accordance with the resolution of the company in the general meeting.

Non-variation of terms of ESOS

Terms of the ESOS cannot be varied in any manner, which may harm the interests of the employee. However they may be changed through a special resolution in a general meeting provided the employee has not yet exercised the ESOS.

Pricing

Companies have the freedom to determine the exercise price subject to conforming to the accounting policies specified. Any discount from the fair market value has to be reflected as deferred employee compensation in the accounting entries.

Lock-in period & Rights of the option-holder

The company has the freedom to specify the lock-in period, there being a minimum period of 1 year between the grant of options and vesting of options.

The employee will not enjoy the benefits of a shareholder, till shares are issued on exercise of option

The company, if any, at the time of grant of option may forfeit the amount payable by the employee, if the option is not exercised within the exercise period or may be refunded to the employee if the options are not vested due to non-fulfilment of condition relating to vesting of option as per the ESOS.

Non-transferability of option

Options granted to an employee shall not be transferable to any person. In the event of the death of employee while in employment, all the option granted to him till such date shall vest in the legal heirs or nominees of the deceased employee.

US GAAP

Accounting for Employee Stock Option Plans in accordance with US GAAP is governed by statement No.123 (FAS 123), Accounting for Stock Based Compensation issued by the Financial Accounting Standards Board (FASB) and opinion No.25 (APB25) Accounting for Stock issued to Employees issued by the Accounting Principles Board.

• In the US GAAP Hierarchy FASB statements and interpretations override APB opinions. FAS 123 states that companies issuing stock options must value the options on the date of grant, using a option valuing model, preferably Black Scholes and the value of the option has to be treated as compensation cost, to be recognized over the service period, which is usually the vesting period.
• However, FAS 123 also allows for companies to account for employee stock options using the intrinsic value method prescribed by APB 25. Under the intrinsic value method, compensation cost is the excess of the quoted market price of the shares on the grant date or other measurement date over the exercise price.
• Companies choosing to follow the intrinsic value, method must make Performa disclosures of net income and EPS as if the fair value method prescribed by FAS 123 had been followed.
• In case of variable plans like Stock Appreciation Rights and other plans where the number of shares, exercise price or both are contingent on a future event, the accounting treatments is based on the share price at the balance sheet date. For example, in case of Stock Appreciation Rights with a vesting period of 2 years with grant price being market price on grant date (say Rs.100), entitling the holder to receive the appreciation in market price over the grant in the form of shares.

If the SARs are granted on 1.4.2000 and the market price on 31.3.2000 is Rs.200, then Rs.100 will have to be treated as compensation cost, to be amortized over 2 years.

           

FASB has also issued a final interpretation of APB 25, primarily covering: -

Treatment of equity awards to non-employees

Modifications of existing awards

Terminological Maze in Stock Options

Incentive stock options (ISOs) & Non-qualified stock options (NQSOs):

In U.S.A, the basic difference between the two lies in the tax burden, which is ultimately borne by the employees. There is no regular tax due on an ISO until the option is actually transferred (sold) by the employee for a price higher than the price at which the option was granted. Employee pays tax on capital gains.

On the other hand, the tax incidence in case of NQSOs is greater. When the option is exercised, the employee has to pay normal taxes on the difference between the option price and the prevailing market price. Secondly, when such shares / stock are sold, there is an incidence of tax on capital gains.

Phantom Stock:

A phantom stock is a bonus that rewards employees based on the value of the company’s stock and the dividend performance of the stock.

               

Discount Stock Option:

A stock option with an exercise price, which is less than the fair market value as on the sale of the grant.

         

Indexed Stock Option:

A stock option with an exercise price equal to the fair market value at grant but the price adjusts upward or downward depending on an index, such as in relation to the market, industry, or peer group performance or some other measure.         

Performance Accelerated Stock Option:

A stock option that has a fair market value exercise price and a service-based vesting schedule (usually longer than traditional options which are generally of a tenure of 10 years) , but which will become exercisable at an earlier date if the specified performance goals are achieved.

Performance Contingent Stock Option:

A stock option that has a fair market value exercise price, but which will become exercisable only if the specified performance goals are achieved. If such goals are not achieved the option lapses.  

Purchased Stock Option:

A stock option that requires the optionees to make a down payment (usually expressed as a percentage of the market price) within a short period of time after grant and before the option may be exercised. Typically, the exercise price may be set below the fair market value to reflect the amount of the down payment. However, the down payment cannot be recovered if the option is not exercised.

         

Reload / Restoration Stock Option:

A stock option that is automatically granted upon the exercise of a previously granted stock option to the extent that the optionee uses shares rather than cash to pay the purchase price of the original option. Typically, the exercise price of the reload option is the fair market value on the date of the grant and the reload option expires on the same date as the original option.

Variable Priced Stock Option:

A stock option with an exercise price that fluctuates upward or downward in relation to stock price performance. Also known as a “Yo-Yo Stock Option”, it is a kind of Indexed Stock Option.

               

Premium Stock Option:

A stock option with an exercise price that is greater than the fair market value on date of grant. Premium options are those, which are issued with an exercise price, which is fixed at grant, but exceeds the fair market value of the stock on the date of grant.