ESOPs turn out to be money-spinners

After a hiatus in 2008 and a mild revival in 2009, 2010 saw a spectacular revival in employee stock options (ESOPs) being offered as a part of executive salaries. Sectors such as banks, pharmaceuticals, FMCG and, to a lesser extent, IT are the top ones to use ESOPs to reward employees.

This past year saw as many as 114 of the CNX 500 companies offer ESOPs, when compared with just 87 companies in 2009 and 84 in the year before that. With more companies jumping onto the bandwagon, there has been a cascading effect on the exercise of options (the holder choosing to convert options into shares).

Soaring market value

The markets zoomed ahead in 2009, but just about held steady in 2010, with considerable volatility. Employees used this bullish sentiment to exercise many more options in 2010 than in 2009. Over 30 crore shares were allotted in 2010, compared to just 11.2 crore in 2009. Only 6.1 crore shares were allotted to employees after they exercised options in 2008. What this has meant is an exponential rise in the market value of the options exercised. In 2010, the market value of the exercised options (number of exercised options multiplied by the market price on December 31) during the year stood at Rs 12,678.7 crore.

To put it in context, that figure is more than three times that in 2009 and nearly nine times that of the year before, as employees may not have exercised options fearing that they may not make reasonable returns, even if the exercise prices seemed attractive.

Attractive price

What seems to have prompted employees to exercise options this time around was the widening gap between exercise prices and the respective company's market price.

The gains have been manifold, allowing option holders to make returns that would have beaten most secondary market picks. For example, HDFC Bank and Dr Reddy's delivered gains of over 489 and 315 per cent respectively. For market-linked options, the returns that ESOP beneficiaries would be sitting on are as high as 709 per cent, as was the case with ACC.

Other par value options would have delivered mind-numbing returns (see Table). Only a small fraction of them offered options at exercise prices that have delivered single-digit or negative returns.

That brings us to the important point that, to the employee, it is the method of determining exercise price that makes or breaks his returns.

Companies such as IDFC, ACC, HDFC Bank, Tube Investments and Aurobindo Pharma that have been running ESOP programmes for several years have kept the exercise price constant across multiple years, even as the market prices zoomed. This has made triple-digit returns vis-à-vis the exercise price possible for holders of these ESOPs.

The truly astronomical returns from ESOPs, however, come from those offered at par value, usually to the senior management. HUL, Wipro, Yes Bank and Dr Reddy's Labs fall under this category. For example, almost all members of the Dr Reddy's management council were alloted par value options (exercise price of Rs 5). There are also some, such as Bharti Airtel, that have stock option programmes running from periods prior to their listing and even have zero price options; some of the options are priced at as low as 45 paisa and those at levels one-tenth of the current market price, as a part of the company's ESOP scheme of 2001.

Complexity in vesting

ESOPs are used by companies as a long-term retention strategy and vest from periods ranging from 1-9 years for employees staying on with companies. So, in many of the cases mentioned earlier, there are multiple ESOP programs running in tandem.

Pricing is done in some cases by taking the average of the high and low closing prices of the stock two weeks prior to the grant. Some companies take exercise price as the closing market price of the share the day before the day of grant. Some of more recent options of ICICI Bank, IDFC and Axis Bank may, therefore, not yet be spectacularly attractive.

Companies such as Dabur India, JP Associates and Glenmark Pharma allotted shares at prices not as attractive as the others, but the notional gains are still much higher than market returns at 35-79 per cent.

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