Structuring an ESOP Scheme Issues & Perspectives

Presentation to WIRC - ICSI, Mumbai July 25, 2009

Presented by: Garima Sharma Mayura Arankalle ESOP Direct

A Snapshot

W H A T
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F O L L O W S

An Introduction to Employee Stock Options (ESOPs) Steps involved in implementation of ESOPs Legal and Regulatory framework Current Status of ESOPs Discussion / Open Issues

What are ESOPs ? ¬ ¬ ¬ ¬ ¬ ¬
A right, a choice, not an obligation Each option converts into one 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 GRANT
Receives the right

L I F E VEST
Earns the right

C Y C L E

EXERCISE
Exercises the right

SALE
Sells the shares

Why ESOPs ?

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

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

Stock Appreciation Rights

T H E
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N A T U R E

A contractual right to receive, in cash or stock, the appreciation in the value of stock over a period of time For example, 1000 SARs granted at a price of Rs. 20 each (Fair Value of the stock today) – maturity one year After one year, suppose the Fair Value per share is Rs. 50 The Company pays the appreciation (Rs. 50 – Rs. 20 = Rs. 30) to the employee in cash (Rs. 30,000) or in stock (600 shares)

What is an ESOP Scheme?

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A combination of the following parameters

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Why (Objectives) Who (Coverage) How much (Quantum) What price (Exercise price) What conditions (Vesting, exercise, separation, etc.)

Normally not a one-time event

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Annual grants On-going policy

Design features

D E C I S I O N
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Objective and Coverage

P O I N T S
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Quantum

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Reward for past association Reward for past performance Reward for future performance Broad-based or selective / Subsidiary

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Principle of adequacy and attractiveness

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Dilution

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Compensation policy

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Broad based Vs selective Equity or cash (phantom)

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Rationalize cash variable pay over the long term Currency for hiring Grant - on performance or in anticipation

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Vesting

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

Time based or performance based Standard across the board or different for key people

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Frequency ¬ Annual grant ¬ One time bumper

General Trends – Employee Coverage

Coverage
105% 100% 95% 90% 85% 80% 75% Senior management Middle management Junior management 86% 100% 100%

Compostion - 29 companies (IT - 14, Pharma - 4, Banking - 4 and Others - 7)

General Trends - Eligibility Criteria

Eligibility Criteria
100% 80% 60% 40% 20% 0% Performance Length of Association Composition - 30 Companies (IT - 15, Pharma - 4, Banking - 3, Others - 8) Future Potential Grade/Position 57% 53% 93% 87%

General Trends – Vesting Criteria

Vesting Criteria
120% 100% 80% 60% 40% 20% 0% 100%

6%

0% Company performance

Passage of time

Individual performance

Composition - 31 companies (IT- 15, Pharma - 4, Banking - 4, Others -8)

General Trends – Exercise Price

Exercise Price
80% 60% 40% 20% 0% Discount Market value Premium

Composition - 24 companies (IT- 11, Pharma - 2, Banking - 4, Others -7)

What is Option Value

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Amount for which the option can be exchanged between knowledgeable, willing parties in an arms length transaction Two broad methods in place

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Intrinsic Value Method

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Intrinsic Value = Market Price – Exercise Price Static Value as on a particular date

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Fair Value Method

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Fair Value = Intrinsic Value + Time Value Computed using an Option-pricing model like Black Scholes, Binomial valuation methods. Considers future life of the option

Guidelines for Accounting

LEGAL FRAMEWORK
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Required for accounting and disclosures relating to stock-based employee compensation cost Indian GAAP

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SEBI Guidelines for listed companies Guidance Note on accounting by the ICAI Intrinsic Value method allowed with disclosures as per Fair Value method

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US GAAP

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SFAS 123 (Revised): Fair Value method mandatory

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International GAAP

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IFRS 2 – Share-based Payments: Fair Value method mandatory SEC considering the proposal to allow companies to file accounts as per IFRS

Accounting

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Valued on the date of grant; once measured, value not remeasured in subsequent accounting periods Compensation cost may vary over the subsequent accounting years due to cancellation or expiration of options Compensation cost is charged to the Profit & Loss over the vesting period Disclosures to be made in the financial statements (even if the Company follows fair value method) –

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If Intrinsic Value method is used

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Disclosure of impact on profits had Fair Value method been used Other detailed disclosures

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If Fair Value method is used

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Detailed disclosures such as number of schemes, options granted, vested, exercised, options granted to senior managerial personnel, terms of scheme, etc.

Wealth Creation

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ICICI Bank
Name K.V.Kamath Lalita Gupte Kalpana Morparia Chanda Kochhar Nachiket Mor Designation CEO & MD Joint MD Deputy MD Executive Director Executive Director Benefit Wealth Created Remuneratio as a % to (Rs.) n (Rs.) CTC p.a. 99,547,500 79,447,775 72,225,250 58,700,000 58,700,000 66,401,921 49,232,288 43,295,653 28,507,137 31,837,231 150% 161% 167% 206% 184%

Horizon = 4 years

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Bharti
Name Akhil Gupta Badri Agarwal Anil Nayar Designation Joint MD President President Benefit Wealth Created Remuneratio as a % to (Rs.) n (Rs.) CTC p.a. 486,298,163 104,147,393 169,288,020 115,830,644 37,251,387 54,441,678 420% 280% 311%

Horizon = 5 years

Wealth Creation

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HDFC Bank
Name Aditya Puri Designation Managing Director Benefit Wealth Created Remuneratio as a % to (Rs.) n (Rs.) CTC p.a. 66,165,000 27,500,000 241%

Horizon = 3 years

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HDFC
Name Deepak Parekh K.M. Mistry R.S. Karnad Designation Chairman Managing Director Executive Director Benefit Wealth Created Remuneratio as a % to (Rs.) n (Rs.) CTC p.a. 196,597,017 108,464,167 108,464,167 82,493,025 45,374,492 44,666,729 238% 239% 243%

Horizon = 4 years

Wealth Creation

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L&T
Wealth Created Remuneration Benefit as a % Name AM Naik A Ramakrishna J P Nayak Y M Deosthalee K Venkatraman R N Mukhija K V Rangaswami Designation Chairman and MD Deputy MD Executive Director Executive Director Executive Director Executive Director Executive Director (Rs.) 1,595,012,500 724,581,250 867,125,000 867,125,000 867,125,000 592,666,250 440,309,375 (Rs.) 52,751,000 44,582,000 30,482,000 31,730,000 31,523,000 23,198,000 13,864,000 to CTC p.a. 3024% 1625% 2845% 2733% 2751% 2555% 3176%

Horizon = 5 years

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ACC
Wealth Created Remuneration Benefit as a % Name M L Narula P K Sinor A K Jain Designation Whole time Director Whole time Director & CS Whole time Director (Rs.) 77,731,500 49,023,500 43,736,500 (Rs.) 38,049,430 18,928,366 23,834,105 to CTC p.a. 204% 259% 184%

Horizon = 6 years

Wealth Creation

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Gujarat Ambuja
Wealth Created Remuneration Benefit as a % Name A L Kapur P B Kulkarni Anil Singhvi B L Taparia Designation Whole time Director Whole time Director Whole time Director Whole time Director (Rs.) 9,201,000 10,096,500 6,967,000 10,992,000 6,967,000 (Rs.) 29,347,098 30,692,188 16,498,996 25,539,470 23,467,274 to CTC p.a. 31% 33% 42% 43% 30%

N P Ghuwalewala Whole time Director

Horizon = 4 years

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HLL
Wealth Created Remuneration Benefit as a % Name M.S. Banga M.K. Sharma D. Sundaram Arun Adhikari S Ravindranath Designation Non Exe Chairman & Director Exe Vice Chairman & WTD WTD MD (Home & Personal care) MD (Foods) (Rs.) 5,800,287 1,750,148 1,330,482 707,887 707,887 (Rs.) 56,978,058 62,221,428 54,709,540 20,110,520 21,229,739 to CTC p.a. 10% Negligible Negligible Negligible Negligible

Horizon = 4 years

Regulatory Framework

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

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Companies Act

Foreign Exchange Management Act (FEMA)

Income Tax Act

SEBI Guidelines - History

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With the IT boom in India, most of IT & ITES companies were issuing ESOPs to their employees to attract & retain talent With the number of companies issuing ESOP on a rise, there was a need for some regulatory governance on ¬ Eligibility for grants

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Terms of grants of options Legal approvals & resolutions Listing requirement of new shares Accounting treatments

SEBI issued its first set of Guidelines – Employee Stock Option Scheme & Employee Stock Purchase Scheme) Guidelines on June, 1999 ESOP Guidelines are applicable to companies whose shares are listed on any recognised stock exchanges in India All listed companies who have issued ESOPs on or after June 19, 1999, are required to follow these guidelines

SEBI Guidelines - Terms

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Guidelines provided for 2 types of Schemes –

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Employee Stock Options Scheme (ESOPs) – Issue of an options convertible into equity shares at a later date Employee Stock Purchase Scheme – Direct issue of shares to employees Only permanent employees of the company are eligible for grant of options (India or abroad) Directors, whole-time or other wise (holding less than 10% of equity) Employees of holding & subsidiary companies eligible (prior shareholders approval)

Eligibility for grants under ESOP/ESPS schemes

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Consultants/promoters/directors holding more than 10% of equity - Not eligible for grants Independent/nominee directors – (August 2008 amendment)

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Agreement between the institution nominating & director – acceptance of ESOPs, renounce of ESOPs & conditions to be fulfilled Institution nomination to file the agreement/contract with the company; company intimate the stock exchange Director to furnish the agreement at the first board meeting post nomination

SEBI Guidelines - Terms
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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 Option holder does not have a right to vote or to dividend as shareholders Options are not transferable to any person Options cannot be pledged, hypothecated, mortgaged or otherwise alienated in any other manner In case of death, all options vest immediately in the legal heirs/nominees In case of permanent incapacity, all options vest immediately in the employee In case of resignation or termination, all unvested options get cancelled, vested can be retained

SEBI Guidelines - Approvals
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Shareholders’ Special resolution for approval of ESOPs – prior to grant Separate resolutions in case of grant of options to –

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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 -

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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

SEBI Guidelines - Approvals

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No ESOS shall be granted unless the company constitutes a compensation committee Compensation committee shall consist of majority of independent directors Compensation Committee to decide the following –

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Quantum of options per employee and in aggregate Conditions for vesting, lapse and termination due to misconduct Exercise period Exercise period in case of termination or resignation Right to exercise all options at once or at various points of time Corporate action adjustment Grant, vest and exercise of options in case of employees on a long leave Procedure for cashless exercise

Compensation committee shall frame suitable policies to ensure no violation of Insider Trading Regulations Grant Date - Date of resolution for actual grant of options by compensation committee

SEBI Guidelines - Approvals

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Once approved the company cannot vary the terms of scheme in any manner which maybe detrimental to the interests of the employees. Vary terms of scheme (options not exercised) – Special resolution in general meeting Incase of re-pricing of options – prior shareholders approval required Notice of such resolutions to provide for

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Full details of variations Rationale thereof Details of employees who are beneficial from such variation

SEBI Guidelines - Disclosures
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Disclosures to be made in the Directors’ Report –

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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

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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

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If options granted 3 years pre 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 Manager Personnel not defined?

SEBI Guidelines - Disclosures
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If options to be granted under the pre IPO scheme, DRHP to provide disclosures as per clause 12.1 of the guidelines, along with – ¬ Impact on profits and EPS of last 3 years in terms of options granted ¬ Intention of shareholders to sell their shares allotted pursuant to exercise of options within 3 months after listing ¬ Intention of directors, senior management personnel, and employees granted shares more than 1% of issued capital, to sell their shares, allotted pursuant to exercise of options, within 3 months after listing ¬ To include name, designation, quantum of shares and quantum of shares they intend to sell ¬ Disclosures required to be made separately for each year and on cumulative basis for all the options/shares issued prior to the date of prospectus Disclosures to be made employee at the time of grant of options – Disclosures as per schedule IV

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Statement of Risk Information about the company Salient features of ESOP scheme

Intimate the stock exchanges Approval of ESOP scheme by shareholders Grant of options to employees Allotment of shares on exercise of options

SEBI Guidelines – Listing of Shares

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Shares arising on exercise of options are required to be listed immediately on compliance of:

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Company before exercise of options has filed statement as per schedule V to obtain an in-principle approval from stock exchange As & when options are exercised, notify the stock exchange as per the statement as per schedule VI

Certificate from registered merchant banker – along with schedule V Certificate from Auditors – Placed before the shareholders at every annual meeting Shares arising after IPO out of options granted under a scheme prior to the IPO shall list immediately upon exercise subject to compliance with IPO disclosures

SEBI Guidelines – Accounting Policies

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Treated as any other 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)

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Graded vesting – each vest considered as a separate grant or Straight line accounting – amortisation over the vesting period on a time proportionate basis

Accounting value to be amortised 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 – ESPS
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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 –

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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 – Pre IPO Schemes
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Fresh grant of options under a scheme framed prior to IPO can be done if –

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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 DIP Guidelines 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 DIP Guidelines

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Companies Act

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No limit prescribed by the companies Act for issue of ESOPs to employees DCA has issued Preferential Allotment Rules 2003 for unlisted Public companies

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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(c) company can issue loan to employees for purchase of shares to the extent of 6 months salary

FEMA Act

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Grant of options to employees foreign subsidiary/joint venture 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

Income Tax Act
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As per the New Finance Bill 2009, FBT tax has been abolished & ESOP have been included in the purview of perquisites under section 17(2)(vi) As per the amended act, any specified security, sweat equity shares allotted or transferred directly or indirectly, free of cost or at concessional rates, the value of such security is to be included as perquisites Effective Date

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These provisions apply to all options exercised on or after 1st April 2009

Quantification of tax The tax liability will now be determined on the exercise date. Tax would be levied on the difference between the fair market value (FMV) of the shares on the date of exercise and the exercise price. The tax would be levied on this value at the rate of the employee salary slab rates

Incidence of tax

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Tax is payable at the time of allotment or transfer of shares, directly or indirectly (through an ESOP trust). All options exercised after 1st April, 2009 are liable to TDS, in which case options vested before 1st April, 2009 but not exercised would also be liable to tax.

Income Tax Act
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A Comparison of FBT & TDS
Details Taxable Value Liability of payment Payable when Tax rate Example TDS / FBT Grant – Ex Price = Rs.50 Market price on Vest Date = Rs.200 Exercise Date = Rs.240 Capital Gains Sale Price = Rs.300 Short Term Capital Gains Listed Companies Unlisted Companies Long Term Capital Gains Listed Companies Unlisted Companies Now TDS on Perquisite Difference between Fair market value on date of exercise and exercise price Taxable in the hands of the employees At the time of allotment or transfer 30.9% Taxable Value = 240 – 50 = 190 Tax = 190 x 30.9% = 58.71 Taxable Value = 300 – 240 = 60 STCG = 60 x 15% = 9 STCG = 60 x 30.9% = 18.54 Earlier FBT Difference between Fair market value on date of vest and exercise price Taxable in the hands of the Company, recoverable from the employees At the time of allotment or transfer 33.99% Taxable Value = 200 – 50 = 150 FBT = 150 x 33.99% = 50.99 Taxable Value = 300 – 200 = 100 STCG = 100 x 15% = 15 STCG = 100 x 30.9% = 30.9

No tax LTCG = 60 x 10% = 6

No tax LTCG = 100 x 10% = 10

Other Compliances

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SEBI Insider Trading Regulations –

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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 –

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As per section 77B 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

SEBI (Disclosure and Investor Protection) Guidelines prohibiting IPO by companies having outstanding warrants and financial instruments shall not be applicable in case of outstanding option granted to employees in pursuance of ESOS 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

ESOP Current Status
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With the recent downfall in the stock markets, most of the options granted during the previous FY are trading below their exercise price To tackle the issue of underwater option, following alternatives have been availed by companies

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Cancel/surrender & re-grant fewer options at prevailing market price Cancel/surrender & re-g-ant options at a lower price/Face value Re-price the underwater options to the prevailing market price

Companies need to consider the accounting implications in each of the following scenario Some of the Indian & Global Trends India
Option E xchang Alternative e Method New P ricingF ula orm Indiabulls Financial Services LtdCancel & Regrant optionsCurrent Market Price Geojit Financial Repricing Current Market Price Subex Cancel & Regrant options15%discount to 15 day avg Dish TV Repricing Current Market Price Dewan Housing Repricing Current Market Price Nam of the C pany e om

Global
Nam of the C pany e om Google Inc. Starbucks Intel Leapfrog Option E xchang Alternative e Method New P ricingF orm ula Exchange ratio 1:1 Current Market Price Value for value exchange Current Market Price Value for value exchange Current Market Price Value for value exchange Current Market Price

ESOP Current Status
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Trust Route for ESOPs - Taking advantage of the low market prices

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Form an Employee Welfare Trust Trust to purchase shares at low price from the open markets Issue share to employees on exercise of options
1 Grant of loan 2 Buy shares from market Direct issue of shares Re-payment of loan 6 5 Issue of shares 3 Issue of options

Company

ESOP Trust

Employees

Exercise of option 4

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Benefits of trust route

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Help reduce dilution for the shareholders Sends out the right signals to the market about the company prospects

Other Issues
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Finance Budget 2009 –

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The government has proposed to increase the threshold for non-promoter public shareholding for all listed companies to a minimum of 25% This limit is to be raised in a phased manner

In order to comply with the minimum public shareholding pattern, companies will have the following routes

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Public offer by promoters, company or preferential allotment of shares Form an ESOP Trust – Transfer from promoters, fresh issue to trust

Shares held by the Trust not form part of the promoter’s shareholding Options can be issued to employees over a period of time ESOPs for PSUs

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DPE has issued notification for revision of pay scales to employees As per the revised pay scales, PSU’s to grant 10-25% of their PRP in the form of ESOPs

IFRS convergence by 2011

Open Issues

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Accounting Guidelines issued by SEBI Vs Guidance note issued by ICAI

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Accounting treatment Disclosures

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Corporate actions? What is variation in terms amounts to detrimental to the interest of employees?

Thanks for your time
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