1

Introduction

In general, ESOPs are likely to prove too costly for very small companies, those with high
employee turnover, or those that rely heavily on contract workers. ESOPs might also be
problematic for businesses that have uncertain cash flow, since companies are contractually
obligated to repurchase stock from employees when they retire or leave the company. Finally,
ESOPs are most appropriate for companies that are committed to allowing employees to
participate in the management of the business. Otherwise, an ESOP might tend to create
resentment among employees who become part-owners of the company and then are not treated
in accordance with their status.

In the United States, ESOPs are a very common form of employee ownership. They have been growing in
strength since about 1974. Around 11,000 companies have an ESOP in place, and nearly 8 million
employees are involved in them. Companies may establish an ESOP for a number of purposes. Most
press attention regarding the use of ESOPs focuses on their use as a takeover defense or as buyouts of
failing companies. The main purpose of an ESOP is to reward and motivate employees. They are also
used to provide a market for departing owners of successful companies. In most cases, an ESOP is given
to an employee, rather than purchased by an employee.

An ESOP is similar to a profit-sharing plan. A company sets up a trust fund, into which it contributes
either new shares of its own stocks or cash to buy existing shares. Another version of the ESOP borrows
money in order to buy existing or new shares. In this case, the company makes cash contributions to the
plan in order to repay the loan.

When employees leave the company, they receives their share options, and the company must be able to
buy back these options. They must buy them back at their full market value. In private companies,
employees are able to vote their shares on major issues such as relocation or closure. In public companies,
employees can vote on all issues.

Growth of Esops (History)

The first ESOP was created in 1956, but the idea did not attract much attention until 1974, when
plan details were laid out in the Employee Retirement Income Security Act (ERISA). The
number of businesses sponsoring ESOPs expanded steadily during the 1980s, as changes in the
 2

tax code made them more attractive for business owners. Though the popularity of ESOPs
declined during the recession of the early 1990s, it has rebounded since then. According to the
National Center for Employee Ownership, the number of companies with ESOPs grew from
9,000 in 1990 to 10,000 in 1997. By 1999, there were 11,000 ESOPs with a total of 9.5 million
employee owners, according to the national ESOP Association. This steady growth stems not
only from the fundamental strength of the economy during the 1990s, but also from small
business owners' recognition that ESOPs can provide them with a competitive advantage in
terms of increased loyalty and productivity.

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.

Definition

• ESOPs are nothing but “contribution employee benefit pension plans”

• ESOP is, A trust established by a corporate which acts as a tax-qualified, defined-contribution
retirement plan by making the corporation's employees partial owners.
• An employee stock option is a call option on the common stock of a company, issued as a
form of non-cash compensation. Restrictions on the option (such as vesting and limited
transferability) attempt to align the holder's interest with those of the business'
shareholders. If the company's stock rises, holders of options generally experience a
direct financial benefit. This gives employees an incentive to behave in ways that will
boost the company's stock price.
• Employee stock options are mostly offered to management as part of their executive
compensation package. They may also be offered to non-executive level staff, especially
by businesses that are not yet profitable, insofar as they may have few other means of
compensation. Alternatively, employee-type stock options can be offered to non-
employees: suppliers, consultants, lawyers and promoters for services rendered.
 3

Employee stock options are similar to warrants, which are call options issued by a
company with respect to its own stock.
• Employee stock options (ESOs) are non-standardized calls that are issued as a private
contract between the employer and employee.

Meaning

An employee stock option plan (ESOP) is a way in which employees of a company can own a share of
the company they work for. There are different ways in which employees can receive stocks and shares of
their company. Employees can receive them as a bonus, buy them directly from the company, or receive
them through an ESOP.

What Does Employee Stock Option Plan - ESOP Mean?

A qualified, defined contribution, employee benefit plan designed to invest primarily in the stock of the
sponsoring employer. ESOPs are "qualified" in the sense that the ESOP's sponsoring company, the selling
shareholder and participants receive various tax benefits. ESOPs are often used as a corporate finance
strategy and are also used to align the interests of a company's employees with those of the company's
shareholders.

Employee stock ownership plans can be used to keep plan participants focused on company performance
and share price appreciation. By giving plan participants an interest in seeing that the company's stock
performs well, these plans are believed to encourage participants to do what's best for shareholders, since
the participants themselves are shareholders.
 4

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 date - An ESOP would provide for a date on which an option is vested with employees
and time frame over which the stock option would vest with employees (‘Vesting period’).

Exercise period - 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’.

There are two ways in which a company can set up an ESOP.

(a) Create a Trust (Special Purpose Vehicle) - Depending on the number of options to be
given to the employees, the company will issue shares or options to the trust. The trust would
need funds to buy these shares. For this, the company can either give soft loans from its own
funds or the trust can raise loans through other sources to meet its financial requirement. The
company can act as a guarantee to the lender to the trust. With the funds so raised, the trust then
acquires shares/options required. The trust repays its loans as and when the employees purchase
the options offered and when they exercise their options by paying the exercise price.

(b) Give options directly to employees - The selection of the employees can be based on
performance of the employee, indicated by the annual performance appraisal, minimum period of
service, present and potential contribution of the employees, and such other factors deemed to be
relevant for the success of the company. Number of options per employee can be determined
 5

taking into consideration, the grade, level, years of service, salary, etc. These selections would
entirely depend upon the objective of the company for setting up the ESOP.

Types of ESOPs

There are two types of ESOPs -- leveraged and nonleveraged. Additionally, ESOPs may be
combined with or converted from other employee benefit plans.

Nonleveraged ESOPs

A nonleveraged ESOP is a stock bonus plan, identified as an ESOP in the plan document, that
invests primarily in company stock and meets certain legal requirements. The sponsoring
employer contributes newly issued or treasury stock and/or cash to buy stock form existing
owners. Contributions generally may equal up to 15% of covered payroll (which usually is the
combined payroll of all employees eligible for participation) or, if the ESOP includes a money
purchase pension plan in which the employer commits to contribute a set percentage of covered
payroll per year in cash or stock, 15% plus the money purchase pension plan contribution
percentage (from 1% to 10%) up to a maximum of 25% of covered payroll.

Leveraged ESOPs

A leveraged ESOP borrows money on the credit of the employer or other elated parties to buy
company stock. It is the only qualified employee benefit plan that can do this. A loan from an
outside lender can be to the ESOP itself, or to the employer, which then relends the money to the
ESOP (lenders generally prefer lending to the employer). The loan from the company to the
ESOP does not have to be on the same terms, provided its terms are sufficiently fair to the ESOP
to be the equivalent of an "arm's length" transaction. The loan can be used for any business
purpose, such as buying stock from an existing shareholder, acquiring new capital, buying a
company, or refinancing debt.

ESOPs Combined With Other Plans

An ESOP, leveraged or not, can be combined with another benefit plan. This provides some
security through diversification if the company goes bankrupt, because then the company stock
held by the ESOP may become virtually worthless. One popular combination is using leveraged
ESOP contributions to fund the company match in a 401(k) plan. Of course, ESOPs can also
exist side by side with 401(k) or other benefit plans without being combined with them.
 6

Converting Other Plans to ESOPs

Any qualified plan may be converted to or replaced with an ESOP. An existing defined
contribution plan, such as a profit-sharing plan, can be converted into an ESOP without
terminating it. Any conversion of a plan that involves using the old plan's assets to acquire
company stock, however, involves fiduciary issues that must be carefully considered.

Other 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.
 7

Advantages :

Employee Stock Ownership Plan (ESOP) is an employee benefit plan. The scheme provides
employees the ownership of stocks in the company. It is one of the profit sharing plans.
Employers have the benefit to use the ESOPs as a tool to fetch loans from a financial institute. It
also provides for tax benefits to the employers.

Employee Stock Ownership Plans Can Benefit Business Owners, Workers Alike:

When a small-business owner wants to cash out or pull some equity out of his or her business,
there are several options. One of the best options for both employers and employees is an
employee stock-ownership plan, or ESOP.

ESOPs allow business owners to sell company shares to employees at a fair price. ESOPs also
provide significant tax benefits for owners while providing retirement benefits for workers.

Workers who own shares usually feel more loyal and driven to
perform, so productivity increases and, as a result, their stock
increases in value. An ESOP can also help finance the expansion
 8

of the business, so everyone benefits. ESOPs work especially well for small, stable companies
with fewer than 100 loyal, long-time employees.

"The employees get all the economic benefits of being a shareholder without the liabilities," said
benefits expert Steve Bohn, formerly of Merrill Lynch and now at Lazard Asset Management.

ESOPs offer several advantages to employers. First and foremost, federal laws accord
significant tax breaks to such plans. For example, the company can borrow money through the
ESOP for expansion or other purposes, and then repay the loan by making fully tax-deductible
contributions to the ESOP (in ordinary loans, only interest payments are tax deductible). In
addition, business owners who sell their stake in the company to the ESOP are often able to defer
or even avoid capital-gains taxes associated with the sale of the business. In this way, ESOPs
have become an important tool in succession planning for business owners preparing for
retirement.

A less tangible advantage many employers experience upon establishing an ESOP is an increase
in employee loyalty and productivity. In addition to providing an employee benefit in terms of
increased compensation, like cash-based profit sharing arrangements do, ESOPs give employees
an incentive to improve their performance because they have a tangible stake in the company.
"Under an ESOP, you treat employees with the same respect you would accord a partner. Then
they start behaving like owners. That's the real magic of an ESOP," explained one executive in
Nation's Business. Some experts also claim that ESOPs—more so than regular profit sharing
plans—make it easier for small businesses to recruit, retain, and motivate their employees.

Disadvantages:
 9

As attractive as these tax benefits are, however, there are limits and drawbacks. The law does not
allow ESOPs to be used in partnerships and most professional corporations. ESOPs can be used
in subchapter S corporations as of 1998, but do not qualify for the rollover treatment discussed
above and have lower contribution limits. Private companies must repurchase shares of departing
employees, and this can become a major expense. The cost of setting up an ESOP is also
substantial -- $15,000 to $20,000 for the simplest of plans in small companies and on up from
there. Any time new shares are issued, the stock of existing owners is diluted. That dilution must
be weighed against the tax and motivation benefits an ESOP can provide. Finally, ESOPs will
only improve corporate performance if combined with opportunities for employees to participate
in decisions affecting their work.

There are a few drawbacks to this plan. The cost of setting up an ESOP is around 30,000 US
dollars (USD) for even the simplest of plans. When any new shares are issued, the stock of
existing employees will become diluted. This dilution will be measured against the motivation
and tax benefits of the ESOP. Also, private companies must buy back departing employees'
shares, and this can become a major expense.

In order to establish an ESOP, a company must have been in business and shown a profit for at
least three years. One of the main factors limiting the growth of ESOPs is that they are relatively
complicated and require strict reporting, and thus can be quite expensive to establish and
administer. According to Nation's Business, ESOP set up costs range from $20,000 to $50,000,
 10

and there may be additional fees involved if the company chooses to hire an outside
administrator. For closely held corporations—whose stock is not publicly traded and thus does
not have a readily discernable market value—federal law requires an independent evaluation of
the ESOP each year, which may cost $10,000.

The ESOP-S Process

ESOP-S' buyout process follows five distinct steps, adding form and structure to a normally
disjointed process. These steps include:

1. Feasibility Study: The results of this study determine if the proposed transaction is
viable. It explores traditional due diligence areas such as market, organizational,
management, operational, financial, and legal issues.
2. Financing: ESOP-S arranges financing for the proposed transaction. Financing may be in
the form of debt instruments, equity investments, or a combination of the two.
3. Plan Development: ESOP-S's legal team develops the ESOP plan document, tailoring it
to fit the individual needs of the client company.
4. Independent Valuation: In accordance with ESOP statutes, a business valuation is
performed by an independent valuation analyst. ESOP-S maintains ties with some of the
Country's leading ESOP valuation firms.
5. Closing: At the close of the transaction, the business interest is sold to the ESOP; and the
selling shareholder receives a check for the fair market value of the shares sold.

Uses for ESOPs

1. To buy the shares of a departing owner: Owners of privately held companies can use
an ESOP to create a ready market for their shares. Under this approach, the company can
 11

make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it
can have the ESOP borrow money to buy the shares (see below). Once the ESOP owns
30% of all the shares in the company, the seller can reinvest the proceeds of the sale in
other securities and defer any tax on the gain.

2. To borrow money at a lower after-tax cost: ESOPs are unique among benefit plans in
their ability to borrow money. The ESOP borrows cash, which it uses to buy company
shares or shares of existing owners. The company then makes tax-deductible
contributions to the ESOP to repay the loan, meaning both principal and interest are
deductible.

3. To create an additional employee benefit: A company can simply issue new or treasury
shares to an ESOP, deducting their value (for up to 15% of covered pay) from taxable
income. Or a company can contribute cash, buying shares from existing public or private
owners. In public companies, which account for about 10% of the plans and about 40%
of the plan participants, ESOPs are often used in conjunction with employee savings
plans. Rather than matching employee savings with cash, the company will match them
with stock from an ESOP, often at a higher matching level

ESOPs: Modus Operandi

Most ESOPs act out of a trust or through a board of directors; this is a direct transfer of shares in
the employee’s name from the company. In the case of a trust, the company commits itself to
transfer a certain amount of shares. It is like a kitty where a onetime preferential issue of
warrants is stored.

In place of actual stock options, companies can also offer phantom stock options, which grant
stock appreciation rights. The recipients in such schemes receive a cash payment equivalent to
 12

the rise in the values of their respective notional stocks without actual transfer of shares in their
names.

Pricing

In India, stock options must be priced according to the same rules that govern the issue of
preference shares. That is, the option price must be at the current market price. Issuing the shares
at a discount to market price is not permissible.

The price at which one should grant shares under ESOP has invited much debate. At one level,
the price should be determined by the employer’s objectives. If it is past performance that one is
rewarding, then employees should be able to buy their shares at a sizeable discount to the market
price so that their gains are immediate. That, of course, will hit the bottom line of an employer of
an employer.

The more profit friendly alternative is best applied when one is using ESOP to spur future
performance. Then, the grant price could well be the same as that of scrip’s current market price,
with the incentives being available only if the recipients can take the company to greater heights
on the bourses.

Payment Mechanics

Since the mechanics of ESOPs involve offering employees the opportunity to buy their
company’s shares, these shares have to be made available in the first place. The source; either a
fresh issue of equity, or buying back one’s shares from the stock market with the intention of
issuing them to employees. Both have a cost.

The second option will mean using the firm’s reserves to bankroll the repurchase. And the first
will carry a two fold cost: power earnings.

The SEBI guidelines specify that the difference between the price at which your employees
exercise their options and the market price on the date on which the option is granted must be
taken as an expenditure on employer’s profit & loss account. Though there is no actual cash
outflow. The only saving grace is- this can be spread out over the entire period during which the
scheme is in play instead of taking the blow in one year.
 13

Identification of the Recipients

If the company wants to make all its employees richer a general disbursal can be opted, with a
short lock in period so that the payback period is tangible. In fact, the straightforward stock
purchase scheme could be the ideal solution since it creates instantaneous ownership. The focus
is on rewarding a track record, not on incentivising future performance.

If like a growing number of the peers, a company wants to use ESOPs as a tool for rewarding the
best, stringent qualification standards need to be set. But then, the company only wants to reward
and motivate the best people. A simple solution is to make either length of service or seniority of
both, the criteria for granting ESOPs which will automatically narrow the number of recipients.

For many companies, ESOPs are actually an obvious carrot for employees to do better in future.
At one level since the market is the ultimate arbitrator of performance, the price it puts on the
company’s scrip will help determine the value of every employee’s stockholding. Judging from
the precedents set by US corporations, the primary choice is between absolute and relative
indicator: improvement in sales, profits, or share prices, either in absolute terms or relative to
those of rivals. One has to take into account the criticality and the market value of both the
position and the individual, when picking the one to reward with ESOPs.

Role of ESOPs in Mergers and Acquisitions

Now we will look at how ESOPs are increasingly being used in raising capital in leveraged
buyouts and divestitures and also as an anti takeover defense.

 ESOPs as a Financing Tool

Equity financing can be obtained from within the company if the firm is willing to share some
ownership control with the employees of the company. An ESOP plan enables employees to
 14

purchase shares of stock in the company by paying cash or by agreeing to deductions from salary
or benefits. The employees become part owners of the business and the firm in turn has
additional funds for other business purposes. In addition, the company also can contribute to the
ESOP by either making an annual cash contribution to the plan for the purchase of company
securities or by directly contributing stock to the plan. In both ways, the company’s contribution
results in the cash price of the stock being returned to the company. The company gets a tax
deduction for the ESOP contribution while effectively retaining the cash.

ESOPs can also be used as leverage for borrowing additional funds for the business. An ESOP
can borrow funds from lenders in order to purchase additional securities in the employer’s
business. Alternatively, the employer can borrow from a lender and re-lend the funds to the
ESOP. The ESOP would then purchase company stock with the cash. In both the situations, the
employer ends up with the cash price of the stock.

However, the use of ESOPs as a financing tool has its own disadvantages. ESOP as a financing
tool may not be prudent for many start up and existing small businesses because implementing
an ESOP is expensive and time consuming.

In addition, participants in the ESOP plan who terminate employment may demand distribution
of stock itself, rather than simple the stock’s cash value. A closely held business may not want
former employees to own stock in the company is to be able to vote as shareholders. Besides, if
the trustees of the ESOP are also the business owners, they may occasionally face a conflict of
interest between their duties to act in the best interest of the ESOP and their duties as directors
and or officers of the company.

 ESOPs and Divestitures

If a subsidiary of a corporation cannot be sold at a reasonable price or if liquidating the
subsidiary would be disruptive to customers, the parent company may initiate a sale directly
through an ESOP. Many corporations are now increasingly considering using employee stock
ownership plans, as a unique cost effective tool for facilitating divestiture.

The employers of the subsidiary can purchase the controlling interest of the subsidiary through
an ESOP since they will have a huge stake in the subsidiary.
 15

Divestitures of a subsidiary through an ESOP can be done by establishing a shell corporation.

The shell company will establish an ESOP will be used to finance the purchase of a subsidiary
from the parent. The shell corporation will be responsible for the operation of the subsidiary and
the ESOP holds the stock of the subsidiary. If the subsidiary is successful, income is generated.
And this income is allowed for tax deductions. This will enable the subsidiary to service its debt.
The subsidiary’s capability as an independent entity and its ability to generate sufficient income
to cover its financing is important. If the subsidiary is in a dying industry and requires a large
amount of transformation then it is better to liquidate the assets of the subsidiary.

 ESOPs and Leveraged Buyouts

ESOPs are also commonly used by employees in leveraged buyouts or management buyouts to
purchase the shares of the owners of privately held firms. The use of ESOPs to finance leveraged
buyouts is seen mostly where the owners have most of their net worth tied up in their firms. The
mechanism is similar to a sale initiated by the owner to the employees.

 ESOPs as an Anti takeover Defense

Usually firms which are potential takeover candidates create ESOPs. The ESOP trust borrows
with the help of the sponsoring firms guarantee and uses the loan proceeds to buy stock issued by
the sponsoring firm. While the loan is outstanding, the ESOPs trustees retain the voting rights on
the stock. Once the loan is paid off, it is generally assumed that the employees will tend to vote
against bidders who they perceive as putting their hobs at risk.

Much of the rising popularity of ESOPs is related to the use of the compensation vehicle as an
anti takeover defense rather than because of its tax advantages. For a large percentage of the
American corporation in Deleware where an anti takeover low became effective, this law
provided that if a bidder purchases more than15% of a firm’s stock he may not complete the
takeover for 3 years unless:

• The bidder purchases as much as 85% of the target shares.

• Two thirds of the shareholders approve the acquisition.
 16

• The board of directors and the shareholders decide to exempt themselves from the
provisions of the law.