Making employees a stakeholder in the company's growth is not easy. One way companies do this is Employee Stock Options or ESOPs , which give employees the option to buy a certain number of shares of the company at a pre-decided price.
"Though information technology (IT) firms started the trend, companies in many sectors such as banking, financial services, manufacturing, consumer goods and capital goods are now giving ESOPs to employees," says Anil Rego, CEO and Founder, Right Horizons.
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ESOPs have a vesting period during which they cannot be exercised. The grant price is usually determined by averaging the stock's market price for a period, let's say, a month before the issue date. It could also be the average market price on the issue date. "There is also a provision under which companies can offer ESOPs at below the market price. But for that they have to do some changes in their books. So, it's not common practice," says Rego.
Most companies give ESOPs over a period. "They are structured in a way that they are exercised over three-five years. This is to ensure that the employees remain with the company for a longer period," says Rego.
Timing It Right
Exercising the options makes sense only if the market price of the stock is more than the grant price. Else, you need not do anything. "ESOPs should ideally be exercised at a lower price as the amount the employee has to pay at this stage depends on the market value of the shares on that day. The tax outgo also depends on that, affecting the cash flow," says Rego.
After you exercise the option , you have to pay tax on the difference between the exercise price and the fair market value of the stock (average of opening and closing prices). At present, ESOPs are taxable as perquisites (salary income) in the hands of employees. The value is the difference between the fair market price of the stock on the day the option is exercised and the price at which it is exercised.
For listed companies, the market price on the exercise day is usually considered as the fair market value. For non-listed companies, the fair market value is determined by a Category I merchant banker registered with the Securities and Exchange Board of India, the stock market regulator.
If you sell the shares after they are credited to your account, the capital gain, that is, the difference between the sale price and the fair market value on the exercise date is taxable in your hands. In such a case, the taxation rules are the same as that on sale and purchase of stocks from the market. This means if the shares are sold within one year of the allotment, you will have to pay 15% short-term capital gains tax. There is no tax if you sell after holding the shares for more than a year.
Let's see how an employee can gain from ESOPs. On April 1 2010, suppose the company grants him 100 shares, at an exercise price of Rs 100 per share, which is also the market price that day. Let's assume that the vesting period is two years. At any point after 1 April 2012, he can pay Rs 100 a share and get the shares. If the market price on 1 August 2012 is Rs 200, he can sell the shares and make a neat profit. However, if the market price is Rs 50, he need not exercise the option. He can instead wait for the stock price to rise.
"It is advisable to exercise ESOPs in a phased manner. Employees must decide the levels at which they want to exercise the option," says Rego. They must seek advice from a financial consultant for this.
Grant date - The date on which the options are granted.
Option price - The price at which the shares are offered. It is also known as ‘strike price’ or ‘grant price’. Normally, it is below the market value/fair value of the shares on the date of grant.
Exercise period - The period within which the employees must exercise the option.
ESOPs were the harbinger of good times in the 1990s, when a large number of IT companies allotted them to employees and helped them take part in their growth, making many of them millionaires. Take the case of Infosys, the first Indian company to issue ESOPs. The company, started in 1981, is known to have given away Rs 50,000 crore worth of ESOPs to employees since inception. In the 1990s, it allotted ESOPs in three tranches, at Rs 50 a share. By 2000s, thousands of employees had become millionaires by encashing these when the stock was at Rs 7,000.
The interest in ESOPs did not last long as the gains depended on the market prices of the shares. The dot.com bubble triggered a dramatic fall in IT stocks and ESOPs worth millions became dud. Infosys, too, discontinued the scheme in 2003-2004 citing lack of employee participation and difficulties in account reconciliation. "Despite this, ESOPs have never really lost sheen and continue to be preferred by companies and employees as a source of remuneration," says Harshu Ghate, co-Founder and CEO, ESOP Direct, which works in the field of equity compensation.Pros & Cons
ESOPs can work wonders, says Ghate, as their value can be much more than the employee's annual income. For senior executives such as CEOs, over a period, the value of ESOPs could be much more than the other salary components put together. "Also, employees opting for ESOPs are not taking any risk as the money is paid only when the option is exercised. They can exercise the options if the market price of the shares is high and sell immediately. Otherwise, they can just let the option lapse," says Ghate.Watch Out
There are multiple factors that must be considered while signing up for ESOPs. They may not be good for the risk-averse as they are linked to the stock markets, which are volatile. "They may also not suit someone looking for liquidity in the near term," says Rego. Similarly, the perquisite tax on exercising the options and capital gains tax if sold within a year could be a drain on your finances, especially if the amount is big.
A: QUESTIONS YOU MUST ASK
IS AN ESOP SCHEME IN PLACE?
Also, when will you be entitled to it? Don’t rely on just a verbal commitment. Ask whether the shareholders and the board have approved the scheme. ESOPs are decided by the company’s compensation committee.
QUANTUM OF OPTIONS YOU WILL GET
There are times when it is not defined accurately. Ambiguity could lead to misunderstanding.
THE VALUE OF THE OPTIONS
The ESOPs do not usually have value on the grant date (if issued at the market price). These become valuable only if the stock rises in the vesting period. Hence, the valuation should be based on expectation of the stock price movement.
LIQUIDITY AND VALUATION OF SHARES
For listed companies, pricing is an issue, as their stock prices do not move in sync with performance. For unlisted companies, the problem is lack of liquidity and clarity on valuation. That is why companies must mention all exit options clearly at the time of grant. For instance, if the initial public offer is the only exit route, it must be stated clearly and the potential uncertainties related to listing brought to the employee’s attention.
B. LISTED FIRMS PAY MORE
Companies see ESOPs as a motivational tool. Employees who accept ESOPs are likely to have a greater sense of ownership than those who don’t sign up. “Driving performance, sharing of wealth with employees and inculcating an ownership culture are some of the objectives of ESOP schemes,” says Ghate of ESOP Direct. However, not all levels of employees are given ESOPs. An ESOP Direct survey of equity compensation trends of 2011 found that ESOPs as an award are not broad-based in India, unlike in global corporations. The senior management on an average gets 63% allocation, of which the CEO/CXO gets nearly 27%. The survey also highlights that the ESOP compensation depends on whether the company is listed or not. At least 68% listed companies and 29% unlisted companies give ESOP benefits amounting to less than the cost to company. Start-ups were found to offer more, around twice the cost to company. According to a recent survey, Global Equity Incentives, by PwC and the National Association of Stock Plan Professionals, the need to attract and retain talent made India Inc give 35% more equity grants in 2012 compared with 2011.