Article: How to make employee stock options work

#TotalRewards

How to make employee stock options work

ESOPs have steadily gained acceptance and popularity in India, not only among corporate management but also among the beneficiaries, the employees
 

The reality is that stock markets are not always on a high

 

The key is how does the company management educate employees that ESOPs work even when market fluctuates

 

ESOPs have steadily gained acceptance and popularity in India, not only among corporate management but also among the beneficiaries, the employees.

With its initial usage in the IT industry, Em-ployee Stock Option Plans (ESOPs) are now a given component of compensation in almost all employee centric organizations.

ESOPs are often looked upon as a legal or a financial instrument and hence administered by the Legal or CFO’s office. Since ESOPs involve issue of shares, payments and taxes, these functions certainly have a role to play. However it is the Human Resources function which usually initiates and implements the Plans. Hence it is up to them to make the ESOP successful and a sought-after tool by the employees.

Success of ESOP is also critical because it’s a costly tool. When companies issue shares to employees, it dilutes the value of shares in the hands of other shareholders. Higher the discount to market price, higher the dilution and hence higher is the associated cost. The management will have to face the shareholders’ wrath, if the ESOP pool is not effectively utilized.

Effective utilization of ESOP pool not only means judicious distribution of the available shares but also ensuring that grant of ESOPs lead to higher motivation levels, better operational performance, appreciation in Stock prices, higher ESOP gains and hence satisfied employees.

When do we say that a company has a successful ESOP implementation? From the employees perspective the most tangible indication is when the employees make money. But that is not always the case. The reality is that the stock markets are not always on a high, irrespective of the company performance. You have Tsunami, Oil crisis, Iraq war, strong Rupee and tons of other reasons why the markets fluctuate like a pendulum. The key is how does the company management educate and communicate with the employees that ESOPs work even when markets fluctuate.
From the management’s perspective, success of ESOPs is manifested in higher motivation levels, higher retention and realignment of the employees’ interest with shareholders’.

How can ESOPs be Made Successful?

Well, it starts right from how you have designed the Options. Higher discounts to market price are not the be all and end all. Giving shares cheap to employees will make monetary gains a certainty which is not good for the spirit of ESOP. On the contrary giving Options at the market price and motivating the employees to help in making the price grow will go a long way in not only increasing the shareholder value but also giving a deep sense of satisfaction to the employee of having achieved something. Satisfaction is always high and long lasting when you have earned something through effort and not as gratis.

Whom to Grant and How Much?

Given the limited pool, one needs to be selective on the coverage and quantum. The choice is between covering a larger base with a smaller allocation vis a vis a smaller employee base with a sizeable allocation to each. How much is adequate is a critical question? Effective strategy could be to grant large chunks to a fewer employees where the potential gains are too high to forego. Often these are more than 100% (annualized) of the cash compensation. This also goes well with the universal perception that employees at junior levels are not necessarily attracted by a long term incentive like a stock option. They would rather have a cash incentive, which though lesser in amount is received yearly and is cash and not an option which they do not understand and takes years to realize.

Frequency of Grants

Here the choice is between granting the whole entitlement once in a year or grant the same quantum but quarterly. Frequent grants have the advantage of pricing the options in line with the market swings. In case of the yearly grant if the grant date coincides with the peak stock price, the entire grant is locked at the highest price. On the contrary if the grants are made quarterly or even monthly, pricing is close to market movements. If the prices were to go down, grants could also be at a lower price. It works the same way like a SIP plan of a mutual fund.

Vesting Conditions

Vesting of options can be time based or performance based. Performance based vesting, which is now gaining popularity will ensure that equity dilution happens only on the demonstrated performance. In a time based vesting scenario vesting happens irrespective of the post-grant performance. Practically it may not be possible to link vesting to performance for employees at all levels, however the allocation to the senior management can be of such a category.

Communication

Key to ensure that the employees are not de-motivated when the chips are down is a very strong communication link with them. It starts right when you grant. They need to be educated that ESOP is a long term instrument giving benefits over a 3 to 7 year period. It is not about a one time spurt in stock price but about sustained growth over a longer time.
When the performance is down the communication needs to focus on why is the performance below expectations, what is the management doing about it, what can the employees do about it, why is it a short term dip before the company will bounce back and so on.

Communication is also essential in making the employees aware about their ESOP entitlements and benefits. Globally more than 30% of the granted options lapse, bulk of them because the employees forget that they hold some vested options. Having a well thought out Communication plan, with adequate budget allocation is essential to make ESOPs successful.

Communication can be in several forms. Pre-grant orientation, grant documentation, help manuals, quarterly / six monthly performance reporting, periodical bulletins, vesting alerts, email campaigns, workshops, presentations, and so on.

Understanding Expectations and Designing Solutions

One of the vital ways of ensuring success of ESOP would be to understand in advance the expectations of the stakeholders and designing solutions to address them. Key stakeholders here are the beneficiaries (eligible employees), management (usually CEO) and the shareholders (promoters, strategic partners, Institutional investors, potential partners).

From the employees’ and management perspective, the Option design should ideally be tailored for different hierarchy levels. Usually the differentiation in levels is made in terms of quantum of the grant. It will help if the Option design is itself different for different levels. One of the variations could be in the vesting condition as mentioned above. The others could be different vesting periods (longer for higher levels), different pricing (premium to market price can be considered for the key senior employees like the CEO or key business leaders).

From the shareholders’ perspective, the expectation is to achieve, high corporate performance with minimum dilution. This can be achieved through judicious use of the available pool and linking vesting to corporate performance.
ESOPs will not work, if there is no buy-in of all the stakeholders. Shareholders have to approve of them wholeheartedly. Management should design and roll them out ingeniously, by being transparent about the process, by being responsive to the expectations, by periodically evaluating the Plan performance and correcting the course if required. Employees have to understand the motive behind ESOPs, understand that Option certificate is not a lottery ticket, which will fructify by fluke neither is it a Government bond which will give returns even if the heavens fall. They are an instrument which makes them part-owners of the organization they work for. It is for them to maximize the returns for themselves and other shareholders who are relying on their skills and abilities. Human resource team has a decisive role in making ESOPs successful in their organization.

Harshu Ghate is Co founder and Managing Director of ESOP Direct and he can be contacted at harshu@esopdirect.com
 

Topics: #TotalRewards, Compensation & Benefits, Performance Management, C-Suite

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