Valuation of ESOPs

What are ESOPs?
Employee Stock Ownership Plans (ESOPs) involve granting some ownership stake in the company to employees (some or all) with a view to creating ownership attitudes and aligning their interests with that of the company and its shareholders. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans and Stock Purchase Plans.
Why do companies set up ESOPs for Employees?
There are many reasons:

  • It is a tremendous motivator and can get employees highly involved in their jobs and focused on corporate performance.
  • It is vital tool to attract and retain quality employees, fostering in them long term attitudes.
  • As a compensation tool, ESOPs offer rewards that can exceed the expectations of employees but are still affordable to the company as they are highly performance driven.
  • Internationally, ESOPs are used for granting retirement benefits to employees and as succession plan for owners.
  • Increasingly, sheer competition dictates setting up ESOPs for employees.
Strategically, economically, financially or philosophically ESOPs are a win-win combination.
What are Stock Options? How do they Work?

Under a Stock Option Plan a company grants to an employee the right (option) to buy a certain number of shares in the company at a fixed price for a certain number of years (option period). The fixed price is called the 'grant' or 'strike' or 'exercise' price and is typically the market value / fair value of the shares on the date of grant. Since the grant price remains fixed over the term of the option, the employee expects that the share price would increase and he would gain by exercising his option at a lower price.

Before the employee can exercise the option he is usually required to complete the vesting period (or fulfill other vesting restrictions) which typically require that he continue to work for the Company for a minimum number of years (three to five years) before part or all of the options can be exercised. Many a times, certain performance targets are set before the options can be exercised.
What are Phantom Equity Plans (PEPs)? How do they work?
Phantom Equity Plans (PEPs) or Stock Appreciation Rights (SARs) provide employees with one or more benefits of stock ownership without actually making them an actual owner. It is a performance based incentive that is linked to the performance of the company as a whole as reflected in its Share Value. An employee who has Phantom Equity Stock can receive the upside benefits of stock ownership, without having to invest any money and thereby eliminating an owner's risk of losing invested capital. PEPs/SARs are used where the existing owners, say in a closely held company, do not intend parting ownership control, but nevertheless intend to derive benefits of an ESOP.
What are Stock Purchase Plans? How do they work?
Stock Purchase Plans are generally used in listed Companies, wherein the employees are given the right to acquire shares of the company at a price lower than the prevailing market price. The discount could vary from 5% to 25% and is expected to act as a sufficient incentive for the employee to acquire the stock, thereby creating ownership attitudes and a focus towards corporate performance.
How do I select an appropriate plan from the above?
Selection of an appropriate plan would depend on various factors both internal and external, including company characteristics, objectives for setting up an ESOP etc. Generally, Stock Option Plans are used both in closely held as well as listed companies. Stock Purchase Plans are generally used in listed companies more often to supplement a Stock Option Plan. Phantom Equity Plans are generally used in circumstances where either the owner does not wish to part with actual ownership or for certain reasons actual ownership may not / can not be granted. There are various nuances in each of the above and quite often more than one plan could be relevant for the company.
Is the current legal framework in place / adequate for setting up ESOPs in India?
The entire legal framework for setting up ESOPs is now in place. Indian Companies Act permits grant of shares and sweat equity to employees. SEBI has also announced detailed guidelines for grant of Stock Options and Stock Purchase Plans by listed companies. The taxability of gains arising out of exercise of stock options etc. has been clarified through necessary amendments to the Indian Income Tax Act. The Reserve Bank of India also permits employees of Indian subsidiaries of foreign companies to acquire shares of the foreign holding company.
How much stake may be given under an ESOP to the employees?
This depends on various considerations many things, including a company's particular situation, its goals for the ESOP, its expansion plans, the industry / sector of business (e.g. technology companies tend to give higher stake to employees) and many other factors. Companies have a great deal of flexibility in deciding how much stake should be given through the ESOPs. Grants under an ESOP should not be a one time phenomenon. Frequent grants to both existing as well as new employees sustain the advantages of an ESOP.
On what basis do I grant ESOPs to various employees?
Here again, one has great amount of flexibility in determining the quantum of grants for various employees. Some companies grant the same number of options etc. across the board to all employees. Most grant it on the basis of salary and grade levels. It is possible to set /fine tune the grant levels on performance criteria which may be set at an individual level, group a division level or for the company as a whole. Since, essentially ESOPs are a pay-for-performance rewards - the level of grants should be calibrated on the extent of performance and responsibility handled.
How can one leverage the power of ESOPs?
Successive research in the USA and elsewhere has shown that employee ownership can bring phenomenal results, if sharing ownership is accompanied by a committed effort to create a culture in which employees are trained and encouraged to think and perform like owners. Educating employees about the plan, the broader aspects of business, providing relevant information and encouraging employees to make informed decisions are some of the key elements in deriving the best mileage from an ESOP.
Can ESOPs be used by a closely held Company as tool for improving employee performance?
Internationally, ESOPs have been used as extensively in closely held companies as in listed companies. ESOPs in closely held companies retain all the distinct advantages. However since the shares are not publicly traded, employees need to be provided with an exit option. There are many approaches and strategies for handling the repurchase obligations, which can be effectively used.