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An ESOP fable

B. Venkatesh

SEBI has sought comments from the public to amend its guidelines on Employee Stock Option Scheme (ESOPs). ESOP has been a popular form of equity-based compensation the world over. But ESOP programme may not be an optimal compensation to employees, considering its total cost to shareholders. Companies can consider providing alternative equity compensation programmes such as shadow options.

ESOPs: This form of compensation was promoted to drive employees to enhance shareholder value. The premise is that if the company does well, so does its stock price. ESOP was, hence, seen as a reward aligning shareholder interest with that of the employees.

There are, however, studies that suggest that ESOPs have been counterproductive. The reason has to do with investor behaviour. Investors are primarily concerned about the short-term stock price movements rather than the long-term prospects of the company. This means that investors reward companies that do well in the near term.

It, therefore, follows that managers strive to improve the near-term cash flows and profitability of their companies. Often, such short-term decisions by managers may not be in the long-term interest of the shareholders. The truth may lie in between. The point, however, is that ESOP became popular as an employee compensation to attract and retain skill sets within the company. But that has a long-term cost on the company and its shareholders.

Non-optimal compensation: ESOP cost typically refers to the discount that the employees get over the market price when they exercise the options. But the total cost may be higher. The reason is that the demand for a company's stock is normally a downward sloping curve. That is, the demand for a company's shares will gradually decline, as more number of shares becomes available in the market. And that may lead to lower valuation of the company's stock.

This is, of course, very difficult to measure. It amounts to saying that a stock will be trading at a higher price in the market if the company concerned had not issued stock options. The cost is, thus, very subtle to measure in a short period of time.Take Infosys. In 2002-03, the company granted 50.61 lakh options under the 1999 Stock Option Plan. This number will only increase with time, meaning that that the total supply of the company's shares will continually increase.

That may result in an excess supply of the shares in the market over the long run and act as a drag on the stock price.

Alternative compensation: Continuing with Infosys, its 2002-03 balance-sheet shows that the tangible cost of ESOP was Rs 23 crore. If the company had provided cash perquisite of Rs 23 crore instead of options, the reported earnings per share (EPS) would have declined 2 per cent that year. The cost due to excess supply of shares may be higher, though not easily measurable.

An alternative compensation programme can look to lowering the total ESOP cost, yet aligning employee compensation with that of shareholder interest. One such programme can be shadow options. The programme can be structured as follows: A company may issue 1lakh options, to be exercised into 1lakh shares. Suppose the exercise price is Rs 75 and the market price of the stock is Rs 100. The company will pay Rs 25 per option to the employees and treat Rs 25 lakh as an expense in the profit and loss statement. This ensures that the shareholders are not exposed to the higher cost due to excess supply of shares in the market.

The employees who want to sell the shares soon after the exercise will be better off. In the present situation, such employees will have to pay the exercise price and then sell the shares in the market. Their gains will be approximately the discount at which they bought the shares from the company. This is the amount they will receive as cash in the shadow options programme.

Those who prefer to hold the shares for the long-term can buy them in the secondary market. The cash that they receive in the shadow options programme will lower their cost of acquisition. The net cost may be approximately the cost at which they would have bought the shares from the company in the current equity compensation programme.

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