The scheme should aim at improving company performance and vesting of options should be linked to that performance
Equity-based compensation in the form of ESOPs or any similar form is often looked at and evaluated as a compensation tool. The decision-making often is restricted to how much an employee makes from it. However, the fact that there are other stakeholders in this initiative is often ignored.
Any equity-based compensation scheme has three prominent stakeholders apart from the employee – Shareholders, Regulators and the Compensation committee or the Management. Each of them has their respective views and perspectives about such schemes. Unless the aspirations of each of the stakeholders are addressed, the scheme is unlikely to take off.
As a shareholder, I would want the lowest possible dilution in my stake (value as well as % holding) as larger the number of shares that are issued, higher the dilution will be. I will also not like it if the company were to hurt its profitability by taking an accounting charge of such a scheme. If the company issues ESOPs to employees at a discount to grant date market price, the discount has to be accounted for as a charge to profits over the vesting period. Both these factors (more shares and lower profits) adversely impact company’s Earnings Per Share (EPS) and hence the market price. As a shareholder, that is the last thing I would want.
I would also expect that the program aims at improving company performance and vesting of options should be linked to that improved performance. Improved market price (result of improved performance) will partially compensate the cost of dilution.
As a regulator, I would like to ensure that the instrument is not misused by the promoters to increase their shareholding or by the senior management to get exorbitant allocations of grant. I would expect companies to disclose as many details about their schemes and options as possible to the stock exchanges and shareholders to ensure transparency. I would also expect that the company management does not take its employees for a ride and is always fair and reasonable by not altering the grant terms unfavorably for the employee. The revenue will expect controls to ensure taxes are appropriately collected and paid on the gains made.
The compensation committee or the senior management, which is responsible for administering the schemes, would like to ensure that the plan objectives of attraction of talent, retention, reward and improved corporate performance are achieved. The Board will expect that best practices in corporate governance are implemented and necessary compliances are adhered to.
As a beneficiary employee, I will expect clarity in terms and conditions and what is expected of me. I will also prefer an instrument where I am not penalized (inconsistent stock price movements) in spite of delivering performance and whatever is expected of me and that I’m able to unlock the value of whatever is offered to me. It does not serve my purpose if my gains will always be on paper.
As a process owner, it is critical for us to know that unless these expectations from all the stakeholders are optimized (they may not be entirely met), the scheme will not be a success. If the scheme is too employee friendly (for instance ESOPs are given at a deep discounted price), the shareholders will not approve it. At the same time, a scheme entailing too few shares / benefit to employees (to ensure low dilution) will not be attractive for employees and will not take off. However, it is possible to optimize on these expectations. For instance, zero dilution can be achieved by resorting to purchase of shares from the secondary market. A discounted price to employees can be justified if the vesting is linked to corporate performance.
Some of the typical trade-offs that need to be addressed while designing the scheme are (i) dilution vis-à-vis accounting charge (options at a discount mean lower dilution but carry accounting charge), (ii) coverage vis-à-vis quantum (given the limited pool, you cannot cover more and still give substantial benefit) (iii) phantom plan vis-à-vis equity backed scheme (phantom will avoid dilution but entail heavy cash outflows whereas equity backed scheme will entail dilution but zero cash outgo, as the market will pay for it).
The skill is in optimizing and finding the midway route, which will address most of the stakeholder expectations, if not all.