The best part of ESOP as a compensation strategy is that it offers freedom to link employee reward with individual performance and companys performance
When cash is scarce and stock is readily available, ESOPs are a popular choice, as seen in case of startups that use ESOPs as their primary tool to reward their strategic and key talent
Employee Stock Options (ESOPs in common parlance) and its variants (Stock grants, stock purchase plans, restricted stock) as an employee reward measure have been used off and on by organizations over the years. We hear and read about the successful use of ESOPs to attract, retain and reward talent by companies like Google, Apple, Facebook and predominantly by Indian companies such as Flipkart, Paytm, Snapdeal, Infosys, L&T and ICICI. Information technology companies pioneered the adoption of stock-based incentive plans in India and continue to lead but companies in other sectors such as manufacturing and consumer goods are also actively using ESOPs as part of their talent management and reward strategy.
The inspiration for an employee to seek participation in an ESOP is the potential to earn wealth many more times the current compensation; and for the employer, it serves the purpose of golden cuffs – keeping the employee in the organization in anticipation of the wealth that ESOPs promise.
What is an ESOP and how does it work?
The market is abuzz with different varieties of stock-based incentives like ESOPs, stock appreciation rights, restricted stock units, stock purchase plan. Stock appreciation rights give employees the monetary equivalent of increase in share price over a specified time. In a scheme of restricted stock units, instead of awarding an option to the employee to buy the shares, the employer awards him shares upfront, subject to certain conditions to be fulfilled over the vesting period before the recipient becomes an outright owner. Stock purchase plans give the employees an opportunity to buy shares at a discounted price. Restricted stock and stock purchase plans are popular in the US and UK and in India, ESOP and stock appreciation rights still find favour.
An ESOP in its simplest form is a promise to an employee to get a share of the company at a pre-determined price over a specified period of time and typically consists of three stages – grant, vesting and exercise. Two or more of these stages may take place simultaneously depending on the type of plan. At the grant stage, an employee is provided with an option to receive shares of the company upon satisfying specified performance or other criteria over the vesting period and does not receive actual shares at this stage. If the employee satisfies the prescribed parameters during the vesting period, (s)he can exercise the ESOP and opt to receive the shares. On exercise of ESOP, the employee receives shares of the company on payment of a pre-agreed exercise price (which is generally discounted to the market price of the shares on the date of exercise). When the shares are sold by the employee at a later date, (s)he can make gains on sale of shares.
Why ESOPs find favour –key factors at play
In recent times, the talent market is experiencing increasing levels of employee mobility and competition for talent. As a result, it becomes imperative for organizations to adopt a rewards framework which is able to retain and motivate key talent, focuses on paying employees for their performance, ensures business growth, finds favour with shareholders and is also competitive with market practices.
The best part of ESOP as a compensation strategy is that it offers freedom to link employee reward with individual performance and company performance. Some of the other advantages of an ESOP are its self-funding capability and deductibility of ESOP costs while computing taxable profits of the company.
When cash is scarce and stock is readily available, ESOPs make a lot of sense, thus it is not surprising that startups which are desperate to attract the best talent opt for ESOPs as their primary tool to reward their strategic and key talent.
For employees, where on the one hand ESOP is a tangible monetary reward, on the other the ability to split tax over two stages becomes an added advantage. The ability of ESOP plans to meet the needs of most stakeholders has brought the spotlight back on them. But as ESOPs become the favourite compensation mechanism among companies, companies should also watch out for the increased public sensitivity around offering stock based rewards and the evolving regulation around ESOPs, as non-compliance with regulations is the worst nightmare for any company.
ESOPs under spotlight of the regulators
The landscape around regulations governing ESOPs has evolved in recent times in lieu of media stories on options backdating by Apple and the fiasco of the Redbus ESOP, and thus, regulators have shifted focus to corporate governance and transparency in disclosures.
With the new ESOP Regulations, SEBI has re-looked at the use of trusts for issue of ESOPs, permitted acquisition of shares from secondary market subject to limits and conditions. SEBI also brought in contra trade provisions i.e. purchase and sale of a share within six months for employees and directors under the SEBI (Prohibition of Insider Trading Regulation), 2015.
A smart strategy to implement ESOPs
A problem with ESOPs often has been their inability to demonstrate a connection between employee’s own performance and the company’s performance. Often, employees below the executive level cannot see the connection and hence do not value ESOPs. Also, ESOPs do not have an immediate spendable value because of vesting restrictions and therefore may not appeal the larger set of employees. Proper choice of employees and proper communication of the value the ESOP plans uphold is the key to a winning ESOP plan. Thus, the communication strategy should clearly show the employee how the ESOP plan will translate into a tangible benefit over a finite number of years for him.
Pricing of ESOP can act as a deal breaker if not planned strategically. An excessively high exercise price may reduce the perceived gain for the employee and will lose out on its motivational value for the employee. A low exercise price may increase tax cost for the employee and thus render the plan unattractive. An appropriate pricing strategy would also impact cost booked in financial statements and earnings per share which is an important consideration for shareholders besides dilution.
A robust exit strategy is necessary for the success of an ESOP since an employee should be able to encash his/her wealth, while ESOP plans of listed companies provide a seamless exit, in unlisted companies,ESOP exit will work best when funded by company getting listed or through a new investors coming in. In case these events are stalled for some reason, a good ESOP plan must always provide for an exit which could be by way of company arranging a buy back at the current market value. Well-planned exit from an ESOP ensures employee confidence and trust in the success of the ESOP plan as a reward and retention strategy.
There is no one-size-fits all approach while designing a long term incentive strategy for the company and every company has to keep the needs of its stakeholders in mind while designing the right ESOP strategy. ESOPs definitely work in favor but need a well thought out feasibility planning and roadmap for successful implementation.