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Definition of 'Employee Stock Option Plan'

An Employee Stock Option Plan is a benefit plan for employees which makes them owners
of stocks in the company.

Definition: An Employee Stock Option Plan (ESOP) is a benefit plan for employees which
makes them owners of stocks in the company. ESOPs have several features which make them
unique compared to other employee benefit plans. Most companies, both at home and abroad,
are utilising this scheme as an essential tool to reward and retain their employees. Currently,
this form of restructuring is most prevalent in IT companies where manpower is the main
asset.

Description: Abroad, ESOP (where the 'O' often stands for ownership) is seen when
employees buy over the stock of an owner or promoter who is relinquishing charge. In India,
ESOP is used largely to motivate employees to put in their best and in turn, help the company
enjoy lower employee turnover and retain its talent pool. These two uses probably account
for over two-thirds of all ESOPs now in existence, and their numbers are expected to increase
with time.

Interestingly, many companies abroad use ESOPs as a technique of corporate finance for a
variety of purposes -- to finance expansion, to make an acquisition, to spin off a division, to
take a company private, and so on. This has yet to catch on in India, perhaps because the
scale of ESOP so far is too small for many of these uses.

So far as the future of ESOPs in India is concerned, as more and more companies realise the
need to retain their best talent in a world which would be dominated by companies with the
best intellectual capital, this management technique would be the phenomenon of the new
century.













Kochi: Muthoot Finance Ltd, India's largest gold loan company today announced the launch of its
maiden Employee Stock Options Plan (ESOP), which would benefit its over 24,000 employees.

The plan was approved as a special resolution in the company annual general meeting held here on
September 27, the company said in a press release.

The plan will grant employee stock options to employees through one or more employee stock
options schemes.

Among the salient features of the ESOP are that options convertible into such number of equity
shares not exceeding three per cent of the paid up capital at any point of time, each option (after it
is vested) will be exercisable for one equity share of Rs. 10 each fully paid up.

All permanent employees, including directors, whether working in India or abroad, would be entitled
in the employee stock options scheme. Options can be exercised within a period of eight years from
the date of grant.

The appraisal process to determine the eligibility of the employee will be specified by the Board and
the number of options that may be granted to workers under the Scheme shall be determined by
the ESOP Committee from time to time.

Commenting on the special provision launch, M G George Muthoot, chairman, Muthoot Finance said
that the plan would not only enable the company reward past loyalty and performance, but also
attract and retain the best talent; besides enabling employees develop a greater sense of ownership
with the organisation.

George Alexander Muthoot, managing director, Muthoot Finance informed that Muthoot Finance
has about 24846 plus employees.

With this maiden ESOP scheme, the company wants not only to reward existing employees who
have been active in achieving long-term corporate goals, but also be the best company to work for
by retaining and attracting new talent to drive the next leg of growth.








History
In the mid-19th century, as the United States transitioned to an industrial economy, national
corporations like Proctor & Gamble, Railway Express, Sears & Roebuck, and others
recognized that someone could work for the companies for 20 plus years, reach an old age,
and then have no income after they could no longer work. The leaders of those 19th-century
companies decided to set aside stock in the company that would be given to the employee
when she or he retired.
In the early 20th century, when the United States sanctioned an income tax on all citizens,
one of the biggest debates was about how to treat stock set aside for an employee by her
employer under the new U.S. income tax laws.
ESOPs were developed as a way to encourage capital expansion and economic equality.
Many of the early proponents of ESOPs believed that capitalisms viability depended upon
continued growth, and that there was no better way for economies to grow than by
distributing the benefits of that growth to the workforce.
[20]

In 1956, Louis Kelso invented the first ESOP, which allowed the employees of Peninsula
Newspapers to buy out the company founders.
[21]
Chairman of the Senate Finance
Committee, Senator Russell Long, a Democrat from Louisiana, helped develop tax policy for
ESOPs within the Employee Retirement Income Security Act of 1974 (ERISA), calling it one
of his most important accomplishments in his career.
[22]
ESOPs also attracted interest of
Republican leaders including Barry Goldwater, Richard Nixon, and Gerald Ford, and Ronald
Reagan.
[23]

In 2001, the United States Congress enacted Internal Revenue Code section 409(p), which
effectively requires that S ESOP benefits be shared equitably by investors and workers. This
ensures that the ESOP includes everyone from the receptionist to the CFO












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Rediff.com Getahead 10 things you MUST know about ESOPs
10 things you MUST know about ESOPs
Comment Share Text size: A A A
May 09, 2005 09:14 IST
oining a firm where part of the package is the lucrative employee stock options?
This is a common bait dangled at those joining software companies.
Here's what an ESOP is and the tax implications of it.
1. What are ESOPs?
An Employee Stock Option Plan is when the company offers its shares to the employees.
An ESOP is nothing but an option to buy the company's share at a certain price. This could either be
at the market price (price of the share currently listed on the stock exchange), or at a preferential price
(price lower than the current market price).
If the firm has not yet gone public (shares are not listed on any stock exchange), it could be at
whatever price the management fixes it at.
5 things you must know before buying shares
2. Why would a company offer an ESOP?
Let's first explain what owning a share entails.
When you invest in shares, you do not invest in the market. You invest in the equity shares of a
company. That makes you a shareholder or part owner in the company.
Owning an equity share means owning a share in the company business.
Companies offer their employees shares because it is considered that having a stake in the company
would increase loyalty and motivation substantially.
3. When are they given?
It depends on company policy and your designation.
There are time limits for availing this scheme. For instance, you can acquire the shares after you
complete a particular period of employment. This could be a year, even longer.
This is known as the vesting period, and generally ranges from one to five years.
If you quit your job before this period is complete, the stock options lapse.
Sometimes, the ESOPs are given in a phased out fashion -- 20% in the second year, another 20% in
the third year, etc.
4. When are they taxed?
The ESOP is not taxed on acquiring the shares.
You are taxed on the profit you make when you sell the shares or transfer them.
Transfer here refers to when you gift it to someone or transfer it to someone else under an irrevocable
deed (they now own it, not you).


















Definition of an ESOP
Technically an ESOP is a tax qualified defined contribution benefit plan. Functionally ESOPs
are a very flexible financial and equity incentive instrument that uses corporate tax-deductible
or tax-free dollars to achieve a variety of individual and corporate objectives, including
shareholder liquidity, perpetuation, raising working capital, and charitable giving
An ESOP is unlike any other employee benefit plan in that the ESOP Trust, or ESOT, is
designed to hold primarily stock of the sponsoring employer.
In its simplest form a company establishes a trust to which the company contributes stock or
cash to purchase stock. The stock is then allocated out to employees' individual accounts
within the trust. When cash is contributed it is used to purchase stock from shareholders and
then allocated out to individual employee accounts.




In the leverage ESOP the, the ESOT borrows the cash to purchase shares then repays the debt
with the contributions contributed by the sponsoring corporation.



























Survey on
ESOP Design Practices 2001
ESOP Practices in India An Overview
The survey report, in the following chapters, addresses the finer aspects of ESOP Design
practices in India. It would however be useful to take a macro view of the overall trends
that seem to be emerging in this relatively new phenomenon in India.
In the subsequent paragraphs we have made an attempt to identify and analyze the macro
trends. We have tried to interpret the findings vis--vis sectors (IT Vs Non-IT) and also
within the sectors, in terms of whether companies are looking at structures unique to their
requirements or is everyone following each other. We have also tried to analyze the
impact of the SEBI guidelines on ESOP and benchmarked the findings versus global
trends, particularly in the US.

Coverage of employees:
There is a noticeable difference in terms of coverage, if one compares the IT and non-
IT companies. While around 43% of the IT companies have given ESOPs to more
than 90% of the employees, only 17% of the Non-IT companies have done so. A
related finding is that more than 75% of the Non-IT companies offer ESOPs only to
the senior and middle management employees.
This is a predictable trend. We believe that apart from the willingness of the
management to offer ESOPs, it is also the preference of the employees, which
influences the decision about coverage. While a worker employee in a manufacturing
company would prefer a cash incentive to a stock option, a fresh software developer
Survey on
ESOP Design Practices 2001
would go for a stock option. It has to be seen how the employees in the IT sector react
to the slump in the stock prices.
It is however interesting that within the IT companies, while only 23% of the large
companies offer ESOPs to more than 90% of the employees, the number is as high as
60% in case of smaller companies. A significant 54% of the large IT companies offer
ESOPs to less than 25% of their employees.
This clearly brings out that smaller companies offer options to the junior employees
also to ensure retention and attracting them from larger companies.

Legal structure:
It is interesting to find that there is no uniform legal structure followed by the
companies. While around 58% of the companies have preferred a direct route
(Without an ESOP trust) a significant number (42%) of companies have preferred a
Trust route.
Also interestingly there is no major shift in the post 1999 (after SEBI guidelines)
period. It was expected that the accounting treatment suggested by SEBI would force
companies to opt for a direct route.

Term of options:
There appears to be no difference in the practices followed by IT and Non-IT
companies with respect to the term of the options. More than 78% of the IT
companies have a term of less than 4 years and the percentage is identical for the
Non-IT companies.
Survey on
ESOP Design Practices 2001
It was expected that the tenure in the non IT companies would be longer since the
attrition rates there are much less than in the IT sector.
If the Non-IT companies look at longer terms, they could optimize by diluting less
equity without affecting the attractiveness of ESOPs.
Interestingly no remarkable difference is noticed between large and small IT
companies. It was expected that small IT companies would have shorter term of
options than the larger companies, to attract and retain talent. However it does not
appear to be so.

Frequency of grants:
Here again there is similarity in the practices followed by the IT and Non-IT
companies. Around 57% of the IT companies grant on a yearly basis whereas around
50% of the Non-IT companies do so.
We expect that as a response to volatility in stock prices, more and more companies
would now go for frequent grants. This would facilitate pricing the options at close to
market price.

Entitlement:
Noticeably large number of companies (77%) give more weightage to individual
performance when it comes deciding the number of options granted. Relatively less
importance is given to Salary grade, Position/title.
Here again the trends are similar in the IT and non-IT companies.
Survey on
ESOP Design Practices 2001

Conditional vesting:
A significant portion (25%) of the companies provide for vesting linked to individual
performance. A comparable figure in the US is around 5%. An apparent trend in the
US is more towards only time based vesting because performance based vesting
requires compliance with variable plan accounting.
As more and more Indian companies start following US GAAP, they are also likely to
follow time-based vesting. Other US features such as performance accelerated
vesting (which avoid variable plan accounting) are also likely to feature in Indian
plans.
Another interesting trend is that while in around 90% of the IT companies the vesting
is time based, the figure is only 67% in the non-IT sector. Significantly large number
(33%) of Non-IT companies link the vesting to individual performance.

Vesting schedule:
Almost all the companies (98%) prefer uniform vesting schedule for all the options.
It seems that companies are not looking at differentiating between say options given
to senior management and junior team. We believe that options could be made more
effective if the vesting schedule (both the term as well as graded schedule) is fine-
tuned based on the target employee segment.

Exercise price:
This is an important factor in the design of an option. Only around 42% of the
companies offer options at the fair market value. The global figure is almost 100%.
Survey on
ESOP Design Practices 2001
The trend is no different between the IT and non IT companies, except that a fair
portion (17%) of the Non-IT companies offer options at a fixed price.
We believe that as ESOP practices mature in India, we will see more and more
companies offering options at the market price.
I.
We do not see companies using differential exercise prices to optimize on the
extent of dilution. This is presumably to avoid the accounting impact.

Provision for facilitating exercise:
Significantly large number of companies (60%) leave it to the employees to make
arrangements for financing the exercise of options. As many as 20% provide for
broker- assisted cash less exercise. An equal portion (20%) provides loans to fund the
exercise.
The global picture is that almost every company offers broker assisted cashless
exercise of options, as a facility to employees.
It is expected that with the new (draft) Insider trading guidelines more and more
companies would provide for broker assisted exercise (through a designated broker).
With more and more banks offering loans against shares, financing of options is also
likely to surge.

Change in Control, Rights, Bonus:
An alarmingly large number of companies have not addressed situations such as
impact of change in control (more than 55%), Rights issue (50%) and Bonus issue
(27%).
It appears that these companies would leave it to the compensation committees to
decide on the impact as and when such situations arise.
Survey on
ESOP Design Practices 2001
We believe that change in control (through takeovers, mergers and de mergers) are no
longer stray incidences. They happen every now and then. So also the occasions when
companies issue Right and Bonus shares. These events have significant impact on the
underlying value of the options and as such should addressed up front in the scheme
document.
It is noticeable that even larger companies (IT as well as non-IT) have been equally
ignorant about this (especially change in control) in their schemes.
Globally companies provide for accelerated vesting in case of change in control and
suitably change the number of options and the exercise price in case of Bonus issues.
Even though more than 73% companies have addressed the issue of treatment to be
given on issue of bonus shares, there is no uniformity in the nature of treatment.
More than 37% of the companies offer bonus options for vested as well as unvested
options.
In order to be fair to the shareholders, option holders should be entitled to bonus
options only on the unvested options. For the vested options, employees should
exercise them to be eligible for bonus. A significant portion (22%) of the companies
do not give bonus options on the unvested options. Considering that the issue of
bonus shares directly influences the price of the shares and hence the value of the
options, it is only fair that the option holders are offered bonus on the unvested
options.
A significant proportion of companies (32%) which grant bonus options, have kept
the exercise price of the bonus options as nil. This could lead to a situation where an
Survey on
ESOP Design Practices 2001
option holder would be able to exercise the bonus options (without exercising the
original options) without paying any exercise price.
It should also be noted that SEBI Guidelines requires that situations such as change in
control, right issues and bonus issues are addressed by the compensation committee
in a fair and reasonable manner.

Response to the slump in stock prices:
It is no secret that after the stock market crash most of the options are under-water
and no longer attractive. Interestingly, the companies have not found it necessary yet
to respond to this situation. More than 92% of the companies have left their schemes
untouched.
We believe that this is the first time IT companies are experiencing the phenomenon
of crashing prices and under-water options. It will take some time for them to react.
We are likely to witness much more on re-pricing, new schemes to swap the earlier
grants, etc.
Concluding remarks:
ESOPs are yet evolving in India, we are yet to see companies differentiating on the
basis of the sector they belong to, the category of target employee, etc. While in the
US responses are faster (more than 30 % of the hi tech companies have re priced their
options), the Indian companies are taking time to react.
We believe that this survey would mark a beginning of information and experience
sharing and help the companies in making their Stock option Plans more responsive
and effective.









THE COMPANY
Advantages to Companies of establishing Employee Share Ownership
The key advantages of establishing an Employee Share Ownership Plan (ESOP) are:
o Align employees interests with those of shareholders;
o Recruit or retain key employees;
o Compensate for lower salaries and relieve pressure on cash flow;
o Lower the supervision required of employees;
o Increase innovation;
o Increase customer loyalty;
o Increase shareholder value;
o Motivate employees to become more productive;
o Improve the communication between employee and managers and increase
cooperation;
o Increase loyalty and reduce staff turnover;
o Increase employee job satisfaction;
o Increase the Companys likelihood of survival;
o Realise owners investment
[1]

Disadvantages to Companies of establishing Employee Share Ownership
There can be some disadvantages:
Where the share price of the companys shares does not increase and
the employee feels they have no control over the share price outcome,
then it can affect morale and retention;
There are costs associated with establishment and administration of the
ESOP;
Share Ownership, specifically option plans can be dilutive i.e as
more shares are issued each share you own becomes a smaller
percentage of the company.
THE EMPLOYEE
Benefits for Employees
Benefits to employees can include:
Financial rewards, linked to individual and organisational performance
or a long term savings and ownership structure;
An increased sense of ownership and association with the enterprise;
Improved awareness about the big picture decisions; directions and
corporate plans of the enterprise;
There is a better partnership and communication between management
and their employees;
ESOPs are often linked with employee engagement and involvement
and this presents the opportunity to influence decisions about products
and process.
Risks for Employees
Sometimes ESOPs can go wrong (if they are not properly structured) and some of the
potential risks are:
The employee has all their eggs in one basket. Essentially the
employee is over exposed to the companys shares, so if the company
does not perform or worse goes into administration the employees
investment is lost (this problem can be minimised by limiting the
amount of salary or shares that the employee can buy);
The share price can decrease and this can impact the value of the
holding for an employee;
The employee does not feel they can influence the share price or
performance measures and as a result the plan has no value for them.























Indian CEOs prefer Esops despite weak stock market
Wed 27, June 2012
The Times of India - By - Samidha Sharma

MUMBAI: Despite a choppy stock market and an overall adverse economic climate,
Indian CEOs and senior executives still prefer employee stock options (Esops) over
deferred cash, according to a study conducted by a global consulting firm, signalling
the high risk appetite of the Indian top brass.
As many as 53% of senior executives in India were willing to take the risk of opting
for shares as opposed to bonuses coming in behind only the Chinese (58.2%) and
American (56.6%) executives, a PwC report on executive pay said.
The study, shared with TOI and conducted along with the London School of
Economics and Political Science, found that while executives around the world were
willing to take a 28% pay cut for their ideal jobs, Indian executives were ready to
forgo 24% of their salaries, making them the least willing among their global peers to
go for a salary cut.
Esops are largely exercised over a 3-5 year horizon and are used as a long-term
incentive by employers to retain talent. Restricted stock units is another form of
equity-based incentive which is becoming popular among Indian firms. A stock
option provides an employee the right (but not the obligation) to purchase the
company's shares at a predetermined price.
"It is interesting that executives in the BRIC nations tend to prefer shares over cash.
Although, both cash and shares are deferred, so if they have to be locked into the
deferral, perhaps they are inherently more optimistic about the upside that shares
provide," said Padmaja Alaganandan, executive director, PwC. The findings confirm
that people largely prefer more certain but less generous over less certain but a more
generous outcome, she said.
"CEOs in Indian conglomerates are far more confident in terms their company's
growth prospects both topline and bottomline despite the slowdown. This is
clearly not the case in the European markets prompting the western senior
management to opt for safer, guaranteed short-term and long-term compensation,"
said Nishchae Suri, MD, Mercer, a global HR consulting firm.
Still, not many companies have been able to take Esops across to a broader employee
base.
In a recent survey released by Esop Direct, half of 115 Indian companies said they
gave out stock options to less than 10% of their employees.
"In India the mindset, cash compensation takes care of day-to-day living costs while
variable pay is a big motivator to get some extra earnings. This is where Esops are
seen as an opportunity of long-term wealth creation among Indian executives," said R
Suresh, CEO, Stanton Chase, an executive search firm.
The report also found that 50% of Indian executives choose a clearer pay package
than a more ambiguous one of the same or potentially higher value and 55% of Indian
executives believed that their firm's long term incentive plan was effective.