The Hindu Business Line : ESOP fables

The new-age perk for the new-economy professional, ESOPs, which made millionaires of software professionals when the going was good, are today the subject of disillusionment.

Raman Khanna is just one of the thousands of expatriate software whizkids who saw their American Dream blown to smithereens when the dotcom bubble imploded. At the height of the dotcom mania, the Employee Stock Option Plan (ESOP) was considered the golden key to the treasure chest. However, unlike the fables, which have a happy ending, the ESOP fable has been a source of grief, disillusionment and heartburn among the wannabe czars of the New Economy. That's what Raman, a Java programmer and networking specialist, discovered in June 2000, when the dreaded `pinkslip' made its way to his desktop with a curt message: ``Meet the HR manager.'' Like many of his ilk from the sub-continent, who till the other day were considered the hottest property in the hi-tech companies, he worked for a high-flying Web services company based in a $67-million hi-tech office complex, Tide Point, in Baltimore.

When employee was king

Flush with $25-million VC money, it had all the trappings of glitz and glamour that became the symbol of cool at the cutting edge of technology. The company also bought a black Plymouth Prowler which it parked on the driveway, ostensibly to lure the cream from Microsoft. And Raman was one of them. He joined the company as a Technology Strategist in 1998 when the dotcom boom threatened to turn conventional business logic and fundamental economic theories on their head. A salary of $80,000 per annum and a `hire grant' along with annual ESOPs in hand, Raman could not have asked for a better deal. ``I thought I had arrived in life after spending all those man hours honing my skills as a programmer in India,'' says Raman, barely controlling his bitterness. ``For over two years, I was on top of the world. But everything just vanished into thin air that June morning when I was told by the HR manager that the company could not afford me any more,'' he says. Since the company was yet to come out with an Initial Public Offering (IPO), Raman was left clutching worthless stocks. Closer home, gone are the days when paper millionaires would peer from magazine covers and were the treat of the corporate cocktail circuit. Words such as valuation, strike price, lock-in period, grant price, going public, vesting, page views, eyeball, et al, no longer dominate a normal conversation in the pubs that dot Bangalore — our very own `Silicon Valley'.

Plummeting stock

A recent study of 15 leading companies from the tech and non-tech sectors, conducted by the Pune-based ESOP Direct, part of KP ESOP Consulting Pvt Ltd, revealed that over 73 per cent of the options that were granted are `underwater' — which means that the current market price of the scrips is lower than the exercise price. The exercise price is the price at which the holder of the option is able to purchase the stock. In India, the exercise price is mostly 15 per cent lower than the market value.

At the time when these options were exercised, technology stocks were ruling the bourses and all those who owned such stocks were delighted to see their personal net worth soar. But, when ICE — Information, Communication and Entertainment scrips — melted, the situation reversed and the market value went under the exercise price. This has created a piquant situation, where the employee has ended up bankrolling the company's operation as an incentive for his contribution.

And, where ESOP constituted a part of the compensation package, the situation is even more complicated. ``As long as ESOP is treated as an incentive tool or the employer is genuinely interested in creating wealth for the employee and it doesn't form a part of the compensation package, the situation is not all that bad. But where it is a component of the compensation package, it's an unfair practice because it links compensation to the fluctuations of the stock market.

Second, it also negates the concept of fair remuneration, which the employee would have got otherwise,'' says Abhijit Sen, now Project Manager with Stingray Technologies Pvt Ltd in New Delhi. Sen was himself at the receiving end of this practice at the hands of his previous employers, Interra, a privately held software developing firm. His annual compensation package included a minimum profit guarantee component worth Rs 50,000 annually, for two years.

In other words, it meant that if the company failed to bring out an IPO after two years from the date of joining, it was obliged to pay Rs 1,00,000 under the minimum profit guarantee. But, in August 2001, when the company announced job cuts citing the slowdown, Sen lost the equivalent of Rs 75,000 for his 18-month stay with the company, based on the concept of fair remuneration. Even in the bluest of blue chip Indian software companies — Infosys, which pioneered the concept of ESOP in India in 1994 — the number of paper millionaires has dwindled to 574 rupee and 34 dollar millionaires from a high of 1,157 rupee and 84 dollar millionaires respectively between March and September 2001.

However, stock-holders covered under Infosys' 1994 ESOP plan, which matured in August 2001, have been spared such ignominy, because the exercise price of 1994 continues to be much lower than the present market value of Rs 3,934 and, for the time being, N. R. Narayana Murthy's philosophy of creating and distributing wealth remains on track. Though the stocks' current valuation stands at a much lower level than in March 2001. Typically, the early employees bear the maximum risks but, at the same time, if the company is successful in bringing out an IPO, they stand to gain the most, simply because they hold more shares and at a much lower exercise price. The major share of the blame lies with the employers, who, at the height of the boom, liberally doled out ESOPs to attract and retain talent. They often created the misleading perception that employees would gain substantially from stock options. lower tax rates on the profit obtained from the gain in stock price over time. Join Oblix now while you are able to receive pre-IPO incentive stock options!'' With stocks going underwater, the dominant but disturbing belief shared by the majority of Indian software companies is: sooner or later the stocks are going to regain their lustre, so where's the need to salvage them. According to a survey by ESOP Direct earlier this year, over 90 per cent of the companies didn't want to tweak the schemes to correct the anomaly.

In the present uncertain scenario, the companies are under no pressure from the employees, who are busy protecting their jobs to get worried about rescuing their badly mauled stocks. Also adding to the inertia is the fact that, since the stock markets crashed, ESOPs have ceased be the carrot with which upstarts could attract talent. On the other hand, existing employees have not moved out even as their personal net worth plummeted. Even more disturbing is that around 52 per cent of the companies who have offered stock options have not cared the least about issues such as what happens in the case of mergers or acquisitions, as is happening all around, or when the company issues rights and bonus shares. Most Indian companies tend to leave such decisions to the whims and fancies of the compensation committee of the new dispensation as and when the situation arises.

Re-pricing dilemma

However, the companies are also caught in a Catch-22 situation. Any attempt to salvage the situation might create a conflict of shareholder-employee interests. ``Re-pricing the option could be a tricky proposition. If the options are re-priced and discounted at prevailing prices, it will naturally upset the shareholders but, at the same time, leaving them underwater for a long period of time is detrimental to the interest of employees who want to liquidate their options,'' says a senior finance executive with one of India's largest Internet Service Providers.

Not many buy this line of argument. Some industry observers firmly believe it's high time companies took corrective measures. This could be done by adopting a variety of strategies such as re-pricing without cancellation, selective re-pricing or cancelling all existing options and granting an equal or fewer number of options at lower exercise price. Compared to their Indian counterparts, American companies have proved to be more nimble in addressing this problem. Over 30 per cent of American companies offering ESOPs have gone in for re-pricing, in accordance with the altered market conditions.

Among the heavyweights, NIIT resorted to re-pricing in April this year. The re-pricing strategy to a large extent depends on how well the option is designed. A plan in which options are granted in yearly tranches, `at-the-money' — market price equals exercise price — fixing is not required. The crux of the problem which has caused so much heartburn is that ESOP benefits were marketed as a sure way of making mega-bucks, without elaborating the downside of stock-holding. The perverse logic for not making employees aware of the downside: once employees become part-owners of the company, they cannot claim that they want only to be on the upside of the company and not downside. Sure. But why was the gimmick hyped up in the first place?

But people like Raman and Sen dunk this theory. ``At the most, stocks issued under ESOPs cannot exceed more than 5 per cent of the total number of outstanding shares, so where is the question of becoming partners in the policy-making process of the company?'' argues Raman. ``It's like a marriage in which one of the partners has just 5 per cent of the decision-making power but at the same time he or she is held to be an equal partner in responsibilities. This is not an equitable arrangement,'' emphasises Sen. The ESOP concept has been around for almost 80-odd years, when George Eastman, founder of Kodak, transferred one-third of his holding to his employees in 1919. But never before did it generate such heated debate, except in 1980 when ``owners went on strike against themselves'' in the famous South Bend Lathe ESOP case over dispute of voting rights with the management. Everybody thought ESOP models had been given a decent burial. But, in the mid-1990s as the dotcom bubble started enveloping the globe and was stretched to the maximum by 1999, the number of Venture Funds based in the US alone peaked to 1,010. These in turn fired up 5,380 start-ups in the US alone, with $103 billion being invested in them.

And then the virtual world came crashing down in March 2000, when total IPOs netted only $8.7 billion — and by January 2001 reduced to zilch. In other words, they simply ran out of money. They burnt through the cash faster than bushfire, and, as return on investment (ROI), they left what Lawrence Hamermesh, a corporate law professor at Widener University Law School in Delaware, describes: ``You get a hodgepodge of goodwill, intangible rights, intellectual property ... The only way to place a value on that is to ... estimate what it will bring in the future. In the dotcom world, that is crystal-balling that amounts to speculation of the highest order.'' ``The hype that was built up around a handful of those who made their millions and left the scene, made others believe that they too had the chance to become millionaires. Plus the fact that most of the newcomers were more interested in ramping up valuation on the stock markets, rather than establishing time- tested business practices, so that the initial investors could exit their investments, created a bubble that burst in due course. This resulted in a feeling of being short-changed among those who faced the brunt of the blow and this caused so much of heartburn and grief,'' says a salary and benefit consultant with leading HR consultancy firm Hewitt LCC, while summing up this round of the ESOP debacle.

Chastened by this experience one can only hope that the next round of the ESOP fable will have a much happier ending.

(Names of persons interviewed have been changed on request)

Illustrations: V.M. Raja

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