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The Rediff Business Special/Murali Iyer

Time was when an employee who dreamed of becoming a shareholder in a company had to either buy his firm's scrips from the open market or apply for the employee quota during the initial public offering, or IPO. But, in this scenario, the employee's status was the same as that of an ordinary shareholder. Ownership of the company's stock did not amount to recognition of his performance or potential.

Times, however, are rapidly changing. The hands-off attitude of the management is undergoing a transformation for the better. And the latest buzzword in corporate corridors is employee stock option plans, or ESOPs.

The ESOP concept

This is the philosophy of sharing wealth with the employees. It encourages ownership behaviour/feeling among them. It is also a tool to motivate employees to perform better and to retain talented hands in times when employee turnover is a norm rather than an exception.

With employees owning stocks in the companies they work in, their performance would directly result in better prices for the stock. This can, thus, be a major source of capital gains for them.

ESOPs are slightly different from other employee benefit plans offered by companies to motivate their employees. ESOPs are seen as an essential tool by companies to retain their employees, particularly those at higher levels.

On the flip side, when used as a binder to retain employees alone, ESOPs can be counter-productive, especially at the junior level.

However, ESOPs have come to be seen more as a part of employee expectations in an intensively competitive job market, particularly in knowledge-based industries, than a tool that companies can use to their advantage.

New-age companies -- infotech, media, communications - are the breeding ground for ESOPs, as this is where employee turnover levels are the highest. But, brick-and-mortar companies too are also viewing ESOPs as an essential part of their long-term plans.

As corporates begin to realise the need to retain their best pool of intellectual capital, the issuance of ESOPs is likely to burgeon. With India being talked about as the hotbed of the new-age technologies, ESOPs have become the corporate mantra.

The success of this management technique to attract and retain talent is quite apparent: along with phenomenal pay packets given to the creme de la creme of b-schools, ESOPs are also on offer.

New-age start-ups are offering ESOPs as a major incentive and brick-and-mortar companies are gobbling them up in the face of standard salary and incentive schemes on offer.

Attracting talent, motivating employees and retaining the talent pool are major uses of ESOPs in India.

Overseas, ESOPs often result in employees buying over a company when the original promoter relinquishes charge. Internationally, corporates also use ESOPs for a variety of other uses in corporate finance such as funding expansions, making acquisitions, spinning off a division as a separate company, and taking a company private.

This phenomenon has yet to catch on in India. But as the Indian economy blends with the global scale of operations, it is just a matter of time before companies begin to put ESOPs to other uses, too.

Allocation, eligibility and holding period

Companies allocate stock options or ESOPs depending upon various factors such as compensation, service with the company, bonus factor, etc.

All of these - individually or together -- are used by companies when deciding upon the ESOPs factor. In case of new-age companies or start-ups, ESOPs are being used as bait for joining up in the growth of the company.

ESOPs are granted to the prospective employee at the time of joining itself. (There is this hilarious case of a new-age dot-com company where at the time of the meeting, a contributor to this content-rich site asked for stock options along with the normal 'per-article' payment as his remuneration.)

In other cases, an employee might become eligible on completion of one year of service with the company.

Ideally, ESOPs are designed to maximise returns for the employee. By this logic, those that offer capital appreciation potential and reasonable liquidity ought to be a thumping success. But various conditions imposed by companies can also lower the returns for an employee.

Typically, the maturity period for ESOPs is three to five years - allowing the company issuing ESOPs to retain talent and show an upward trend in its earnings graph. But ESOPs have also been issued by companies where there is a provision for employees to offload a certain percentage of their ESOPs in the very first year itself.

The balance is then spread out over the remaining period of maturity, with the bulk of the options to be encashed at the end of three or five years from allotment. This lock-in period is fixed so that it acts as a deterrent to employees wanting to change jobs. In case an employee does jump ship, then he can at least cash in on some of his earnings.

Some companies also structure ESOP in such a manner that no dividend is paid during the tenure of the lock-in.

Tax issues

While SEBI made some clarifications in the guidelines for ESOPs, companies and employees were not very clear on the treatment that would be given to ESOPs, as it is still a relatively new concept in India.

There was some ambiguity on tax implications, both for companies and employees. There was also a divide on whether the employee should be taxed at the time of availing the ESOP or at the time of sale of securities.

The Union Budget '99 contended that stock options would be taxed as a perquisite at the time of exercise of the option by the employee, and subsequently as capital gains at the time of the sale of security.

Recently, two senior employees of Zee Telefilms have moved court against the Central Board of Direct Taxes, or CBDT, as they contend that ESOPs are basically perquisites, being given in lieu of actual compensation and, as such, cannot be taxed at the time of vesting of or exercising the option.

They also contend that any increase in the stock price does not really accrues to the employee, as he is still holding on to the asset. The employees of Zee have a valid argument as they were offered shares at a price of Rs 212 as against the then ruling price of about Rs 1,100 (on the par value of Rs 10).

The shares have a lock-in period during which they cannot be sold. The stock currently trades at a price of around Rs 750 on a par value of Re 1. They have also contended that no dividend is paid during the lock-in period and any income accruing to such shareholders comes only after the lock-in period.

The CBDT has taken a line that they can levy a tax of 33 per cent on the difference between the option price and the then ruling market price.

Parliament recently cleared certain modifications to Union Budget 2000, wherein it has been made clear that ESOPs would not be taxed as a perquisite at the time of exercise of the option by the employee, but only as capital gains at the time of the sale of securities.

This would also bring to an end the fight between employees of Zee and CBDT. However, what has not been mentioned is whether employees, who have paid tax on ESOPs as per CBDT's directives, are liable to get a refund on the same.

Such a directive would bring cheer to employees of a lot of companies, who after having paid tax are actually incurring a loss as the share prices have crashed below the option price.

For companies, it is basically an accounting problem. Employees make their profits by exercising their options, but the companies do not record any compensation expense.

The other issues that need to be settled relate to the determination of the total compensation cost and the period over which this needs to be used.

Experts contend that as ESOPs are still in a nascent stage in India, they should be valued using appropriate pricing models, and the compensation expense should be reflected in the profit & loss account.

Lately, companies have started to treat the difference between the option price and the existing market price as an expense to be written-off over time. This could be the time between the granting of options and the time when they would be allowed to be sold in the open market, or a definitive time-frame of three or five years.

For instance, say VisualSoft issues ESOPs to its employees at a price of Rs 10 as against the current market price of Rs 7,000. The difference of Rs 6,990 would be written-off as an expense in the books of VisualSoft over a period of three years, i.e. Rs 2,330 each year multiplied by the number of shares allotted via ESOPs.

Looking ahead

With the passage of time, ESOPs will gain importance in all industries in India. Attracting and retaining talent has been the bane of employers and ESOPs offer them a very good option to do exactly that.

Already brick-and-mortar companies like Reliance Industries and Mahindra & Mahindra have joined the ranks of the ICE (infotech, communications, entertainment - the three components of the convergence technologies) companies in offering stock options to their key employees.

Meanwhile, the Saurashtra Cements group is contemplating awarding its dealers and distributors with stock options to reward them for their loyalty and also as an incentive for achieving higher sales.

This is an interesting move considering that earlier companies only used to allot shares on a preferential basis to dealers and distributors during the IPOs. This stock option scheme would mean that dealers are being recognised for their performance.

Ordinary shareholders will benefit in the same manner as with the awarding of ESOPs to employees better results can be achieved. Better results translate into better stock prices and dividends, not to mention also better capital appreciation for employees and dealers. The story comes a full circle here. May their tribe increase!

Definitions under SEBI guidelines

As the capital market watchdog on securities transactions and issuance, the Securities and Exchange Board of India, or SEBI, has formulated guidelines for the issue and maintenance of ESOPs. They have been formulated under Section 11 of the SEBI Act, 1992.

These guidelines, called SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999, apply to any company whose shares are listed on any of the recognised stock exchanges in India.

Some of the points have been elucidated hereunder:
A) Definitions:
i) "Employee" means:
a) A permanent employee of the company working in India or out of India; or
b) A director of the company -- whether a whole-time director or not; or
c) An employee as defined in sub-clauses (a) and (b) of a subsidiary, in India or out of India, or a holding company of the company.
ii) "Employee compensation" means the total cost incurred by the company towards employee compensation, including basic salary, dearness allowance, other allowances, bonus and commissions, but does not include :
a) The fair value of an option granted under an employee stock option scheme; and
b) The discount at which shares are issued under an employee stock purchase scheme.
iii) "Employee stock option scheme (ESOS)" means a scheme under which a company grants option to employees.
iv) "Employee stock purchase scheme (ESPS)" means a scheme under which the company offers shares to employees as part of a public issue or otherwise.
v) "Exercise" means making of an application by the employee to the company for issue of shares against options vested in him / her in pursuance of the ESOS.
vi) "Exercise period" means the time period after vesting within which the employee should exercise his right to apply for shares against the option vested in him / her in pursuance of the ESOS.
vii) "Exercise price" means the price payable by the employee for exercising the option granted to him / her in pursuance of the ESOS.
viii) "Grant" means issue of option to employees under ESOS. ix) "Independent director" means a director of the company not being a whole-time director and who is neither a promoter nor belongs to the promoter group.
x) "Market price" of a share on a given date means the closing price of the shares on that date on the stock exchange on which the shares of the company are listed.
(If the shares of the company are listed on more than one stock exchange, but quoted on only one on the given date, then the price on that stock exchange will be considered. If the share price is quoted on more than one stock exchange, then the stock exchange where there is the highest trading volume on the given date will be considered. If there is no quotation on the given date, then the trading price on the next trading day will be considered.)
xi) "Option" means a right but not an obligation granted to an employee in pursuance of ESOS to apply for shares of the company at a pre-determined price.
xii) "Promoter" means :
a) The person or persons who are in overall control of the company;
b) The person or persons who are instrumental in the formation of the company or the programme pursuant to which the shares were offered to the public;
c) The person or persons mentioned in the offer document as promoter(s), provided that a director or officer of the company, if they are acting as such only in their professional capacity, will not be deemed to be a promoter. (Where a promoter is a body corporate, the promoters of that body corporate shall also be deemed as promoters of the company.)
xiii) "Promoter group" means:
a) An immediate relative of the promoter (i.e. spouse of that person, or any parent, or any siblings - brother(s) or sister(s), or child of the person or of the spouse);
b) Persons whose shareholding is aggregated for the purpose of disclosing in the offer document "shareholding of the promoter group".
xiv) "Share" means equity shares and securities convertible into equity shares and include American Depository Receipts / Shares, or ADRs / ADSs, Global Depository Receipts, or GDRs, or other depository receipts representing underlying equity shares or securities convertible into equity shares.
xv) "Vesting" means the process by which the employee is given the right to apply for shares of the company against the option granted to him/her in pursuance of the ESOS.
xvi) "Vesting period" means the period during which the vesting of the option granted to the employee in pursuance of the ESOS takes place.

B) All other expressions unless specified in the above have the same meaning as have been assigned to them under the SEBI Act, 1992, or the Securities Contracts (Regulation) Act, 1956, or the Companies Act, 1956, SEBI (Disclosure and Investor Protection) Guidelines, or any other statutory modification or re-enactment thereof, as the case may be.

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