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2010-06-03

King of all Sops: ESOP

ESOP is a powerful tool to retain and reward your top performers and encourage loyalty.

Quasar Media, a digital media and e-solutions company, was about to go for a 75% takeover by another company, WPP, when the management realized that the pie is going to be huge. Harish Behl, the CEO tells us, ‘We wanted to share the wealth with our key employees who had worked whole heartedly to build the company and had not been opportunists. ‘We did it through the ESOPS plan thereby giving equity stake to deserving employees in the company. This strategy has helped us motivate and retain our best brains and has also set up a culture of sharing wealth with those who have helped create it. So someone who was getting a package of over 10 lakh got a bonanza of over a crore’, Behl adds. 

 

ESOP or Employee Stock Option Plan is a plan to allow your employees to profit from the growth of the company by giving them an option to acquire equity stake in the company. Thus your employees become richer as the company grows and its valuations increase.

Small businesses operate on tight budgets and thus cannot afford to offer industry standard salaries to talented individuals. Employee Stock Options (ESOPS) are a good way to bridge the gap. They serve as a long term incentive to employees and prevent them from leaving. If the employee leaves the company before the options vest, he has to forego the entire benefit of owning the shares of the company.’ If it is a growing company and the valuations are increasing, the gain the employee will make are far too attractive to let go,’ says, Harshu Ghate, Managing Director, ESOP Direct, the only specialized ESOP firm in India.   

This strategy inculcates a great sense of ownership, thus spurring performance. ‘ESOPs offer rewards that can match or exceed the expectations of employees but are still affordable to the company as they are highly performance driven,’ says Ketan Dewan Managing Director, KRD Vision.

 

How it works?

Lets suppose your company Tulip Infotech is listed on BSE and its share is trading at Rs. 55 at present. You would like your employees to contribute to the company’s growth and push the share price up over the long term. You identify the employees who will play a crucial role in this growth on the basis of seniority, performance record etc. say a senior software programmer is one of them. This is how you can go about offering ESOPS to him:

You allot 1000 stock options to him, thereby giving him the right (not the obligation) to buy shares of the company.

These options will vest in him, or be activated, over a period of five years, say 200 options at the end of each year. The logic is to spread out the benefits and keep the employee motivated for five years.

At the end of each year, the employee may exercise the options that have vested in him. Exercising an option means that the employee will give Rs. 40 (the exercise price) to the company for each share of the company. If, say, after the end of the first year, the share is trading at Rs. 60, the employee would want to exercise the option – i.e. pay Rs. 40 for a share which actually is worth Rs.60. If, however, the share is trading at Rs. 35, the employee would obviously not exercise his option – why would he pay Rs. 40 for something which he can buy in the stock market for Rs. 35.

So the employee only makes money if the company does well and the share price goes up.

 

Right time to offer ESOPS?

ESOPS can be granted anytime form the startup stage to the scaling up stage. ‘Usually the vesting period is of three years in which employees are allowed to part with one-third of the shares every year. But for a SME the period can be a bit shorter of i.e of two years as it is enough time to develop understanding and trust from both the sides. ESOP can also be issued after 1 year but it can be for purposes other than retention for e.g. rewarding the past performance,’ informs, Ketan Dewan, KRD Vision.

A company can hire ESOPS even if it is not listed yet. However in that case, the company should show clear liquidity possibilities to the employee, else he would not value it. Say, you must assure the ESOP holders that the company plans to go in for an IPO once in another 3 years.

 

How much equity should you give away as ESOPS?

There are no fixed benchmarks, however normally the founders and financiers of the firm hold about 75-80% of the total value of the firm. The remaining 20—25% can be given as ESOPS to employees. Harshu Ghate, ESOP Direct says, ‘It is a function of the employee size to be covered, equity base of the company, shareholding pattern and ability of the key promoters to dilute their holding.

 

Caveats attached with ESOPS

 

ESOPS are complex instruments and therefore it is very important to communicate the benefits to the employees.  Another major problem in making ESOPS a lucrative exercise for employees is that ESOPS are not freely traded as they can be sold only after the permission of the employer or when the company buys back its shares.  Secondly Dewan adds, ‘this option can be provided only when share process are going up. No employee will entertain ESOPS if the prices are going down. Moreover the company’s equity structure runs the risk of becoming unstable if too many employees try to sell their options to take advantage of gains in the market price.’

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