CA.CS. Naveen.

Rohatgi TYBMS: Special study in finance

EMPLOYEE STOCK OPTION

Employee Stock Option Plan (ESOP), is a plan through which a company awards Stock Options
to the employees based on their performance. Under an ESOP, the employees have right to buy
the shares of the company on a predetermined date at a predetermined price. The objective of
ESOP is to motivate the employees to perform better and improve shareholders' value. Apart
from giving financial gains to the employees, ESOP also creates a  sense of belonging and
ownership amongst the employees. A stock option granted to specified employees of a
company..

Different terms used in an ESOP

Grant date - The date on which the company grants an option to its employee.

Option price - The price at which such shares in a scheme are offered. It is also known as the
‘strike price’ or ‘grant price’. Normally such option price would be below the market value/ fair
value of the shares on the date of grant.

Vesting period : Vesting has two components – vesting percentage and vesting period. Vesting
percentage refers to that portion of total options granted, which you will be eligible to exercise.
Vesting period is the period on the completion of which the said portion can be exercised.

The following table presents an example of an employee who is granted 200 options on January
1, 2004 with a vesting schedule of 30%, 30% and 40% at the end of one, two and three years
from the date of grant respectively.

Date of grant: January 1,2004

Vesting Details
1st Vesting 2nd Vesting 3rd Vesting
Percentage 30% 30% 40%
Date January 1,2005 January 1,2006 January 1,2007
Options vested 60 60 80
Exercise period and Exercise date - The employees would be given a time period, called exercise period,
within which they are required to exercise the option. The date on which employees exercise this option is
known as ‘exercise date’.Exercise period is the period within which you can decide to exercise your options.
This period starts from the date of vesting.

lapse of options
Options lose their validity in certain circumstances i.e. expiry of the exercise period, separation,
abandonment etc. These options then cannot be converted into shares and lose their value. Such options are
said to be lapsed.
CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

Different types of ESOPs

ESOP can be a one-time plan or an ongoing scheme depending upon the objectives that the
company wants to achieve. ESOPs can be in the form of ESOS (Employee Stock Option
Schemes), ESPP (Employee Stock Purchase Plans), Compensation Plans, Incentive Plans,
SAR/Phantom ESOPs etc.

Employee Stock Option Scheme (ESOS) - Under this scheme, the company grants an option to
its employees to acquire shares at a future date at a pre-determined price. Eligible employees are
free to acquire shares on vesting within the exercise period. Employees are free to dispose of the
shares subject to lock-in-period if any. Generally exercise price is lower than the prevalent
market price.

Employee Stock Purchase Plan (ESPP) - This is generally used in listed companies, wherein
the employees are given the right to acquire shares of the company immediately, not at a future
date as in ESOS, at a price lower than the prevailing market price. Shares issued by listed
companies under ESPP will be subject to lock-in-period, as a result, the employee cannot sell the
shares and/or the employee has to continue with the employer for a certain number of years.

Share Appreciation Rights (SAR)/ Phantom Shares - Under this scheme, no shares are offered
or allotted to the employee. The employee is given the appreciation in the value of shares
between two specified dates as an incentive or performance bonus, that is linked to the
performance of the company as a whole, as reflected in its share value.

SEBI GUIDELINES

1. Issue at discount Issue of stock options at a discount to the market price would be
regarded as another form of employee compensation and would be treated as such in the
financial statements of the company regardless the quantum of discount on the exercise
price of the options.
2. Approval: The issue of ESOPs is subject to the approval by the shareholders through a
special resolution.
3. Minimum period and Maximum period A minimum period of one year between grant
of options and its vesting has been subscribed.. A Maximum period of eight year
between grant of options and its vesting has been subscribed. Employee stock option
must be exercised within the period of five years
4. Superintendence The operation of the ESOP Scheme would have to be under the
superintendence and direction of a Compensation Committee of the Board of
Directors in which there would be a majority of independent directors.
CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

5. Eligibility ESOP scheme is open to all permanent employees and to the directors of the
company but not promoters and shareholders. The scheme would be applicable to the
employees of the subsidiary or a holding company with the express approval of the
shareholders.
6. Director's report The Director's report shall make a disclosure of the following:
 Total number of shares as approved by the shareholders
 The pricing formula adopted
 Details as to options granted, options vested, options exercised and options forfeited,
extinguishments or modification of options, money realized by exercise of options, total
number of options in force, employee-wise details of options granted to senior managerial
personnel and to any other employee who receive a grant in any one year of options
amounting to 5 percent or more of options granted during that year
 Fully, diluted EPS computed in accordance with the AS-20

Rules and Regulations

Companies Act
Issue of stock options requires approval of shareholders by way of a special resolution as per
section 81(1 a). This is not applicable for private companies who can issue stock options without
shareholder approval but approval by the board of directors.

Income Tax Issues

For employees:
Till recently, the difference between the cost of the share to the employees and market value on
the date on which an employee got the share would be taxed as perquisite in addition to capital
gains tax payable by the employee on sale of those shares. However with the recent
announcement by the Finance Minister the perquisite tax has been removed. Tax is now payable
only at time of sale of shares as capital gains.Since perquisite tax has been removed employers
are not liable for tax deduction at source, thus removing administrative inconvenience.

For the company:

As per SEBI guidelines listed companies have to account for ESOP by treating the same as an
expense. As yet there is no clarity whether this expense will be allowed as deductible expense by
the Income Tax authorities.

ESOPS issued by the company

CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

BPO pioneer Raman Roy was setting up Spectramind in 2000-2001, its human resources head S.
Varadarajan offered share ownership to 500 staff members. “We wanted to share wealth with
people who helped create the company,” Varadarajan says. When Wipro bought out
Spectramind, everyone made the equivalent of at least a year’s salary on their ESOP plans. Even
better, turnover among the top managers was zero. Now, at Quattro BPO Solutions, another start-
up from Roy, Varadarajan heads human resources and is replicating the ESOP experiment,
covering employees from the supervisor level.

Believers like Varadarajan are growing but the pool of companies using ESOPs in India remains
limited. The wealth creation potential of ESOPs has not been fully exploited in India. The trend
is yet to catch on with a large number of firms. There are many who are sceptical. During the
best of times, amid war for talent, nothing could guarantee stickiness of executives, not even
ESOPs. “There was always somebody who was willing to better the deal — offer a bigger
package and lure away executives,” says Prabir Jha, HR head, Dr. Reddy’s Labs.

The Indian ESOP is unique in how it is implemented. It’s used as a carrot, dangled in front of
employees so they don’t quit. It’s a long-term incentive but employees don’t seem to get the
point. ESOPs “are not considered part of compensation in many Indian organizations and are
not communicated as such” says Padmaja Alaganandan, India business leader (human capital),
Mercer Consulting.

This is unlike in the West, where it forms a substantial chunk of a senior executive’s total
compensation. In the US, ESOPs are used to push productivity, link reward to performance and
align the interests of the shareholders and executives. In India, where ESOP adoption is still in its
early stage, companies use stock options to attract and retain employees.

And ESOPs’ appeal depends on the stock market. Until 2007, when the going was good, ESOPs
were a very attractive incentive to lure potential employees. Globally, start-ups have used ESOPs
to recruit key executives, reward and share the risk with them.

Bajaj Electricals, for instance, hired staff from other sectors for as little as a 10 percent jump in
salary (when 50-100 percent increases were normal), by using attractive ESOP offers, says
executive director R. Ramakrishnan. Private banks like Axis Bank, with no global tag and not-
so-deep pockets, used ESOPs to compete for talent against multinational giants. From unlisted,
family-managed entities like Murugappa group to old-fashioned manufacturing firms like Larsen
& Toubro, companies have used them to gain shine in the job market.
CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

Then, the slowdown hit and Indian entrepreneurs were hit hard. Earlier, India’s hot job market
and economic boom meant ESOPs got marketed as the biggest and quickest way to riches. This
mis-selling made everyone look only at the upside and forget the downsides. “Excitement around
ESOPs has waned. Unpredictable stock market has taken the sheen off,” says Sanjiv Sachar,
speaking about the immediate aftermath. He is partner, Egon Zehnder International, a leading
executive search firm.

Compensation experts say India’s demography too has had an impact. Across the hierarchy of
positions, people are spending less time with one job. “Everyone prefers more cash in hand than
something that’s long-term and uncertain,” says Shekhar Purohit, Asia-Pacific head
compensation & corporate governance, Hewitt Associates.

Now that economic recovery has begun, experts believe corporate India will see a mature ESOP.
Those who do vouch for ESOPs say there is no one formula that fits everyone at all times. An
ESOP plan must be fine-tuned in sync with a company’s growth cycles to be effective.

Telecom major Bharti group began its ESOP journey in 2001. In its pre-IPO stage, it covered the
top 100-125 executives. In 2005, it launched the second stage where everybody was covered and
ESOPs were linked to the employee’s loyalty and performance.

On a sharp growth trajectory at that time, Bharti wanted to reward and incentivise its staff. In
2006, it offered performance share plan to senior executives pegging the allotment to different
kinds of performance — individual, stock price and competition. By 2008, it figured that its 2005
wide-base ESOP strategy wasn’t working as the younger staff preferred deferred bonus plan or
cash. Hence, now the company has restricted the plan to the middle management and above.
ESOPs work “when a company constantly does course correction and customisation to be more
current and better aligned,” says Inder Walia, group director for HR at Bharti Enterprises.

Now is the time to build the foundation for the next wave of ESOP adoption in the country. Here
are five major trends that may shape the future of ESOPs:

New Products, New Segments

From a plain vanilla ESOP plan, companies are now willing to experiment with variants of
ESOPs to suit their needs better. These range from phantom options to restricted stock units
(RSUs), stock appreciation rights (SARs) to performance share plans. Companies like Wipro are
looking at alternative means like deep-discounted restricted stock units to make options
CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

attractive. L&T offered SARs to avoid equity dilution and yet offer its staff the upsides of the
stock movement. Companies like Infosys are going one step ahead, giving ESOPs to independent
directors and driving board level involvement.

Sweat equity :

1. Issue of sweat equity shares is governed by the provisions of S. 79A of the Companies Act.
Sweat equity shares’ to mean equity shares issued by the company to employees or directors at a
discount or for consideration other than cash for providing the know-how or making available
rights in the nature of intellectual property rights or value additions, by whatever name called. It
is, therefore, necessary for the issue of sweat equity shares that the concerned employee either
provides the know-how, intellectual property rights or other value additions to the company.

2. In terms of the said Section, a company may issue sweat equity shares of a class of shares
already issued, if the following conditions are satisfied :

(a) such issue is authorised by a special resolution of the company in the general meeting;

(b) such resolution specifies the number of shares, current market price, consideration, if any,
and the class or classes of the directors or employees to whom such shares are to be issued;

(c) such issue is after expiry of one year from the date on which the company was entitled to
commence business; and

(d) in the case of an unlisted company, such shares are issued in accordance with the prescribed
guidelines.

3. The guidelines referred to in S. 79A are the Rules issued by the Central Government, which
need to be followed by unlisted companies. The Rules inter alia provide the procedure to be
followed by a company issuing sweat equity shares for consideration other than cash. Rule 9 of
the Rules provides that where a company proposes to issue sweat equity shares for consideration
other than cash, it shall comply with the following :

(a) the valuation of the intellectual property or of the know-how provided or other value addition
to consideration at which sweat equity capital is issued, shall be carried out by a valuer;

(b) the valuer shall consult such experts, as he may deem fit, having regard to the nature of the
industry and the nature of the property or the value addition;

(c) the valuer shall submit a valuation report to the company giving justification for the
valuation;

(d) a copy of the valuation report of the valuer must be sent to the shareholders with the notice of
the general meeting;
CA.CS. Naveen. Rohatgi TYBMS: Special study in finance

(e) the company shall give justification for issue of sweat equity shares for consideration other
than cash, which shall form part of the notice sent for the general meeting; and

(4). The issue of sweat equity shares to employees and directors shall be at a fair price calculated
by an independent valuer.

6.The issue of sweat equity shares in a year to 15% of the total paid-up equity share capital or
shares of a value up to Rs.5,00,00,000/- (Rupees five crores only), whichever is higher. If this
limit is to be exceeded, the same is required to be done with the prior approval of the Central
Government.

7. For issue of sweat equity shares, the following broad procedure needs to be followed :

(i) Convene and hold a board meeting to consider the proposal of issue of sweat equity shares
and to fix up the date, time, place and agenda for general meeting and to pass a special resolution
for the same;

(ii) Issue notices in writing for general meeting with suitable explanatory statement containing
the particulars required as per Rule 4 of the Rules;

(iii) Pass a special resolution; and

(iv) Allot sweat equity shares.

Sweat equity shares are often misunderstood as another form of ESOPs since there is a
superficial similarity. For example, both are usually issued to employees and directors. Sweat
Equity Shares are however issued for something done in the past or something being done and
further, they are issued for consideration other than cash and normally intangible assets. If one
goes by the classic understanding of this term, it is that ownership (“equity”) that is created
through the efforts (“sweat”) of the employees and directors. Issuance of Sweat Equity Shares is
recognizance and reward of this toil. While there is some further resemblance with ESOPs in the
sense that Sweat Equity Shares also create a sense of ownership and loyalty for the Company,
the basic structure is often different. Sweat Equity Shares are also very useful for financial
structuring when some owners are unable to bring in cash but are able to bring in or create
intangible assets.