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Concepts & Tutorials

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.

  • Anonymous says:

    >I believe there is a difference between the price at which one can exercise an option (called the exercise price) and the price of that option (called premium). So when you said …”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 price, and get the shares in your name.”…it is not correct. When you execrice, you pay the exercise price and not the option price.

  • Deepak Shenoy says:

    >You’re right – I meant the exercise price there! There’s no “option price” since the option is given at zero premium.

  • Anonymous says:

    >How do ESOP’s of foreign based companies work? For example, I work in a company headquartered in the US and I have been give stock options of the US shares. How much tax do I have to pay on the profits I get? Also do you have any idea of the recent stock options scams that took place in US in the last few months? Thanks.

  • Deepak Shenoy says:

    >Just about the same as Indian companies. You’ll pay tax as much as you pay at the highest bracket that you’re in – the “marginal” rate of tax, if your holding period is less than one year. If your holding period is more than one year, you pay 10.3%.

  • Ranjit kumar says:

    >Hi Deepak,

    Nice article. This ESOP thing is a very sticky issue to investors. I like buffett’s opinion on ESOP’s. He says that they should be declared as expenditure. In this way there is less harm to the investors. In the wake of several stock option backdating scandal’s in US, it is obvious that in India also there will be a lot of them. If you invest in a business feeling as an owner, which almost all value investor’s do its a pain.

    Regards
    Ranjit kumar

  • Dhananjay says:

    >Hi Deepak,
    Have you managed to collect & collate some info on below (SIP Vs Equity Vs Lumpsum Inv etc). I eagerly await your analysis.
    Thanks Dhananjay

    I have managed to collate (Slowly & Painfully- I am unfortunately not adapt at excel formulas so did every calculation individually after finding out its NAV on that date) the details for HDFC Equity MF & Reliance Growth MF – for upto 10 years each for Investments of SIP of 1K on 1st of every month & 12K lumpsum on 1st april every year. Surprisingly the 12K lumpsum came out on tops in both funds.(So much for the SIP is better than Lumpsum theory in this case)
    I now wish to do this excercise for Infosys & Rel Ind shares as well. Where can i get info on historical share prices + historical dividends & bonus + change in face value of shares (Rs 10 to Rs 2 etc), what else would i need to consider while doing this, or have u or someone else done this or similar analysis already.
    Thanks & regards,
    Dhananjay

    (Yr earlier reply is given below for yr kind ref)
    Dhananjay, I don’t have these figures, unfortunately. Would be good to build them – in fact I would love to see this myself.I think I shall collate this myself, perhaps need this weekend to do so. Will post an update, cheers! Deepak Shenoy, at Apr 4, 2007 5:51:00 PM

    Dhananjay: Sorry mate, haven’t had the time to do this yet. Will try to do this soon …
    Deepak Shenoy, at Apr 17, 2007 9:16:00 AM

  • karthik says:

    >Hi Deepak,
    I just requested you today morning in market advise post about ESOP. I never thought you would make a post on this within a short time. I m stunned to see this in the evening.
    Thank you very much for this knowledge.

  • Anonymous says:

    >I have a query, Companies like L & T, do not have any owner and the CMD issues ESOP for himself, is there any guideline. As he is bribing all the board members also with the ESOP, the entire board supports all his discisions. The actual share holder is suffering even the comapny performs well

  • Anonymous says:

    >Deepak, Looks like you have answered the question but again for my clarity. I work in a MNC whose stock is not listed in India. They have given me stock in 2001 which got vested over a period of 4 years. I exercised the option in 2007that means the transactions shows I bought the stock at 80 and sold it at 100 on same day. Will it come as Capital gains tax or I need to pay difference as income tax

  • Deepak Shenoy says:

    >1st Anon: There are guidelines for ESOPs and the boards must actually be following it.

    2nd Anon: Did you exercise pre-march 31 2007? If so then this should be considered as long term gains which is taxes at 20% (since the sale wsn’t done on an Indian exchange). This only applies if the stock option plan was registered in India. Otherwise you will pay short term capital gains, which means it’s added to your income and you pay full income tax on it.

  • nathan says:

    >rDeepak

    Thanks for ur reply. The company in question is IBM and I did sales some time in August.I am not sure what u meant by “The stock option plan registered in India”.

  • Deepak Shenoy says:

    >Nathan: Stock option plans need to be somehow registered with the Income tax dept (or such authorities) to take advantage of tax laws – but I may be wrong, perhaps you can get a legal opinion?

  • intradaytips9 says:

    >Hi, all its a very good article. and i want to ask something that" My former employer filed for Chapter 11 Reconstruction and also prior to the filing petitioned for a dissolution of the ESOP. Will I see any of the monies from my 14 years of service with the company"?
    Please give me some way……..

    Regards,

    hi, i am new to this website.my name is sanjeev. I am a technical analyst. i give share tips for Indian stock market .

  • Anonymous says:

    >Hello Deepak,
    My question would sound similar but it is related to RSUs( Restricted Stock Units). The US based MNC which I work for gave me 500 RSUs in Nov 2009 (0 priced shares), 25 % of which will be vested each year.
    Hence, I would be having 125 vested shares in Nov 2010.
    Will the tax structure be different if sell the vested shares in Nov 2010 compared to holding it for another year and selling it in Nov 2011.

    And will the tax be deducted by US or by my company.
    Thanks