Implementation of ESOPs – Do’s and Don’ts for Employers

Stock Options or ESOPs, as used in a generic sense, is a very effective tool to retain key talent in the Company’s ecosystem. It not only assists the employee to create wealth for himself, but also, helps in aligning the individual objectives of the employee with Company’s overall goal. Having said that, while implementing a Stock Option Program it is really important to keep in mind the do’s and don’ts.

Like every coin has two sides, the Stock Option can fail if the Company doesn’t implement the program cautiously. Listed below are some do’s and don’ts for Company in respect of Stock Option Programs.

Do’s for a Stock Option Program

1. Thought through Program:

ESOPs are a long-term instrument. It is a reward mechanism and once introduced is difficult to withdraw or materially change it. This makes it imperative to meticulously plan prior to its introduction. Aspects such as objectives planned to the achieved, long term dilution appetite, extent of coverage of employees need to be thought through.

2. Understand the Industry Best Practices and Market Trends:

Stock Options have now become an integral part of compensation, especially at the senior management level. Over the last couple of decades, since use of ESOPs has increased there is enough data available with respect to Option structures, terms and their impact on the business objectives.   It is  important to understand the prevalent practices and experience in this regard.

3. Effective Employee Communication:

The Employee should clearly understand the terms of options being granted to them. It is very important that they get an in depth understanding of the Scheme provisions and terms of their individual grants. While they should get a sense of what wealth creation can happen for them subject to their alignment with the Company’s goal, they also need to know that every year and every Grant may not be a money spinner – businesses do go through ups and downs in normal course.

It is also crucial to ensure that the Grant documentation is legally complete and adequate. Lose wordings in Appointment letters or a side letter need to avoided.

Periodical communication of financial and operational performance of the Company is also a good practice to follow to facilitate sense of belonging.

4. Revisit the program at regular intervals

The Company should revisit the plans at a regular frequency to ensure it is aligned to the Management Objectives, Applicable Laws and Rules as well as Industry Practices. Usually the shareholder approvals provide for some flexibility to tweak the terms to re align with business realities.

Don’ts for a Stock Option Program

1.  Ad hocpractices

The Company should never  implement an ad hoc Stock Option Program. These programs should ideally be made to suit  the requirement of the Company and the objective it is desirous of achieving. It is important to understand the legal structure of the Company, the business plans, the compensation policy, the industry practices to devise the right program.

Ad hocism of policy in terms of adding and deleting a category of employees, abrupt changing of terms ,etc. should be avoided.

2. Commitment to Employees without having a Scheme

The Company should not commit the employees before the Scheme is actually implemented. For instance the grant quantum for a particular employee will depend upon the choice of instrument (ESOPs / RSUs / SARs) as well the wealth creation anticipated for that particular employee. Making a commitment without finalizing the framework and having a scheme in place, may not give the Company flexibility which ideally it should have keeping the constraints in mind.

The Management should not issue grant letters without securing the Shareholder’s approval for creation of the desired ESOP Pool and implementing the proposed Scheme. This activity, being void ab initio, is null and void in the eyes of law.

3.  Committing wealth creation

Benefit from Options solely depend on the appreciation in the business valuation. Apart from the business performance, the valuation is also dependent on several external factors. Companies should not venture into estimating and committing value appreciation whether formally or informally. On the contrary, while communicating the benefits, employees should also be made aware about the possibilities of delayed and uncertain returns.

4.  Mention of ESOPs in Appointment letters or employment contracts

ESOPs are discretionary. They are not Salary or other components of remuneration which are quantifiable and committed. Companies are not legally obligated to issue ESOPs year after year to the employee. Even options granted may also have performance linked vesting which means even after Grant the benefit is not certain. Making it a part of Appointment letter or employment contract will convey the meaning that it is the employee’s right to get ESOPs year after year. Such a mention should be avoided.  ESOP agreements are separate legal contracts which is a good practice to follow.