ESOP – Aspects & Perspective

Presented by:Uma Shankar Acharya ESOP Direct

NIRC - ICSI, Study Circle Meeting, New DelhiSeptember 16, 2011

A Snapshot

¬ Introduction to Employee Stock Options Plans (ESOP)

¬ Steps involved in Designing an ESOP Scheme

¬ Legal and Regulatory Framework

¬ Disclosure Requirement

¬ Compliance Aspects

¬ Perspective

W H A T F O L L O W S

Employee Stock Based Compensation Plan

Employee Stock Option Plan (ESOP)

ESPS is an offer given to employees to buy the shares of the company immediately at a pre determined

price, with a lock-in period for sale

Phantom Stocks Stock Appreciation Rights (SAR)

An employee receives shares or cash equal to the increase in

the value of the specified number of shares over a specified period of time.

Employee receives phantom stock which is settled in cash for an amount equal to the value of defined number of

shares. Methodology adopted is that of ESOP except that

settlement is in cash.

Restricted Stock Units (RSU)

An employee receives stock which is settled in shares; the right to receive the

shares may be subject to performance. Generally, the strike price is the face value

of shares.

ESOP is an option, a right, a choice given to employees to buy the shares of the company at a future date at a pre

determined price

Stock Based Compensation Plans - Instruments

Employee Share Purchase Scheme (ESPS)

Stock Index Plans

What are ESOPs ?

¬ A right, a choice, not an obligation

¬ Each option converts into one or more equity share

¬ To buy shares of the company at a future date

¬ At a price fixed today – the exercise price

¬ Exercise price remains fixed even if the market price goes up in future

¬ Employee would pay only if the market price is attractive – no investment upfront unlike the stock market trading

T H E L I F E C Y C L E

GRANTVEST

EXERCISESALE

Receives the right

Earns the right

Exercises the right

Sells the shares

Why ESOPs ?

¬ Market pays, not the company from its cash kitty

¬ Attract and retain talent at start up / high growth stage

¬ Sense of ownership, particularly at a senior level

¬ Links personal wealth creation to the organization’s value creation

¬ Industry trend

T H E R A T I O N A L E

ESOP - Wealth Creation Aspect

Wealth Creation

(Time Periods) T1T0 T2 T3 Tn------------------------

Exercise Price (Current FMV of share)

Fair Market Value of shares of the company

Optionsbeing granted at T0

¬ Say 5,000 options are granted at Exercise Price of Rs. 100 each (current FMV) in T0

¬ Vesting Schedule is say 25%-25%-25%-25% each year for 4 years¬ Following benefits can be estimated in line with share price movement

T0 T1 T2 T3 T4 Total

FMV 100 150 225 300 400

Less: Exercise price 100 100 100 100

Benefit per option 50 75 200 300

Total benefit 62,500 93,750 250,000 375,000 781,250

Total benefit (if all options are exercised in the last year)

- - - 15,00,000 15,00,000

All Rs.

¬ Objective

» Reward for past association» Reward for past performance» Reward for future performance

¬ Coverage» Broad-based or selective / Subsidiary

¬ Compensation policy

» Rationalize cash variable pay over the long term

» Currency for hiring» Grant - on performance or in anticipation

¬ Quantum» Principle of adequacy and

attractiveness

¬ Dilution & Mode of Issue» % of allocation» Fresh issue or existing shares» Direct Issue or Trust Route

¬ Vesting» Time based or performance based» Standard across the board or

different for key people

¬ Frequency¬ Annual grant¬ One time bumper

¬ Exit alternatives» IPO the only exit option?» If no IPO, then Company/promoter

buy back » Tag along clause

Designing an ESOP Scheme – Decision Points

¬Pricing

» Market value – more dilution, no accounting charge» Discount – less dilution, benefit buffer with accounting charge

ESOP Structure – Necessity of Trust

¬ Market purchase of shares

¬ Providing an exit in case of unlisted Companies

¬ Meeting shareholding requirements

¬ Administrative convenience

What is the trend in listed and unlisted Companies

[Source: Extracts from Equity based compensation trends 2010 – An ESOP Direct Survey]

What is the trend in listed and unlisted Companies

[Source: Extracts from Equity based compensation trends 2010 – An ESOP Direct Survey]

No uniform legal structure followed

in India

No uniform legal structure followed

in India

Legal & Regulatory Framework

¬ SEBI (Employee Stock Option Scheme & Employee Stock Purchase Scheme) Guidelines, 1999

¬ Companies Act, 1956

¬ Foreign Exchange Management Act (FEMA), 1999

¬ Income Tax Act, 1956

¬ Department of Public Enterprise (DPE) Guidelines (additional Guidelines for PSUs only)

SEBI Guidelines - Highlights

¬ Two types of Schemes

¬ Employee Stock Options Scheme (ESOPs)¬ Employee Stock Purchase Scheme (ESPS)

¬ Eligibility for grants under ESOP/ESPS¬ Only permanent employees including Directors of the company or its subsidiary or

holding company¬ Promoters excluded

¬ Exercise price - Freedom to determine the exercise price

¬ Vesting period - Minimum lock-in of one year between grant & vest

¬ Company has freedom to specify the lock-in period post exercise

¬ Constitution of Compensation Committee

¬ Certain terms and conditions to be framed by Compensation Committee only

¬ Certificate from Statutory Auditors – Placed before the shareholders at every AGM

Option holders though do not have a right to vote or dividend like a shareholder, all documents sent to a shareholder are required to be sent to them

Option holders though do not have a right to vote or dividend like a shareholder, all documents sent to a shareholder are required to be sent to them

¬ Employee eligible, employee not to include promoters and directors holding 10% or more of outstanding share capital

¬ Shareholder approval required

¬ Separate resolution for grants to –

¬ Employees of holding and subsidiary companies

¬ Identified employees holding = or > 1% of issued capital

¬ Explanatory statement to include –

¬ Price of shares and number of shares offered

¬ Eligibility of employees

¬ Total number of shares to be issued

¬ Number of shares offered maybe different for different categories

¬ Special resolution to conform to accounting policies

¬ Freedom to determine the exercise price

¬ Shares issued to be locked in for a minimum period of one year from the date of allotment

¬ If ESPS part of public issue and shares issued to employees at the same price as in public issue, shares issued to employee under ESPS, would not be subject to lock-in

SEBI Guidelines – ESPS

¬ Shareholders’ Special resolution for approval of the Scheme – prior to grant

¬ Separate resolutions in case of grant of options to –

¬ Employees of holding or subsidiary company

¬ Identified employees, during one year, equal to or exceeding 1% of the issued capital at the time of grant of option

¬ The explanatory statement to the Notice and resolution contains details of

¬ Total number of options to be granted

¬ Classes of employees entitled to participate

¬ Requirements of vesting and period of vesting

¬ Maximum period during which the options would be vested

¬ Exercise price or pricing formula

¬ Exercise period and process of exercise

¬ Determining the eligibility of the employees

¬ Maximum number of options to be issued per employee and in aggregate

¬ A statement that the company would conform with accounting policies

¬ Method to value the options – Fair Value/Intrinsic Value

¬ Statement - To disclose in the directors report the Compensation cost impact

Approval of Shareholders

Unlisted Companies also follow the SEBI prescription as a best practiceUnlisted Companies also follow the SEBI prescription as a best practice

¬ Required for accounting and disclosures relating to stock-based employee compensation cost

¬ Indian GAAP

¬ SEBI Guidelines for listed companies

¬ Guidance Note on accounting by the ICAI (not mandatory)

¬ Intrinsic Value method allowed with disclosures as per Fair Value method

¬ US GAAP

¬ SFAS 123 (Revised): Fair Value method mandatory

¬ International GAAP

¬ IFRS 2 – Share-based Payments: Fair Value method mandatory

Guidelines for Accounting

L E G A L F R A M E W O R K

¬ Treated as another form of employee compensation in financial statements

¬ Accounting value of options = intrinsic value / fair value of options

¬ Where the scheme provides for graded vesting, accounting can be (amendment August 2008)

¬ Graded vesting – each vest considered as a separate grant or

¬ Straight line accounting – amortization over the vesting period on a time proportionate basis

¬ Accounting value to be amortized over the vesting period

¬ In case of lapse of unvested options, the accounting to be reversed

¬ In case of lapse of vested options, the accounting to be reversed

¬ Options granted through a Trust – Company required to account assuming the company has issued the options directly to the employees

SEBI Guidelines – Accounting Policies

¬ Two broad methods in place¬ Intrinsic Value Method

¬ Intrinsic Value = Market Price – Exercise Price

¬ Static Value as on a particular date

¬ Fair Value Method

¬ Amount for which the option can be exchanged between knowledgeable, willing parties in an arms length transaction

¬ Computed using an Option-pricing model like Black Scholes, Binomial valuation methods.

¬ Considers future life of the option

¬ Required for disclosure and accounting purposes

¬ SEBI Guidelines

¬ ICAI Guidance Note

ESOP - Option Valuation

¬ Tax impact on Company

¬ Tax impact on employees

¬ Perquisite at the time of exercise: amount of FMV at the time of exercise lessthe exercise price is taxed

¬ Capital gain at the time of sale of shares: Net sales consideration less FMV as on date of exercise is taxed.

[Long or short term capital gain would depend on period of holding of the asset]

¬ Share valuation report from a Category –I Merchant Banker for exercise of options in case of an unlisted Company

Taxation

Company is responsible for Tax Deduction at Source (TDS) on the perquisite value of ESOPs

Company is responsible for Tax Deduction at Source (TDS) on the perquisite value of ESOPs

¬ Disclosures to be made to the employees at the time of grant of options as per Schedule IV to the SEBI Guidelines¬ Statement of Risk

¬ Information about the company

¬ Salient features of ESOP scheme

¬ SEBI (Issue of Capital and Disclosure Requirement) Regulations, 2009¬ DRHP to provide detailed disclosures regarding options granted or shares issued under the

pre IPO Scheme in last 3 years (similar to disclosure in Directors’ Report)

¬ Intimate the Stock Exchanges

¬ Approval of ESOP Scheme by the shareholders

¬ Grant of options to employees

¬ Allotment of shares on exercise of options

¬ Disclosure in the Notes to Accounts as per Guidance Note issued by ICAI¬ Particulars of the ESOP Scheme(s)¬ Date and no. of options granted, life of options, fair value & assumptions, weighted

average exercise price, details of options cancelled/lapsed/ forfeited.

¬ Disclosure in the Directors’ Report as per SEBI Guidelines[details given in the next slide]

Disclosures

¬ Disclosures to be made in the Directors’ Report –

¬ Options granted

¬ Pricing formula

¬ Options vested

¬ Options exercised

¬ Total number of shares arising out of exercise

¬ Options lapsed

¬ Variation in terms of options

¬ Money realised by exercise of options

¬ Total number of options in force

Disclosures – Directors’ Report

¬ Employee wise details of options granted to –¬ Senior management personnel¬ Any employee getting more than 5% of total

options granted¬ Identified employees granted options = or >

1% of issued capital at the time of grant

¬ Diluted Earnings per share

¬ Employee compensation cost, its impact on profits and EPS

¬ Weighted average exercise price and weighted average fair values

¬ Method and assumptions used to estimate fair value of options

¬ If options granted 3 years prior to IPO are outstanding, disclosures to be made in the Directors’Report –

¬ With respect to the details mentioned in clause 12.1 of the guidelines &¬ Impact on profits and ¬ Impact on EPS

¬ SEBI has not clearly mentioned – Disclosures for grants during a FY or cumulative?¬ Senior Managerial Personnel not defined?

Compliances – Listing of Shares

¬ Certificate from registered Merchant Banker – along with Schedule V to the SEBI Guidelines

¬ Certificate from Statutory Auditor

¬ Company to file information in Schedule V along with Merchant Banker and Auditor’s certificates to obtain in-principle approval from the concerned Stock Exchanges before exercise of options

¬ As & when options are exercised, notify the stock exchange as per the statement as per schedule VI to the SEBI Guidelines

¬ Shares arising after IPO out of options granted under a scheme prior to the IPO shall be list immediately upon exercise subject to compliance with IPO disclosures

¬ Fresh grant of options under a Scheme framed prior to IPO can be done if –

¬ Such Pre IPO scheme is in accordance with the Guidelines

¬ Such scheme is ratified by the shareholders in general meeting subsequent to the IPO, before grant of new options

¬ No change can be made in the terms of the options issued unless approved by the shareholders, corporate actions excluded

¬ Provisions of lock-in in SEBI (ICDR) Regulations not applicable to shares allotted to employees other than promoters under a pre IPO scheme subject to compliance with disclosures to be made at IPO and ratification for fresh issue of options

¬ ESOP / ESPS shares held by promoters prior to IPO shall be subject to lock in as prescribed under SEBI (ICDR) Regulations

¬ IPO permissible without liquidation or exercise of outstanding options granted pre IPO, if the Scheme is compliant to Guidance Note/ Accounting Standard issued by ICAI

SEBI Guidelines – Pre IPO Schemes

Companies Act

¬ No limit prescribed by the Companies Act for issue of ESOPs to employees

¬ Central Government has issued Preferential Allotment Rules 2003 for Unlisted Public companies

¬ These rules are applicable to all public Ltd. companies issuing any financial instrument convertible into equity shares

¬ Special Resolution prior to such issue

¬ The shareholders’ resolution authorizing the Board of Directors to issue convertible options

¬ The special resolution needs to be acted upon within a period of 12 months

¬ Pricing – Needs to be determined and approved by the shareholders

¬ Auditor’s certificate – Issue is compliance with the rules

¬ Loan to employees for purchase of shares – As per section 77, Company can issue loan to employees for purchase of shares to the extent of 6 months salary

FEMA

¬ Grant of options to employees being a foreign national/ resident out of India

¬ Scheme is drawn in compliance with the SEBI guidelines

¬ Share issued not exceeding more than 5% of the paid up capital

¬ The company to furnish a report to the RBI within 30 days from the date of issue of shares stating

¬ Name of persons & number of shares issued

¬ A certificate from the Company Secretary stating the issue limit within the 5% mark

Other Compliances

¬ SEBI Insider Trading Regulations –

¬ Exercise of options allowed in the period when the trading window is closed

¬ Sale of shares allotted on exercise of options shall not be allowed to be exercised when the trading window is closed

¬ Buy back of shares –

¬ As per section 77A of the companies Act, companies can issue new shares arising from exercise of options within the six month from the date of buy back

¬ As per the Buy Back Regulation issued by SEBI, no exercise of options is permitted during the pendency of the buy back

¬ Clause 49 of the listing agreement -

¬ As per the clause I(B) a prior shareholders’ approval required for grant of options to non executive directors including independent directors stating the number of options granted in any financial year & aggregate

⌐ 2nd Pay Revision (Rao) Committee in late 2008 recommended Performance Related Pay (PRP) for all PSUs

⌐ Cabinet approved recommendations & DPE directed all PSUs to implement PRP, an integral part of the compensation package of the PSUs annually

⌐ 10% to 25% of PRP to be paid as ESOPs to the employees of the PSUs annually

⌐ Applicability of recommendations from financial year 2007-08

⌐ 60% of PRP to be given with a ceiling of 3% of Profit before Tax (PBT)

⌐ 40% of PRP to come from 10% incremental profit of the PSUs

⌐ Apart from above all other legal and regulatory provisions to apply to a PSU

DPE Guidelines for PSUs

Perspectives

¬ Most of the Companies realize that ESOPs have been instrumental in achieving the objectives

¬ Companies in almost all sectors have been issuing ESOPs for more than last 5 years

¬ More Companies in the manufacturing and engineering sector yet to go for ESOPs

¬ Public Sector Undertakings have started issuing of ESOPs pursuant to Department of Public Enterprise (DPE) recommendations

¬ Private equity funds wish for ESOPs in their investee companies for stabilization and growth

¬ Even private unlisted Companies have started showing interest in ESOPs

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