ESOPs are used to foster an ownership culture among employees and boost their morale.
Consider well before you answer this one. In what capacity would you be motivated to work more? As an employee or as an owner of a business?
Most among us would likely be inclined to go the extra mile if we owned the business (or at least a part of it). For the majority of us, the idea of better and additional rewards (profit share) for more efforts, in contrast to a fixed take-home (salary) is a carrot, hard to resist.
Also, when you have skin in the game (in the form of invested capital among other things), one is likely to put in extra to avoid losses. This combo of profit incentive and loss disincentive makes owners drive themselves harder.
To put this broad philosophy into action, ESOPs (employee stock option plans) were introduced by companies to enable employees become part-owners of the business.
Initially introduced in India by software firms (the likes of Infosys and other IT biggies), this innovative form of employee compensation and retention soon became a rage, with sectors as varied as media, banks, retail and many others hooking on the ESOP bandwagon to incentivise employees. ESOPs are also widely used by start-ups to foster an ownership culture and boost employee morale.
What, When, How?
ESOPs basically grant employees the right (option but no obligation) to buy a specific number of shares of the company, at a pre-determined rate (the exercise price) after a specific time period (vesting period).
Say for instance, a company offers its employees the option to buy its shares one year from now at a price of Rs 100; the vesting period would be one year, and the exercise price would be Rs 100.
The exercise price may be at a discount to market price to make the offer seem attractive to the employee, though this need not always be the case.
In some cases, the option to buy the shares may be staggered over a time-period. This is called as ‘vesting percentage'. For example, the ESOP scheme may lay down that an employee can exercise 25 per cent of his ESOP entitlement every year over the next four years. Now, why would employers do that? Primarily, as a tool for employee retention.
Suppose, an employee quits at the end of the second year; in this case, he would lose his entitlement to the ESOPs becoming due in the third and fourth years. In high-attrition sectors where employee turnover shoots up when times are good, this ESOP staggering mechanism sometimes comes handy for employers.
Now, after the end of the vesting period, does the option to buy extend indefinitely for the employee? Not really. The employee needs to exercise his choice within a certain specified period (the exercise period), else the option would lapse.
The good thing about ESOP is that it is an option and not an obligation on the employee to buy. So, if at the end of the vesting period and before the end of the exercise period, the market value of the share is higher (say Rs 175) than the exercise price (Rs 100), the employee may likely choose to exercise the option.
On the other hand, if the share trades at less than the ESOP price (say Rs 90), it will make sense to let the option lapse.
Sometimes, there is also a lock-in period, post exercise of the option. This simply means that the employee would be obliged to hold the shares for a specified period after exercise.
In case of unlisted companies where market price is not available, the board of directors internally decides the price at which shares under the ESOP are to be issued.
Prices are reviewed and re-set periodically, which may help the employee decide on the exercise of the option, and also exit post-exercise, depending on the price advantage.
Several companies arrange for broker services to help employees exercise their options and sell the shares.
Essentially being another form of employee compensation, ESOPs fall under the tax net, with the taxation happening in two stages. First, at the time of exercise of the option, and next, when the shares are sold.
Prior to the July 2009 Budget, ESOP was treated as a fringe benefit to employees and companies used to pay fringe benefit tax (FBT) on the difference between the fair market value on the date of vesting, and the exercise price. In most cases though, FBT was passed on to employees. Later, when the employee sold the shares, he would also have to pay capital gains tax on the excess of the sale price over the fair market value on the date of ESOP vesting.
However, with the scrapping of FBT in last year's Budget, exercise of options is considered as a perquisite for employees in the first stage.
Employee is liable to pay perquisite tax on the difference between the fair market value on the date of exercise, and the exercise price.
Capital gains tax continues to be applicable in the second stage, with the excess of sale price over the fair market value on the date of ESOP exercise being considered as gain.
However, capital gains on ESOPs of listed companies, sold after a holding period of more than one year after allotment, would be long-term in nature, and exempt from tax.
Desirable or not?
When the going is good and markets are on a roll, ESOPs can be highly rewarding and generate a lot of wealth for employees across the hierarchy ladder.
The example of Infosys in which thousands of employees, including those at the lower rung, laughed all the way to the bank, is often quoted to illustrate the potential value of ESOPs. On the other hand, when stock prices hit a trough, as it happened in 2008 and early 2009, ESOPs lose their sheen and exercise of options dips sharply.
Employees may also suffer some heartburn in such cases, since they would have already paid a part of the tax on exercise of the option and would now be staring at further losses. Clearly, not a nice situation to be in.
However, with the markets reviving strongly over the last year, ESOPs are again making a comeback with companies across several sectors planning fresh issues. Also, employees with existing ESOPs stand to make a neat packet on their holdings.
However, caution needs to be exercised by employees before deciding to exercise their options. ESOPs may increase concentration risk borne by employees, since both their regular income (salaries) and investment income (dividends and capital gains) would hinge on the fortunes of the company they work in. If the company was to go belly-up, as happened in the case of Enron, the employee would suffer a double-whammy.
Hence, while ESOPs may have good reward potential, it is important not to put all your eggs in one basket. It is imperative to spread your risks by having a diversified portfolio, of which ESOPs may also be a part.
Also, just like in any other financial market investment, go for ESOPs only after you study and are confident about your company's prospects.
Don't let emotions, peer pressure or coercion overcome rational investment decision-making.