Resolution for Esop Grant by ylv53705


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November 2008
Making most out of the Underwater Options

With stock markets crashing by more than 50% most of the Stock options issued by the
companies in the last 12-18 months are heavily underwater. The fall is unprecedented and calls
for equally uncommon resolution. In the normal course, any reduction in the stock prices does
not warrant any adjustment to the ESOP terms. Market forces usually take care of temporary

While the Corporate India and the Board room discussions are still focused on addressing
recessionary business challenges, discussions around what to do with the underwater options
have started doing rounds in the management meetings.

What are the alternatives before companies and how do they affect the different stakeholders,
employees, shareholders and corporate managers?

The first question to be answered is whether any adjustment to the current options is
warranted? If the fall is abnormal and cannot be made good during the remaining Option life,
it calls for course correction. What is an abnormal fall depends on the track record of each
company. For some a 30% fall would be unusual whereas for some volatile scrips, that can be
made good in a 3-6 months period. The other factor to be considered is the reason for the fall.
If the company’s business is doing well but still the price is down because of the market panic,
the price is likely to bounce back once the mayhem is over. In such a case drastic action is not
necessary. However if the industry outlook itself is in doubt and recovery back to 2007 levels in
the short term is ruled out companies should look at alternatives for making underwater
options more meaningful.

Having decided that some correction is needed, companies usually grapple with the, what and
how part of the correction. Several questions come up when one sits down to decide what to
change. Is it just the exercise price, or exercise period, or vesting period or all of them? Should
we continue with the old options or exchange them entirely with new options? Here again
there is no single right solution. Typically, tinkering with just one parameter, say the exercise
price would not give the optimum solution though it would be easy to implement and will
address grievance of one of the stakeholders, viz the employee. ESOP is a very critical
instrument having direct impact on shareholders and their dilution. Shareholders are key
stakeholders and their interests need to be kept in mind while deciding what to correct.

The issue can be approached by listing down the stakeholders and their objectives with respect
to the change. For instance, the shareholders would not desire any additional benefit to be
handed over to employees unless it results in ploughing back some of the issued options
thereby reducing the dilution and improving the EPS. Employees may want a structure which
ensures that they have a lower downside risk even if it means capping the upside. The
management would aim for retaining the key talent and keeping them motivated with out
paying out too much cash. This part of the exercise is extremely critical in deciding the
framework in which the solution needs to be designed.
There are several ways to decide how the changes could be brought about. Some of the
alternatives which could be evaluated are:

    •     Just re-price the existing options
    •     Cancel all the existing options and pay cash to all the employees
    •     Cancel all existing options and issue fresh ones at current market price
    •     Cancel some of the existing options and issue fresh ones to a few employees and
          payout cash to the other employees
    •     Grant more options at current prices keeping the existing ones unchanged

The decision on the extent and nature of change needs to be evaluated from the dilution,
benefit to employees and the accounting charge perspectives. Mapping of the alternatives
with these perspectives (reflected in the diagram below) will help in crystallizing the priorities
and choosing the optimum solution.

         High                                                                                            Low

                                                                                 Grant more Options
                                                                                 at current price
 Dilution                             Re pricing                                                         Benefit
                                         1                                                               to employees

                           Cancel and partly pay cash, partly issue shares           4
                           and partly fresh Options
                                                                        Cancel and Issue fresh Options
                Cancel and pay cash          3
        Low             2                                                                                High

                High                                                                              Low
                                                   Accounting charge

Companies who have exhausted the permissible dilution would prefer an option which makes
some shares available for future use. So canceling existing options and paying off cash to them
would free up the shares for immediate or future use. The optimum solution is one where
dilution is the lowest, accounting charge in minimal and benefit to employees is high. The
Exhibit below would help in understanding the alternatives and their implications.

The current situation provides an ideal opportunity for companies to have a re look at some of
its objectives and ESOP policy. Since many companies have been issuing ESOPs for more than 4-
5 years, there must have been several learnings with respect to employee coverage, grant
practices, volume of grants, option structures and so on. Now is a good opportunity to re visit
some of these and see whether some of these mistakes can be rectified. It is seen that many
companies, in the zest of covering larger number of employees, end up granting too few to too
many. In the bargain benefit to employees is not significant enough to make a difference at the
same time the dilution is higher. Most of the companies apply one Option structure to all the
employees. Volume of grant is the only differentiator across the hierarchy. ESOP objectives and
expectations are not the same at all the levels of employees. In the given situation, Options
with performance based vesting make more sense than time based vesting. It would be useful
to evaluate such structures especially at senior levels. In order to satisfy all the stakeholders,
companies would be well advised to use a combination of more than one of these alternatives.

We strongly believe that the companies can and should use the current turmoil to its advantage
by re aligning the existing ESOPs with the revised business strategies and goals. This can be
achieved by using the alternative 3 (Cancel and settle partly by cash and partly by using shares
and freshly designed Options). Needless to say each company will have to decide on whether to
cancel some or all options, whether and how much cash should be paid to whom, how many
fresh shares to be issued and what should be the design of the new options. Markets would not
provide a similar opportunity again. It’s for the companies to lose.
       Exhibit: Comparative assessment of the alternatives

 Alternatives      Re pricing              Cancellation and        Settlement            Grant more at current
                   existing options        Re-grant                in cash               prices

                   • Exercise price is     • Existing    options   • Existing options    • Existing options are
Modus                modified                are cancelled           are cancelled         untouched
operandi           • All          other    • Fresh       options   • Cash paid in lieu   • Fresh options with
                     parameters remain       granted with new        of     cancelled      similar terms are
                     constant                parameters              options               granted at current
                                                                                           market price

                   • Vesting     period    • All     parameters    • Immediate           • Easy to implement
                     remains unchanged       can be varied /         liquidity     to    • Employees get to
Pros               • Number of options       revisited               employees             average the cost and
                     remain unchanged      • Dilution may be       • No        equity      have larger number
                                             lowered                 dilution              of options
                                                                                         • No       incremental
                                                                                           accounting charge

                   • Incremental           • Incremental           • Cash outflow for    • Leads    to    higher
                     accounting charge       accounting charge       the company           dilution unless the
Cons                 for modification        for modification      • Cash   received       earlier options lapse
                   • Dilution    remains   • Minimum period of       by    employees       being underwater
                     unchanged               1 year for vesting      would be net of     • Benefit            to
                                             of new grants           tax                   employees is limited

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