Stock market volatility: Should ESOP holders, companies panic?

Volatile stock market is affecting individuals as well as various sectors contributing towards the economy

Updated: Dec 12, 2018 04:14:31 PM UTC
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If you are an equity investor, chances are that you have seen more reds than greens in your portfolio recently. To put things in perspective, if you invested in a Fixed Deposit (FD) instead of the S&P BSE Sensex at the start of the year, you would have made more money. At the time of writing, Sensex was up only 2.7 percent year-to-date (YTD) while the BSE Midcap and BSE SmallCap indices were down 20 percent and 27 percent respectively. Autos, Industrials and Telecom are some of the worst hit sectors. What’s going on?

Some say it’s a justified correction for irrational exuberance in the past while others blame it on unfavorable macroeconomic developments. You take your pick. But times like these are more-than-a-gentle reminder of the risks involved. During such periods, there is one thing that you hear a lot – “Stock Market is very volatile”.

Volatility, by definition, is a measure of dispersion from the mean. It is direction neutral. However, you tend to hear of the market being volatile mostly when the market is down. Somehow, when the Sensex is rising, there is little noise of the market being volatile. Media headlines too turn into “Sensex reaches an all-time high”.

As per the S&P BSE Sensex 3-Month realised volatility index, volatility has been lower over the last two years compared to the same period before that. Yes, the index does show a short-term spike in volatility, but the last time things were this “volatile” was in February 2018, when the Long-Term Capital Gains (LTCG) Tax was increased from Nil to 10 percent. Another important consideration when it comes to equity investments is the period of investment. Annualised Sensex return rises from 7.1 percent to 11.0 percent as we increase the holding period from one year to five years. Patience pays.

There is one more channel through which stock market volatility could directly impact you – Employee Stock Options (ESOPs). From an employee perspective, a sharp rise in stock market volatility (which they interpret as a sharp fall in stock price) can trigger an emotional reaction and an irrational action. Let’s consider the reaction first. When the stock price is rising, you will seldom hear employees complain about the low correlation between their effort and the stock price. However, this argument suddenly finds a voice when things are going south. As an employee, one must accept that market risk is a reality. The basic principle behind granting ESOPs is to align the interest of the employees with those of the long-term shareholders. You can’t expect to be decoupled with shareholders’ interests when the chips are down. The maturity of award recipients as well as a balanced communication from the employer are critical. While granting ESOPs to employees, there is nothing wrong with projecting an optimistic wealth creation scenario but always highlight the risks as well. Turning to action. What choices does the employee have when the market is extremely volatile?

Firstly, a fall in the stock price implies that on exercise employees can now pay a lower perquisite tax on gain from ESOPs. However, to create wealth, employees would now need to hold these shares (which involves risk). One mistake to avoid is to immediately sell the shares acquired via ESOPs out of fear. Selling shares is not wrong if you are doing it for the right reasons. One must rationally assess the stock basis fundamentals of the organisation and then act as appropriate. Volatility could be short term but strong fundamentals last longer. In the extreme circumstance of ESOPs going under water, unfortunately, there is little in the hands of employees except to work hard, have patience and hope for a turnaround.

How should boards handle extreme stock market volatility with respect to ESOPs? The key word to focus on here is extreme. Markets have always been volatile and will continue to be so. Some phases are more volatile than others while very few are truly Black-Swan events. The first task is to identify the degree and cause of volatility and put things in perspective. Dealing with fresh ESOP grants is relatively straightforward. If the board believes that the current stock price does not reflect the true worth of the company (in either direction), averaging techniques can be applied to set a more sensible exercise price. Alternatively, it could simply wait for the market to catch its breath and defer grants for some time. Dealing with existing ESOP grants that have gone down in value is where it gets tricky. Under-water ESOPs will lead to a cost for the company and no benefit to the employees –a lose-lose scenario. And with employees making their unhappiness heard, the board may be under pressure to “do something”.

There are broadly four things a board can do:
» Modify the original ESOP plan parameters (extend the exercise period for instance)
» Reprice the options (reduce the exercise price)
» Grant more ESOPs at the current valuation to compensate for the loss from old ESOP grants
» Do nothing

It is at this point of time that boards must remember that while keeping employees engaged is important, they are not the only stakeholders they cater to. Boards exist to govern, i.e. to do what is in the interest of the truly long-term shareholders, including minority shareholders. Modifying the original scheme with the benefit of retrospect and repricing options is not aligned with the shareholder value creation principle. The most valuable brands in the world have a defined compensation governance philosophy to not reprice options under any circumstance. Granting more ESOPs to compensate for the loss of previous grants may also set a dangerous precedent. The first three alternatives are not likely to go down too well with shareholders, regulators and institutional shareholders advisory bodies.

Sometimes, the right and the hardest thing to do, is to not do anything at all.

The author is a Senior Consultant: Executive Compensation and Governance at Aon India Consulting.

The thoughts and opinions shared here are of the author.

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