Employee Stock Option Plan

2. Employee Stock Option Plan

Introduction

Employee Stock Options Plans is defined as an incentive program that gives the qualifying employees the right to buy the firm's common stock (ordinary shares) at a discount. It is also called stock option plan or stock purchase plan.

Many companies use employee stock options plans to compensate, retain, and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. Employees who are granted stock options hope to profit by exercising their options at a higher price than when they were granted.

An example of a typical employee stock option plan:

An employee is granted the option to purchase 1,000 shares of the company’s stock at the current market price of $5 per share (the "grant" price). The employee can exercise the option at $5 per share typically the exercise price will be equal to the price when the options are granted. Plans allow employees to exercise their options after a certain number of years or when the company’s stock reaches a certain price. If the price of the stock increases to $20 per share, for example, the employee may exercise his or her option to buy 1,000 shares at $5 and then sell the stock at the current market price of $20.

Companies sometimes revalue the price at which the options can be exercised. This may happen, for example, when a company’s stock price has fallen below the original exercise price. Companies revalue the exercise price as a way to retain their employees.

In India, stock options which were virtually unheard of till the late 1990’s are gaining popularity and a lot of attention, particularly in knowledge-intensive sectors like information technology, entertainment, and health care. This trend is expected to gather momentum because it is generally believed that stock options align closely the interest of managers with those of shareholders. After all, the value of a stock option depends mainly on the share price which is the dominant component of shareholders total return.

SEBI Guidelines on Employee Stock Option Scheme (ESOS)

A company whose shares are listed on a recognized Stock exchange has to abide by the SEBI guidelines on ESOS. The Key guidelines are as follows

Eligibility:

An employee shall be eligible to participate in the ESOS of the company, provided (a) he is not a promoter or (b) he is not a director who directly holds more than 10% of the outstanding equity shares.

Compensation Committee:

No ESOS shall be offered unless the company constitutes a Compensation Committee, which shall be a committee of the board of directors consisting of majority of independent directors, for advice and superintendence of the ESOS.

Shareholder approval:

No ESOS can be offered to employees of a company unless the shareholders of the company approve ESOS by passing a special resolution.

Pricing:

A Company granting option to its employees pursuant to an ESOS will have the freedom to determine the exercise price subject to the conforming to the accounting policies specified in the guidelines.

Lock-in period and rights of the option holder:

There shall be a minimum period of one year between the grant of options and vesting of options. The company shall have the freedom to specify the lock-in period for the shares issued pursuant to the exercise of options. The employee shall not have any rights as a shareholder till shares are issued on exercise of options.

Accounting treatment:

The accounting value of options may be determined either by the Black-Scholes model or as the difference between the market price and the exercise price. The accounting value of the options should be written off as employee cost uniformly over the vesting period.

Design of an Employee Stock Option Plan

Two important issues in designing an employee stock option plan relates to coverage and the type of plan.

Coverage:

Coverage deals with the extensiveness of the employee stock option plan. In the US where employee stock option plan are used in a wide range of industries, companies like Microsoft and Amazon.com had plans that covered all employees, whereas companies like General Electric and General Motors have plans that cover 10 to 15 percent of the employees. In India, employee stock option plans are popular mainly in information technology companies like WIPRO and Infosys.

Type of Plan

Companies often do not pay much attention to the way the stock option plan is structured. Their directors believe that having an employee stock option plan is important the details are considered trivial. Hence, the task of designing the form of the employee stock option plan is delegated to compensation consultants and HR departments. Such a laissez-faire approach may lead to inefficiently designed plans. Hence, before choosing a particular plan, a firm must know how various plans motivate value-creating behaviour.

An option plan may be a fixed value plan or a fixed number plan or a megagrant plan.

Fixed Value Plan:

Under a fixed value plan, an employee gets option of a predetermined value every year over the term of the plan. For example, the CEO may receive options worth Rs.2 million annually for the next five years or the value of options may be a fixed percentage of the CEO’s cash compensation. To determine the value of the options, Black-Scholes or similar valuation formula is used which considers factors like stock price, exercise price, expiration period, stock price volatility, risk-free interest rate and dividend rate.

Fixed value plans are popular because they enable companies to carefully control the compensation of executives and the proportion of that compensation derived from stock grants. They are ideal for companies that want to keep executive compensation in line with competitors. By doing so, companies hope to minimise retention risk, the possibility that executives may be lured by competitors.

Fixed value plans however suffer from a serious disadvantage. Because the value of future option grants is fixed in advance, the link between pay and performance is weakened. In periods of strong performance and high stock value executives receive fewer options and in periods of weak performance and low stock values executives receive more option. Thus, fixed value plans provide a weak incentive.

The fixed value plan is often quite appropriate for non-executive employees where minimising retention risk is at least as important as providing incentives for value creation. It is, however, ill-suited for large, sluggish companies that lack entrepreneurial drive.

Fixed Number Plan

Under a fixed number plan, an executive will receive a fixed, predetermined number of options every year during the term of the plan. For example, the CEO may receive 50,000 at-the-money options every year for five years.

Because the value of at-the-money options moves in line with the stock price, an increase in the stock price increases the value of future option grants. By the same token, a decrease in the stock price diminishes the value of future option grants. Thus, a fixed number plan provides a more powerful incentive, compared to a fixed value plan.

The fixed number plan usually provides a good balance between high-powered incentives and low retention risk. It is well suited for post-IPO start-ups which are presently using megagrants.

Megagrant Plan

Under a megagrant plan, an executive receives a large lumpsum grant of options upfront. For example, the CEO may receive a grant of 250,000 options exercisable at a certain price during a certain period. Usually when a megagrant is given, the vesting may occur in stages over a period of time.

Because changes in stock prices have a huge impact on the value of the megagrant, a megagrant plan is the most highly leveraged plan.

While the megagrant plan provides the most high-powered incentives for value creation, it accentuates retention risk. If the stock price falls significantly, the megagrants receiver will have a weak incentive to continue. He may leave unless his options are repriced.

The megagrant plan is suitable for large, stable companies that lack entrepreneurial vigour, particularly when the retention risk is not high in the event of stock price decline. However, it is not suitable for post-IPO high-tech start-ups that want to minimize retention risk in the face of volatile stock prices

The case for Indexed Options

Conventional stock options are structured as fixed price options, the meaning that the exercise price is fixed on the day the options are granted and stays unchanged for the entire option period. If the share price rises above the exercise price, the option holder gains. Thus, fixed price options rewards executives for any increase share price, even if the same is well below what competitors or the market have realized. B the same token, they do not reward executives when there is a decrease in share price, even if the company’s share has outperformed the market or its peer group.

Since incentive compensation should reward relative performance and not absolute performance, there is a strong case for Indexed Options rather than the conventional fixed price options. The exercise price of an Indexed Option is linked to a benchmark index, which may be a broad market index or a specific sector index.

To illustrate how the Indexed Options work, let us consider an example. Modern industries limited’s equity stock is currently selling for rs. 100 per share when the nifty is at a level of 5000. modern industries limited grants and option to its CEO which entitles him to purchase 100000 shares at an exercise price of rs. 100, but the same will move in the line with Nifty in future. Put differently, the CEO is given Indexed Options. The value of the option granted to the CEO unde4r various scenarios is shown in Exhibit 35.4

From Exhibit 35.4, it is clear that the Indexed Options reward the CEO only when the companies stock outperforms the market. Irrespective of whether the market as per moves up or down. As Alfred Rappaport puts it: “Indexed Options do not reward under performing executives simply because the market is rising. Nor do they penalize superior performers because the market is declining. They can keep executives motivated in the bull markets everyone has grown accustomed to but also in sustained bear markets.” In nutshell, Indexed Options reward superior performance in all markets.

Value of Indexed Option under Different Scenarios

S T O C K P R I C E S	Index
		Rises	Falls
	Outperforms the Index	Index : 5750 (by 15%) Indexed Exercise : Rs. 115 (by 15%) Price Stock price : Rs. 120 (by 20%) Value of option: Rs. 500000 (Rs. 5 * 100,000)	Index : 4250 (by 15%) Indexed Exercise : Rs. 85 (by 15%) Price Stock price : Rs. 90 (by 10%) Value of option: Rs. 500000 (Rs. 5 * 100,000)
	Underperforms the Index	Index : 5750 (by 15%) Indexed Exercise : Rs. 115 (by 15%) Price Stock price : Rs. 110 (by 10%) Value of option: 0	Index : 4250 (by 15%) Indexed Exercise : Rs. 85 (by 15%) Price Stock price : Rs. 80 (by 20%) Value of option: 0

3. Features of an Appropriate Capital Structure

A capital structure will be considered to be appropriate if it possesses following features:

1. Profitability:

The capital structure of the company should be most profitable. The most profitable capital structure is one that tends to minimize cost of financing and maximize earning per equity share.

2. Solvency:

The pattern of capital structure should be so devised as to ensure that the firm does not run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company. The debt content should not, therefore, be such that it increases risk beyond manageable limits.

3. Flexibility:

The capital structure should be such that it can be easily manoeuvred to meet the requirements of changing conditions. Moreover, it should also be possible for the company to provide funds whenever needed to finance its profitable activities.

4. Conservatism:

The capital structure should be conservative in the sense that the debt content in the total capital structure does not exceed the limit which the company can bear. In other words, it should be such as is commensurate with the company’s ability to generate future cash flows.

5. Control:

The capital structure should be so devised that it involves minimum risk of loss of control of the company by the existing group of shareholders.

6. Clear-cut Objectives:

The sound capital structure should be guided by clear-cut objectives. Its objectives can be maximization of wealth of the company and the minimization of the companies cost of capital.

7. Simplicity:

An efficient capital structure should be as simple as possible, i.e. it should be easy to understand and simple to operate.

8. Balanced Leverage:

A sound capital structure should ensure balanced leverage, i.e. it should ensure a proper balance between different types of ownership and debt securities.

9. Safety:

A sound capital structure should ensure safety of investment. It should be so determined that fluctuations in the earnings of the company do not have heavy strain on its financial structure.

10. Attention to potential investors:

An efficient capital structure should after certain attraction to potential investors in the matter of income, convertibility, safety, control etc.