Esops

A FEW REALITIES ……  Pareto’s Principle  High attrition  Organizations striving for achieving competitive advantage through its human resources  Need for achievement and recognition

NEED OF THE HOUR  Offer something extra to the extraordinary performers.  Motivate & retain employees  Talent Management  Make employees a partner in the Company’s wealth

ESOPs EMPLOYEE STOCK OPTION PLANS

MEANING  Employee Stock Option Plan (ESOP) is an employee benefit plan, which makes the employees owners of stock in that company.  A stock option is a right but not an obligation given by the Company to its employees to buy its shares  The right of the employees is by way of an entitlement to exercise his/her option & buy shares in the Company.  It is a qualified, defined contribution plan that invests primarily in the stock of the employer company.  The basic aim of ESOPs is to enhance corporate performance on a sustained basis.

VARIOUS TERMS USED IN ESOPs  Employee Stock Option: it represent rights given by the employer company to the employees to acquire its shares at a predetermined price after the end of a specified period and usually for a certain period of time thereafter.  Employee Share Purchase Schemes: represents those schemes under which the employee is allotted shares at a pre-determined price.  Grant of an option: means giving an option to the employee to acquire the shares of the company as per the terms of the scheme.

 Vesting Period: means that period of time after the grant of the option during which the employee cannot exercise the option by applying for the shares.  Exercise period: means that period of time during which the employee can exercise the option by making an application to the company for allotment of shares.  Lock-in-period: represents that period after the allotment of the shares to the employee during which the employee cannot sell the shares and casually also no create a charge on the shares.  Staggered Options: represents a feature where by the options are gradually granted over a period of time instead of the employee being granted all the options at once.

EXAMPLE ‘X’ is granted an option on 01-01-2001, if the vesting period is 1 year, it would vest with ‘X’ on 01-01-2002, on vesting the option could be exercised and ‘X’ may buy shares against the Option at the pre-determined price

EXAMPLE Company XYZ has granted an employee, option to buy 100 shares under a scheme which states ; • Only 20 shares will vest after a period of 2 years • So if the employee has to get the entire 100 shares, the period would be 10 years. When such a scheme is structured, a company has to keep in mind the actual worth of its shares as if the share price is low then an ESOP scheme with a long vesting period would not be attractive.

 Sweat Equity: is mostly offered to core promoters who have conceived the project or idea. It is issued in larger chunks to constitute substantial stake in the company.  EBS - Employee Benefit Scheme: calculates the benefit to be given to the employees on the basis of the value of shares of the company. The actual shares are not handed over to the employees & thus the employees have no right in participating in the ownership of the company.  Phantom Shares: This option plan is a cash bonus plan under which the amount of the bonus is determined by reference to the increase in value of the shares subject to the option. No shares are actually issued or transferred.  Employee Stock Ownership Plan: Here, the ownership of the enterprise is turned in favor of the employees through stock holding. It is aimed at ownership by employees & is aimed at all the employees

PROCESS Identify the need to introduce ESOPs Feasibility of offering ESOPs Design structure for ESOPs Work on the terms and conditions Decide the eligibility criteria for the scheme Communicate to the employees Implementation of ESOPs

FEASIBILITY STUDY • Preliminary Appraisals • Design Study • Financial Analysis • Repurchase Liability Study

TYPICAL ESOP STRUCTURES (1) Form a trust which would act as an administrator of the ESOP. The company issues ESOP shares or warrants to the trust, which then transfers them further to individual employees.

(2) Company issues shares or warrants directly to the employees under the Guidelines of SEBI. This structure though easy to operate does not provide an exit route

ELIGIBILITY CRITERIA  Length of service  Seniority  Grades  Responsibility handled  Market value for specific skills  Achievements & Potential  Loyalty  Performance appraisals  Potential contribution of the employee

HOW DO ESOPs WORK?  No maximum limit up to which ESOPs can be issued to an employee  ESOP plan usually provides for eventualities like resignation, termination and retrenchment  The ESOP entitlement to the employees depends on the objectives of the company for setting up the scheme  In an era of free pricing, companies have the flexibility to determine the exercise price of the options  The said price at which the employee buys the option is usually lower than the prevailing price of the share in the market.

 An option is said to vest in the employee when he/she is given the right to apply for shares  A company may also have a lock-in period for the shares following the exercise of the option by the employee.  Thus, the shares allotted to the employee pursuant to an ESOP cannot be transferred for a fixed number of years.

USES 75% of the companies use ESOP’s for the following purposes : As an extra employee benefit plan.  Used as a technique of corporate finance for purposes like finance expansion, making an acquisition etc. It is viewed as a long term incentive which seeks to encourage loyalty.

FROM HR PERSPECTIVE ……  To retain talented employees  To enable the employees to gain from the growing wealth & valuation of the company.  To infuse a sense of ownership in employees  To retain employees or specific skills groups among employees in the face of apprehended high turnover  An ESOP ensures the employees' commitment to the company's growth by making them part of the growth process.  Since the benefits of ESOP are theoretically infinite, this acts as an incentive for best of talents to give their best

DEMERITS  When ESOPs are exercised, it leads to a further issue of equity shares of the company which means that the equity of the company is being diluted further and has an adverse effect on the EPS (Earning Per Share).  ESOPs are nothing but an alternative employee remuneration plan for employees.  The difference between market price and the option price is nothing but a cost to the company and should be charged to the P&L account.  If the company tanks, employees may end up burdened with worthless paper in the form of sweat equity.  On the contrary, when the company performs too well, and so the options appreciate in value, there can be criticism that the employees have been benefited the most.

ESOPs AT INFOSYS • When employees join they are offered say 100 shares at the current price in the market which can be bought as and when needed and that too at the same rate.

•Even after 2 yrs, the employees can buy the shares at the same rate. • In the 1st year, employees can’t buy any shares, in the 2nd year he/she can buy 30 shares and then in the 3rd year, he/she can buy the remaining no.of shares.

• No. of shares allotted is fixed for employees at different levels for Software engineers – 100 shares Program Analysts – 250 shares

• Scheme stopped since October, 2003

ESOPs – TAX IMPLICATIONS  The government has made ESOPs taxable.  Previously, stock options were taxed as a "perquisite" at the time of exercise of the option by the employee.  But since 2000-2001, ESOPs are taxable only at the time of

selling of stocks.

 At the time of sale of the security by the employee, the difference between sale consideration and cost of acquisition (defined as fair market value of these options) would be taxed as "capital gain".

 Can ESOPs be Gifted ?

AN EXAMPLE IES CORPORATE HOUSE MR. Y

MR. X

ESOPS

12/2/2006

12.2.2005 @ 100/ [Exercise Price] 12.2.2005 @ 200 [Market Value]

Sells @ 500/-

Sale price 500/-

Cost of acquisition 100/-

Taxed as Capital Gains i.e. Tax on Rs. 400/-

TAX IMPLICATION Mr. X

Mr. Y

Gifts

Mr. Z

Sells @ 800/12.2.06

12.2.05 Market Price 300/-

Cost of acquisition 100/-

Taxed: 300 – 100 = 200/-

Sale Price

Fair market value on the date of the gift

Taxed: 800 – 300 = 500/-

Can ESOPs be Gifted ?

The answer to this is, ‘Yes’. The employee who is entitled to the ESOP may gift the options to any person. However, the donor will have to pay income tax on the notional gains on the date of gift i.e. he will have to pay capital gains tax on the difference between the fair market value of the gifted shares / warrants on the date of gift and the option price, if it has already been paid. The done, if and when he actually sells the shares will have to pay capital gains tax on the difference between the actual sale proceeds and the fair market value on the date of gift. The reason for having this provision is that, in the past, many employees gifted the option shares / warrants to relatives / friends without paying any tax. These friends / relatives sold the shares / warrants and either, gifted back the sale proceeds to the employee, or in case of a close relative such as spouse, let the money remain with the spouse.

SUMMARY …… • An option to buy the company’s share at a certain price • • • •

which could be the market price or some other price. To make an ESOP attractive, the option price is lower than the market price. Option to acquire shares is generally exercisable over a time period known as Vesting period (1-5 years ). The first options are exercisable generally after a year. ESOPs work as an incentive for retaining employees since options lapse if the employee leaves employment before the vesting period is over.

ESOP is not something that is ‘free’ or some benefit that is ‘immediate’