ESOP. Introduction. Definition. Balkrishna Parab

Transcription

1 ESOP Balkrishna Parab Introduction An employee stock option is a call option on a company's own stock issued as a form of non-cash compensation. Traditionally, employee stock option plans have been used as a way for companies to reward top management and key employees and link their interests with those of the company and other shareholders. More and more companies, however, now consider all of their employees as key. As a result, there has been an increase in the popularity of broad-based stock option plans. Definition An employee stock option is a right given to an employee by the employer to buy (exercise) a certain number of shares 1 of 1 The definition of the term share has been expanded in the context of employee stock options. Clause 2.1 (14) of the Guidelines defines the share as follows: share means company stock at a pre-set price (the grant, strike or exercise price) over a certain period of time (the exercise period). The Companies Act, 1956 (CA 1956) defines an employee stock option as: An option given to the whole time directors, officers or employees of a company which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a predetermined price 2. The Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999 (Guidelines, for short), equity shares and securities convertible into equity shares and shall include American Depository Receipts (ADRs), Global Depository Receipts (GDRs) or other depository receipts representing underlying equity shares or securities convertible into equity shares.. 2 Section 2 (15A) of the Companies Act, 1956.

2 also defines employee stock options in exactly the same terms 3. The various terms in the above definition are explained below: Exercise refers to the communication by the employee of her decision to assert her right under the ESOS and apply to the company to issue her shares upon payment of the pre-set option price 4. Exercise price is the price the employee has to pay to acquire the shares from the company, if she decides to exercise her stock options. The exercise price is also called as grant price and strike price 5. The companies granting option to its employees are free to determine the exercise price subject to conforming to the accounting policies specified in the Guidelines. Exercise period means the time period after vesting within which the employee should exercise her right to apply for shares against the option vested in her in pursuance of the ESOS 6. The stock options are extinguished if the employee fails to exercise them within this period. Vesting means the process by which the employee is given the right to apply for shares of the company against the option granted to her in pursuance of ESOS 7. Vesting period specifies the time when these stock options may first be exercised 8. The companies are free to decide this period. Vesting period can be a single time period or a series of time periods. In other words, vesting can take place in one stroke or in staggered time periods. Stock options only continue to vest so long as the holder is employed, that is why 3 Clause 2.1 (2A) of the SEBI (ESOS and ESPS) 4 Clause 2.1 (5) of the SEBI (ESOS and ESPS) 5 Clause 2.1 (7) of the SEBI (ESOS and ESPS) 6 Clause 2.1 (6) of the SEBI (ESOS and ESPS) 7 Clause 2.1 (15) of the SEBI (ESOS and ESPS) 8 Clause 2.1 (16) of the SEBI (ESOS and ESPS) they are sometimes jokingly referred to as golden handcuffs. The employees may feel compelled to work out the time until they are able to exercise the stock even if they might otherwise prefer to leave the company. If the employee leaves the company during the vesting period, the stock options get extinguished. The employee do not have right to receive any dividend or to vote or in any manner enjoy the benefits of a shareholder in respect of option granted to him, till shares are issued on exercise of option 9. This is obvious because the right to vote and to receive dividend when declared are available only to shareholders. Employeestock option holders are not shareholders; at best they are shareholders-in-waiting! Eligibility to Participate in ESOP Employee stock options can be granted only to employees. Employees are defined to include: (i) a permanent employee of the company working in India or out of India; or (ii) a director of the company, whether a whole time director or not 10 ; or (iii) an employee, as defined above, of a subsidiary, in India or out of India, or of a holding company of the company 11. However, some employees have been excluded from being granted stock options. These ineligible employees include: An employee who is a promoter or belongs to the promoter group Clause 9.3 of the SEBI (ESOS and ESPS) 10 Non-whole time directors (non-executive directors), in general law and under the Companies Act, 1956, are not considered as employees. However, for the purpose of granting employee stock options, the nonexecutive directors are also included in the definition of employees. 11 Clause 2.1 (1) of the SEBI (ESOS and ESPS) 12 Clause 4.2 of the SEBI (ESOS and ESPS)

3 A director who either by himself or through his relative or through anybody corporate, directly or indirectly holds more than 10 per cent of the outstanding equity shares of the company 13. Promoter means: (a) the person or persons who are in over-all control of the company; (b) the person or persons who are instrumental in the formation of the company or programme pursuant to which the shares were offered to the public; or (c) the persons or persons named in the offer document as promoter(s) 14. However, a director or officer of the company will not be deemed to be a promoter if they are acting as such only in their professional capacity 15. Promoter group means: (i) an immediate relative of the promoter, that is, spouse of that person, or any parent, brother, sister or child of the person or of the spouse; or (ii) persons whose shareholding is aggregated for the purpose of disclosing in the offer document shareholding of the promoter group 16. Authorisation A listed company has to get its shareholders approval for implementing ESOS by passing a special resolution in its general meeting 17. The explanatory statement to the notice and the resolution proposed to be passed in general meeting for ESOS should contain the prescribed disclosures. A separate approval of shareholders, by way of separate resolution in the general meeting, is required in the following cases: Grant of option to employees of subsidiary or holding company. Grant of option to identified employees, during any one year, equal to or exceeding one per cent of the issued capital (excluding outstanding warrants and conversions) of the company at the time of grant of option. Compensation Committee A company intending to introduce an employee stock option scheme should constitute a compensation committee for its administration and superintendence. All the members of this committee should be members of the board of directors, and a majority of them should be independent directors 18. This committee is entrusted with the task of formulating the detailed terms and conditions of the ESOS 19. The Compensation Committee is also required to frame suitable policies and systems to ensure that the employee do not violate the provisions of the SEBI (Insider Trading) Regulations, 1992 and SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, Clause 4.3 of the SEBI (ESOS and ESPS) 14 Clause 2.1 (12) of the SEBI (ESOS and ESPS) 15 Proviso to Clause 2.1 (1) of the SEBI (ESOS and ESPS) 16 Clause 2.1 (13) of the SEBI (ESOS and ESPS) 17 Clause 6.1 of the SEBI (ESOS and ESPS) 18 Independent director means a director of the company, not being a whole time director and who is neither a promoter nor belongs to the promoter group (Clause 2.1 (9) of the SEBI (ESOS and ESPS) Guidelines, 1999). It should be noted that this definition is different from the definition of independent director in Clause 49 of the listing agreement of stock exchanges. 19 Clause 5.3 of the SEBI (ESOS and ESPS) 20 Clause 5.4 of the SEBI (ESOS and ESPS)

4 Disclosures of Risks Investments in shares or options on shares are subject to risk as the value of shares may go down or go up. In addition, employee stock options are subject to additional risks. The guidelines require that the company bring these risks to the notice of the employees to whom employee stock options are being granted. The following risks are mandated to be disclosed 21 : 1. CONCENTRATION. The risk arising out of any fall in value of shares is aggravated if the employee s holding is concentrated in the shares of a single company. 2. LEVERAGE. Any change in the value of the share can lead to a significantly larger change in the value of the option as an option amounts to a levered position in the share. 3. ILLIQUIDITY. The options cannot be transferred to anybody, and therefore the employees cannot mitigate their risks by selling the whole or part of their options before they are exercised. 4. VESTING. The options will lapse if the employment is terminated prior to vesting. Even after the options are vested, the unexercised options may be forfeited if the employee is terminated for gross misconduct. Lock-In Period The minimum period between the grant of options and vesting of option is fixed at one year 22. Companies are free to set a vesting period beyond one year. When can an employee sell the shares she acquired by exercising her stock options? The guidelines do not make contain any stipulation in this regard and the company is free to specify the lock-in period for the shares issued pursuant to exercise of option 23. Consequences of Failure to Exercise Options Generally, a company collects an option price at the time of granting stock options. In the case of options on shares or commodities, the amount is forfeited by the grantor of the option. But, should this practice be made applicable to be employee stock options, if, for any reason, the employee does not exercise her stock options? The guidelines provide that the amount paid by the employee, at the time of grant of option may be: forfeited by the company if the option is not exercised by the employee within the exercise period, or refunded to the employee if the option are not vested due to non-fulfillment of condition relating to vesting of option as per the ESOS 24. Listing of Shares The shares arising pursuant to an ESOS shall be listed immediately upon exercise in any recognized stock exchange where the securities of the company are listed subject to compliance of the following 25 : 21 Part A of Schedule IV of the SEBI (ESOS and ESPS) 22 Clause 9.1 of the SEBI (ESOS and ESPS) In a case where options are granted by a company under an ESOS in lieu of options held by the same person under an ESOS in another company which has merged or amalgamated with the first mentioned company, the period during which the options granted by the transferor company were held by him shall be adjusted against the minimum vesting period (Proviso to Clause 9.1 of the SEBI (ESOS and ESPS) Guidelines, 1999). 23 Clause 9.2 of the SEBI (ESOS and ESPS) 24 Clause 10.1 of the SEBI (ESOS and ESPS) 25 Clause 22 of the SEBI (ESOS and ESPS)

5 (a) The ESOS is in accordance with these Guidelines. (b) The company has filed with the concerned stock exchanges, before the exercise of option, a statement in prescribed form 26 and has obtained inprinciple approval from such stock exchanges. (c) As and when employee stock options are exercised the company has notified the concerned stock exchanges by filing a statement in the prescribed form 27. Valuation An employee stock option is an entitlement, a valuable right in the hands of the employee. However, computing the value of employee stock options in practice is very difficult. Two methods are used in valuing employee stock options: intrinsic value method and fair market value. Intrinsic Value Intrinsic value of an employee stock option means the excess of the market price of the share under ESOS over the exercise price of the option including upfront payment, if any 28. For example, if an employee stock option is granted to an employee when the market price of the company s share is Rs. 100 and the predetermined exercise price is Rs. 60, then the intrinsic value of the employee stock option is Rs. 40. Fair Value The fair value of an employee stock option is the price that can be obtained for that option in an arm s length transaction 26 The form is prescribed in Schedule V of SEBI (ESOS and ESPS) 27 The form is prescribed in Schedule VI of SEBI (ESOS and ESPS) 28 Clause 2.1 (9A) of the SEBI (ESOS and ESPS) between a willing buyer and a willing seller 29. The fair value is required to be estimated using an option-pricing model (for example, the Black-Scholes or a binomial model) that takes into account the following factors as on the date of grant of employee stock option 30 : Exercise price. Expected life of the option 31. Current price in the market of the underlying stock 32. Expected volatility 33. Expected dividends on the stock Paragraph (i) of Schedule III of the SEBI (ESOS and ESPS) 30 Paragraph (ii) of Schedule III of the SEBI (ESOS and ESPS) 31 The expected life of an award of stock options shall take into account the following factors: (a) The expected life must at least include the vesting period; (b) the average lengths of time similar grants have remained outstanding in the past (if the company does not have a sufficiently long history of stock option grants, the experience of an appropriately comparable peer group may be taken into consideration); (c) the expected life of employee stock options should not be less than half of the exercise period of the employee stock options issued until and unless the same is supported by historical evidences with respect to employee stock options issued by the company earlier (Paragraph (v) of Schedule III of the SEBI (ESOS and ESPS) Guidelines, 1999). 32 Market price means the latest available closing price, prior to the date of the meeting of the board of directors in which options are granted shares are issued, on the stock exchange on which the shares of the company are listed. If the shares are listed on more than one stock exchange, then the stock exchange where there is highest trading volume on the said date shall be considered (Clause 2.1 (10) of the SEBI (ESOS and ESPS) Guidelines, 1999). 33 If the company does not have a sufficiently long history of traded stock prices to estimate the expected volatility of its stock, it may use an estimate based on the estimated volatility of stocks of an appropriately comparable peer group (Paragraph (vi) of Schedule III of the SEBI (ESOS and ESPS) Guidelines, 1999).

6 Risk-free interest rate for the expected term of the option 35. The fair value of an option estimated at the grant date is not allowed to be adjusted later for changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate 36. The company is free to decide what valuation method it would use to compute the value of the employee stock options granted by it. The company is required to obtain the approval of its shareholders to the choice of the valuation method. Transferability The guidelines provide that no person other than the employee to whom the option is granted shall be entitled to exercise the option. In other words, the stock options granted to an employee are not transferable to any person 37. The option granted to the employee cannot be pledged, hypothecated, mortgaged or otherwise alienated in any other manner 38. In the event of the death of employee while in employment, all the options granted to her till such date shall vest in the legal heirs or nominees of the deceased employee 39. In case the employee suffers a permanent incapacity while in employment, all the option granted to him as on the date of permanent incapacitation, shall vest in him on that day 40. In the event of resignation or termination of the employee, all options not vested as on that day shall expire. However, the employee shall be entitled to retain all the vested options, subject to the scheme framed by the compensation committee in this regard 41. The options granted to a director, who is an employee of an institution and has been nominated by the said institution, shall not be renounced in favour of the institution nominating her The estimated dividends of the company over the estimated life of the option may be estimated taking into account the company s past dividend policy as well as the mean dividend yield of an appropriately comparable peer group (Paragraph (vii) of Schedule III of the SEBI (ESOS and ESPS) Guidelines, 1999). 35 Where the exercise price is fixed in Indian Rupees, the risk-free interest rate used shall be the interest rate applicable for a maturity equal to the expected life of the options based on the zero-coupon yield curve for Government Securities (Paragraph (iii) of Schedule III of the SEBI (ESOS and ESPS) Guidelines, 1999). 36 Paragraph (iii) of Schedule III of the SEBI (ESOS and ESPS) 37 Clause 11 of the SEBI (ESOS and ESPS) 38 Clause 11.3 of the SEBI (ESOS and ESPS) Balkrishna Parab is a member of the core faculty at Jamnalal Bajaj Institute of Management Studies. Contact details: <balkrishnaparab@jbims.edu> Cell Clause 11.4 of the SEBI (ESOS and ESPS) 40 Clause 11.5 of the SEBI (ESOS and ESPS) 41 Clause 11.6 of the SEBI (ESOS and ESPS) 42 Clause 11.7 of the SEBI (ESOS and ESPS)