ESOPs: Back in Fashion

When BPO pioneer Raman Roy was setting up Spectramind in 2000-2001, its human resources head S. Varadarajan offered share ownership to 500 staff members. “We wanted to share wealth with people who helped create the company,” Varadarajan says. When Wipro bought out Spectramind, everyone made the equivalent of at least a year’s salary on their ESOP plans. Even better, turnover among the top managers was zero. Now, at Quattro BPO Solutions, another start-up from Roy, Varadarajan heads human resources and is replicating the ESOP experiment, covering employees from the supervisor level.

Believers like Varadarajan are growing but the pool of companies using ESOPs in India remains limited. The wealth creation potential of ESOPs has not been fully exploited in India. The trend is yet to catch on with a large number of firms. There are many who are sceptical. During the best of times, amid war for talent, nothing could guarantee stickiness of executives, not even ESOPs. “There was always somebody who was willing to better the deal — offer a bigger package and lure away executives,” says Prabir Jha, HR head, Dr. Reddy’s Labs.

The Indian ESOP is unique in how it is implemented. It’s used as a carrot, dangled in front of employees so they don’t quit. It’s a long-term incentive but employees don’t seem to get the point. ESOPs “are not considered part of compensation in many Indian organizations and are not communicated as such” says Padmaja Alaganandan, India business leader (human capital), Mercer Consulting.

This is unlike in the West, where it forms a substantial chunk of a senior executive’s total compensation. In the US, ESOPs are used to push productivity, link reward to performance and align the interests of the shareholders and executives. In India, where ESOP adoption is still in its early stage, companies use stock options to attract and retain employees.

And ESOPs’ appeal depends on the stock market. Until 2007, when the going was good, ESOPs were a very attractive incentive to lure potential employees. Globally, start-ups have used ESOPs to recruit key executives, reward and share the risk with them.

Bajaj Electricals, for instance, hired staff from other sectors for as little as a 10 percent jump in salary (when 50-100 percent increases were normal), by using attractive ESOP offers, says executive director R. Ramakrishnan. Private banks like Axis Bank, with no global tag and not-so-deep pockets, used ESOPs to compete for talent against multinational giants. From unlisted, family-managed entities like Murugappa group to old-fashioned manufacturing firms like Larsen & Toubro, companies have used them to gain shine in the job market.

Then, the slowdown hit and Indian entrepreneurs were hit hard. Earlier, India’s hot job market and economic boom meant ESOPs got marketed as the biggest and quickest way to riches. This mis-selling made everyone look only at the upside and forget the downsides. “Excitement around ESOPs has waned. Unpredictable stock market has taken the sheen off,” says Sanjiv Sachar, speaking about the immediate aftermath. He is partner, Egon Zehnder International, a leading executive search firm.

Compensation experts say India’s demography too has had an impact. Across the hierarchy of positions, people are spending less time with one job. “Everyone prefers more cash in hand than something that’s long-term and uncertain,” says Shekhar Purohit, Asia-Pacific head compensation & corporate governance, Hewitt Associates.

Now that economic recovery has begun, experts believe corporate India will see a mature ESOP. Those who do vouch for ESOPs say there is no one formula that fits everyone at all times. An ESOP plan must be fine-tuned in sync with a company’s growth cycles to be effective.

Telecom major Bharti group began its ESOP journey in 2001. In its pre-IPO stage, it covered the top 100-125 executives. In 2005, it launched the second stage where everybody was covered and ESOPs were linked to the employee’s loyalty and performance.

On a sharp growth trajectory at that time, Bharti wanted to reward and incentivise its staff. In 2006, it offered performance share plan to senior executives pegging the allotment to different kinds of performance — individual, stock price and competition. By 2008, it figured that its 2005 wide-base ESOP strategy wasn’t working as the younger staff preferred deferred bonus plan or cash. Hence, now the company has restricted the plan to the middle management and above. ESOPs work “when a company constantly does course correction and customisation to be more current and better aligned,” says Inder Walia, group director for HR at Bharti Enterprises.

Now is the time to build the foundation for the next wave of ESOP adoption in the country. Here are five major trends that may shape the future of ESOPs:

New Products, New Segments
From a plain vanilla ESOP plan, companies are now willing to experiment with variants of ESOPs to suit their needs better. These range from phantom options to restricted stock units (RSUs), stock appreciation rights (SARs) to performance share plans. Companies like Wipro are looking at alternative means like deep-discounted restricted stock units to make options attractive. L&T offered SARs to avoid equity dilution and yet offer its staff the upsides of the stock movement. Companies like Infosys are going one step ahead, giving ESOPs to independent directors and driving board level involvement.

Pushing Performance
In a difficult business environment where pushing employee productivity is the key to survival, companies are pegging their stock option plans to corporate and individual performance. To calculate eligibility, they are moving away from the volatile measures of the stock market and going for more predictable pointers such as business orders, profit margin, relative performance in an industry and customer satisfaction. Some sanity is returning to compensation planning too. Purohit of Hewitt Associates sees a dip in heavily used deep discounted ESOPs. Cash-starved firms are looking at supplementing salaries with options.

New Vistas for ESOPs
The recommendation of the 2nd Pay Revision Committee set up by the Department of Public Enterprises which looked at the compensation structure for the PSU staff, will have a significant impact. One of the major recommendations is the mandatory portion of Performance Related Pay (PRP) for every PSU employee and interestingly it is mandated that at least 10 to 25 percent of the PRP should be in the form of ESOPs. Many PSUs, especially those who face competition for talent from the private sector — insurance, oil and gas, telecom, etc. — wanted to implement ESOPs but were unable to do so in the absence of clear guidelines and government nod. With these recommendations in force, they are soon expected to roll out Equity Options to their employees.

Another development is the recommendation in the last Budget for the companies to have a minimum of 25 percent public holding as a pre-requisite to maintain their listing status. If the company were to approach the public every year with a 5 percent offer, it’s not only a laborious process but also costly. ESOPs provide an ideal solution. Employee holding is considered as public holding and implementing ESOPs is not costly and not time consuming (no approvals apart from Shareholders’ approval is required). ESOPs also help achieve multiple objectives such as wealth sharing with employees, and broad-based employee ownership helps synchronize interest of employees and shareholders. This will help in minimising the negative impact on share price, preferential allotment could come with some other constraints such as board representation, restriction on promoter share transfers, and other operational covenants. ESOPs would have no such constraints or impact on the company management and operations.

Transparency and Communication
For many in India, ESOPs weren’t clearly thought out and transparent. Not many had robust performance management system. Loyalty and favouritism played a critical role in shaping ESOP plans. Especially in promoter-driven companies, decisions were quite subjective. Worse, some oversold their ESOP plans highlighting only the expected upsides. “Through the years of hyper growth, there did not seem to be any reason to warn against the downside,” says Mercer’s Alaganandan. This led to a lot of heartburn when the value of ESOPs evaporated in the markets. “Clearly, stating out the objectives and scheme parameters will hold the key,” says Mayura Arankalle, manager consulting, ESOP Direct.

Unlisted Opportunity
It’s the unlisted companies that provide the biggest upsides and can benefit the most with ESOP as a tool. While they have been offering aggressive ESOP plans to woo talent, they are also getting savvier and smarter in using them. They are adopting the boutique approach to customise ESOPs. To take one example, some firms are offering different classes of shares with different voting rights. Responsible behaviour during uncertain times is boosting confidence as well. ICICI’s insurance JV, which offered ESOPs to its staff with an eye on exit during the IPO, repurchased the shares six-eight months ago. Since the IPO got postponed due to poor market conditions, this was the company’s way of offering an exit to the employee shareholders.

Regulatory norms too have helped. Since 2007, all unlisted companies in India have to get an annual valuation certificate. For the moment, any conversation around ESOPs draws disinterest and impatience from employers and employees alike. It is understandable because many have burnt their fingers and seen their millionaire dreams crash. But this may well be the inflection point that could lay the foundation for ESOP’s next stage of growth in India.

But all this introspection, turmoil and return of some sanity could well be signals of a new beginning.

Did you know?
Pakistan seems ahead of India when it comes to implementing ESOPs in public sector entreprises. At least 7 PSUs in Pakistan — in the oil & gas, power and machine tools sector — have issued up to 12% of the equity to employees from the government’s holding.

In the recent downturn, some companies such as Jain Irrigation, India Infoline, Dish TV and Bajaj Electricals re-priced their options to maintain their attractiveness to the employees. This trend was not as widespread in India as in the US