The Hindu Business Line : Sops by way of ESOPs

Employee stock options (ESOPs), a compensation tool long followed in the IT sector, are gradually becoming a part of the salary package in media, retail and other high-growth sectors. What is so special about ESOPs and are they any replacement for hard cash?

An ESOP is, quite literally, an option but not an obligation to buy the shares of the company you work for. An agreement is signed with the employer that gives the employee the right to buy a specific number of shares of the company’s stock, during a specific period, and at a price that the employer specifies.

ESOP Ownership

Owning options is not the same as owning the company’s shares. It simply confers the right to buy shares of the company. The price the company sets on the stock is called the grant or exercise price. Since this must appear rewarding to the employees, it is usually lower than the market price of the share at the time the employee is given the options. Converting options into shares by paying the exercise price is known as exercise of options. Most companies have tie-ups with brokerage firms to enable this conversion process.

If your company does well and its stock price rises beyond your exercise price, you now have the option to buy shares at the exercise price and sell it at the market price for a profit. Incentive enough for you to work harder, got it?

The plus side is if the stock price goes down, then you need not really exercise the option. Nothing lost, nothing gained. . ESOPs, therefore, simply offer the carrot of potential capital gains in addition to your regular salary. To illustrate, suppose one has options to buy 100 shares of the company at an exercise price of Rs 100. The stock is currently trading in the stock market at Rs 125.

You have the choice of converting options into shares by paying Rs 100 per share and selling them at Rs 125 in the market. Voila! You have made a profit of Rs 2,500. On the other hand, if the market price of the share is Rs 75, you can choose to not exercise the option at all.

Also if you want to maintain a ‘wait and watch’ approach, in anticipation of further gains in stock price, you can sell, say 50 shares now and the remaining 50 shares later.

Timing and quantity restrictions

Another important concept with regard to ESOP is that of vesting. Vesting has two associated aspects, vesting period and vesting percentage. Vesting percentage is the portion of total options granted to the employee which he is eligible to exercise.

Vesting period is the period on completion of which the said portion can be exercised. Both of these are decided by the company and are part of the original agreement on ESOPs. So, as in the previous case, if you have been allotted options to buy 100 shares of the company, you may have a vesting period of, say, four years. There may also be a vesting percentage of 25 per cent per year.

This means that you can buy 25 shares of the company by paying the exercise price, at the end of the first year, 25 shares at the end of the second year and so on until the end of the fourth year when your options will be fully vested.

Lapse of options

It is important to know that ESOPs have an expiration date. That is, even within the vesting period, one can exercise his options only within a particular time window specified in the agreement.

If the options are not exercised within that period, they lapse. This period is called the exercise period.

If the employee decides to leave the company, he can exercise only the vested options, but all future vestings will be void.

ESOPs of unlisted companies

In unlisted companies, there is no ‘market price’ or a grant price available for an employee. The company here fixes an internal value to its shares. This is decided by the board of directors of the company through a voting system.

This value is reviewed and re-set periodically. In such cases, an employee can exercise the option if he finds it advantageous and sell the shares back to the company.

Variations of compensations

Employee stock purchase plan: The company issues shares to employees after a specific time period in the job.

A predetermined amount is withheld from the employee’s salary towards the share purchases.

Restricted stock units: This entitles the employee to receive stock or cash equivalent of the stock after a vesting period.

Tax Implications

In India, ESOPs are taxable as a fringe benefit.

(For complete information on tax implications, please read the Tax Talk section of Business Line dated September 9, 2007.)

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