Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Foundations

What is an ESOP?

Employee Stock Option Plans (ESOPs) are commonly heard today, especially in IT companies. So what’s this all about?

Okay, let’s start with history. Companies would earlier hire people and pay salaries and bonuses. That’s ok. But some companies couldn’t afford high salaries, so they hoped to provide their employees with shares of the company, in lieu of salary. The idea being, as the company did well, the stock price would go up, and the shares would yield rich returns, perhaps much more than the salary they forego.

But if you just gave an employee shares, he may resign the next day and gain from future stock price increases but give the company no value. That’s not good.

So companies make the shares “options” – this is a derivative product. The idea being, if you work for the company for this long, we give you so many shares. This is called the “vesting period”. Companies have vesting periods of 2 years or so, and after that every year, further shares are offered.

But do you get the shares free? No. Earlier companies used to give shares at very low prices, but that affects other investors (I will explain later). So SEBI has regulation on how the pricing of stock options can be made (typically, average price over the last six months).

So, a stock option is the right to buy shares at a certain price (called the ‘exercise price’), and ESOPs are rights to buy shares at a certain price after the vesting period, provided you still stay employed in the company.

When your shares vest, do you automatically get them? Again no. You have to pay some money to get the shares – this is called “exercising the option”. When you exercise, you pay the option’s exercise price, and get the shares in your name. Some people don’t want to pay up, so the options remain vested, but unexercised.

Let me show this with an example. Let’s say Shenoy Solutions, an IT company, has 100,000 shares currently priced at Rs. 10. The company offers an employee, Girish, options for 1000 shares at Rs. 10, after two years.

After two years, the price of the share is Rs. 40, and Girish exercises the option – he pays Rs. 10,000 and the company issues a further 1000 shares, taking the total number of shares to 101,000. Girish now owns 1,000 shares.

How does this affect you, if you are a normal shareholder? It dilutes your equity. The EPS is a guiding factor to the value of a company – if the number of shares increase, the EPS will go down. You may think it’s inconsequential – but look at recent times – Infosys’ EPS will be hit by 10% (!!) in 2007-08 because of exercised ESOPs.

One of the recent problems with ESOPs is the change in legislation – companies are required to pay FBT on ESOPs – on the difference between the market value and the offered value. This is too much to handle, so nearly all companies asked employees to exercise their vested ESOPs. So nearly all tech companies will have an EPS hit this year with larger number of shares now available.

ESOPs are good tools for retention and compensation. But there is a cost to the option – if you tried to sell the same option in the marketplace, people would be willing to pay a high premium. This is money that the company does not recover from the employee, so technically, it’s a cost to the company – that must be reflected in the balance sheet. But India has no such law, so the cost goes unreflected – and I must say I agree that the profits will then appear inflated to that extent.

ESOPs are interesting – for you as a shareholder, to assess the impact on your companies’ EPS, and as an employee for potential future gains.

Like our content? Join Capitalmind Premium.

  • Equity, fixed income, macro and personal finance research
  • Model equity and fixed-income portfolios
  • Exclusive apps, tutorials, and member community
Subscribe Now Or start with a free-trial