Employee Stock Option Plan An Overview

N. N. Akhouri Sr.VP-HRM Hero Honda Motors

The flow..
Concept of ESOP Trend of ESOPs Employer experience-Some facts Type of ESOPs Governance Issues Infosys and Dr. Reddy Lab Example Taxability Disadvantage of ESOP Future of Stock option
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Concept of ESOP
In vogue for over a decade in India. Definition according to SEBI Plan under which company provides options to the employees the benefit or the right to purchase at a future date the securities offered by the company at a pre determined price. Introduced initially in technology based companies and now spread over Pharmaceutical, Communication, Entertainment, information technology sectors. In 1992, only One million employees held stock options, mostly managers and executives. By mid-1990s, growing steadily over the decade to 10 million. Infosys, HLL, WIPRO, Polaris, Dr Reddy, Ranbaxy, Wockhardt, Lupin, Gillette.have introduced this.
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Objective 0f ESOP
Retention tool and bring in a sense of commitment. Form of Compensation/reward. Creating a vibrant ownership culture. Improvement in indvidual and group performance. Loyalty due to ownership factor.

Methodology
Grant of options to the employees. Employees can convert the options in to shares at a pre determined price. Disposal of share in the market after a specified period of time as stipulated by the company. Exercise price (price which the employee is required to pay) or the intrinsic price ( difference between market price and exercise price).

Global Trend
Russia: Average ownership by non management employees is between 50%-60%.Employees prefer to hold the stock than sell them. China: Many enterprise have offered ESOP. Several local companies have sold their enterprises to the employees. UK: Has been in place since 1980s. Aims at broad ownership of the employees. US: Started in the late 70s. Several enterprises where employees hold 2-3% in the firms.

Employer Experience some facts

According to survey conducted by Hewitt the following were the findings: Companies which had ESOP had a greater ROA (return of asset) compared to industry peer group. Greater total Shareholder return compared to peer group. Greater employee impact on the Business results. Looking at 345 companies world wide , 69.6% survived through 1999, compared to 54.8% of the non-ESOP matches. "Survival" here means continued to do business as the same entity. Closing, sale, or merger would constitute non-survival.
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Types of ESOPs
Option: Right of the employee to buy or sell the shares at a pre determined price and predetermined date. Restricted Stock: Shares given with vesting conditions. (Vesting percentage refers to that portion of total options granted, which you will be eligible to exercise. Vesting period is the period on the completion of which the said portion can be exercised) Stock appreciation: The employee receives the net amount of the increase in the stock price.

Governance Issues
ESOPs to be approved by the shareholders during the meeting. ESOPs can be issued for ADR/GDR or securities convertible in to shares. Minimum period of 1 yr between grant of option and the vesting period and a max period of 8 yrs. The scheme to be administered through the compensation committee. Taxed as a benefit, recovered from the employee. Accounting of the stock option happens at the time they are granted to the employees. Company to have a taxable expense at the time when the employee sells the stock.
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Governance Issues
Board of Directors to disclose the following information: Total number of shares covered by the ESOP scheme as approved by the shareholders. Pricing Formulae Options granted Options exercised. Employee wise details of options granted to the personnel. The accounting value of the options to be treated as employee compensation in financial statement.

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Example: Infosys
One of the first companies to introduce ESOP Objective: *Wealth creation opportunity . *Long term reward proposition. ESOP -1999 plan If the employee leaves before the lock in period, the shares are sold back to the trust. Vesting pattern is back loaded and is fairly long term: a)1st yr-10% return b)2nd yr- 20% return c) 3rd yr-30% return. (Black Scholes valuation method) : Expected life:2-5 yrs. Risk free interest: 6% Volatility: 60%-70% Dividend yield: 0.2% Have opted for the ESOP trust which obtains its funds by way of loan and then allots the shares to the employee.

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Example: Dr. Reddy Lab

Rationale for introducing ESOP: Retention, Wealth creation and Wealth sharing, Rewarding High Performers The lock in period is one year after which the employee can exercises 25% of the options every year. Has been implemented so as to cover about 25% of employees The Result : The company has not been able to fully achieve the intended objective of employee retention through ESOP. Most employees during switch (from one Company to another) are asking for the 'lost value in not exercising options' to be reimbursed by the hiring Company. Internally , employees have rated 8/10 for ESOP...amongst various employee reward recognition mechanisms...including PMS. The problem has a unique dimension with respect to Pharma companies since the FBT for employee related benefits and expenses is different in this sector.
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Taxability
Prior to April 1, 1999 - No specific provision on taxability of ESOPs April 1, 1999 to March 31, 2000 - Specific provision - Section 17(2)(iiia) inserted in the Income Tax Act, 1961 (Act) to tax benefit on exercise/allotment of shares issued free of cost or at concessional price April 1, 2000 upto March 31, 2007 Section 17(2)(iiia) was withdrawn and following proviso to Section 17(2)(iii) inserted: Single point taxation at the time of sale of shares in case of ESOP compliant with Central Government guidelines Character of income Capital Gains in the hands of the employee No responsibility on the employer to report and/or withhold tax April 2007 onwards- FBT at the time of allotment and tax to employees as capital gain at the time sales.
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Disadvantage of ESOPs
Any fluctuation in the market prices. there is a tendency to offload the ESOPs. It defeats the very purpose of:
Ownership (as employees sell the allotted quota); Retention (as employees switch jobs and get compensated for the lost value by the new employer);

Inbuilt uncertainty due to fluctuating stock prices. When the stock prices go down, ESOP becomes worthless paper
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Future of Stock option

Increasing volatility in stock market .beyond companies control . Employee stock purchase plan-ESPS (plan under which the company offers shares to employees as part of public issue or otherwise) preferred to ESOPs which provides immediate gratification. Need to develop innovative and secure options for employees ESOP in combination with other reward to be looked as a holistic measure.
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Thank You for your attention

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