ESOP Taking Stock Of Talent - bohemian Maverick
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
ESOP Taking Stock Of Talent
ESOPs are an important and powerful tool to boost
employee morale and curb attrition in companies
I
n today’s fast paced world, the biggest problem Imagine an employee’s gain per share at the very onset of
facing each and every company is attrition. A his share purchase. ESOPs have the power to turn
company spends thousands of rupees and hundreds fortunes around as can be seen from the numerous
of hours of manpower on recruiting, training and newly-started IT companies in the Silicon Valley in the
inducting every candidate, only to see them leave for a US in the 90s. They are millionaires today only due to the
meagre salary raise or some petty perk. An employee’s virtue of their ESOPs.
exit can therefore be draining, emotionally and finan-
cially, on a company. ESOPs can be issued either by a listed company or an
unlisted company. The decision to buy the shares offered
There are two ways of retaining the staff. One is through in an ESOP lies solely with the employee. ESOPs are
the carrot and stick method and the other through non-transferable and most of the times, these shares
Employee Stock Option Plan (ESOP). While in the come with an inherent lock-in period attached to them,
former, using a stick to motivate can push an already that is, the shares cannot be sold until the lock-in period
dissatisfied employee to the edge and expedite his is over. This is mainly to ensure that employees don’t sell
resignation process and using the carrot method in the off their shares the moment they acquire it and then quit
form of internal promotion, commission, incentives, the company immediately.
perks and monetary benefits can have their limitations
too. The latter, therefore, seems the right thing to do. WHY DO COMPANIES GIVE ESOPS?
WHAT IS AN ESOP? The key word here is motivation. The philosophy behind
issuing ESOPs is very simple. An employee who owns a
ESOP is a tool used by companies to motivate their part of the company in the form of shares of the company
employees by allocating some of their shares to their is likely to work with greater dedication and a greater
employees at a certain price over a set period of time. In sense of responsibility and sincerity than an employee
other words, it is an option granted to an employee to buy who is working merely for salary.
the company’s shares at a fixed price during a fixed
predetermined period. He/she would also strive to take the company forward
and deliver better results so that when the growth in the
Suppose an employee is offered an ESOP to buy shares company’s balance sheet translates into an increase in the
of ABC company at a price of Rs 100, after a period of stock price, the value of the employee's ESOPs also
one year. In such a scenario, if after one year, the stock move up correspondingly.
ABC trades at a price of Rs 500, the employee would still
have to buy the shares at the ESOP price of Rs 100. ESOPs are widely used by start-up companies as a non-
42
Beyond Market 22nd Jul ’10 It’s simplified...
cash-based incentive as most of these firms are usually option and buy shares, as he would be in profit from the
cash-crunched. Employees showing faith in these start- very point of delivery of the shares. If the current market
ups and holding on to their ESOPs will reap rich rewards price of the share is almost the same as the exercise price,
when such companies come of age and the stocks of then factors such as future prospects of the company,
those companies flare up. market conditions, taxes, brokerages and other charges,
etc, should be taken into consideration and if he feels that
IMPORTANT COMPONENTS OF THE ESOP the stock has the potential to rise in the future, he could
PROCESS exercise his options.
Grant Date: The date on which an employee is provided If, however, the current market price is way below the
the option to convert into shares is known as the grant exercise price, then it would not make any sense in
date. Generally, an employee is informed about the grant buying at a price higher than the market price. The
date through a grant letter. person would be staring at a loss right from the begin-
ning. In such a scenario, it would be prudent not to
Vesting Period: Vesting period is the length of time that exercise his option and just let it lapse. Whatever the
must elapse before the right to buy shares by an case, as an employee he would have a much better under-
employee becomes active. Sometimes companies offer standing of the business model and the internals of the
these shares in a staggered manner. For example, a company and would be in a better position to take a more
company XYZ stipulates that the employees can exercise informed decision about the shares than any outsider.
only 20% of their total ESOPs each year and spread the
entire option over a period of five years. The primary The tax angle of ESOPs is a vast and complicated topic
reason behind employing such a staggered approach is to and cannot be covered in its entirety in just a few lines or
try and retain the employees in the company with the lure paragraphs and hence it would be prudent to take the
of the remaining balance ESOPs which he or she would advice of a tax consultant/professional in this matter and
otherwise stand to lose if he/she quits the job. understand the nuances of ESOP taxation, so that a
person knows beforehand what his tax obligations are.
Exercise Price: This is simply the price at which shares
are offered to the employees. It is also known as strike While we are on the subject of ESOPs, it would almost be
price. The exercise price is usually fixed at a price lower criminal if we do not touch base with a close relative of
than the prevailing market price so as to give the ESOPs, sweat equity.
employee the incentive to acquire shares at a discount.
SWEAT EQUITY
Also note, the right to exercise the option is not open
indefinitely. There is a time period within which the Sweat equities are shares allotted to employees or
employees have to exercise their options and this period directors of a company as a reward for their services
is called as exercise period. And the date on which the rendered. This too is a form of non-cash-based incentive
options are exercised is the exercise date. If an employee and is more prevalent in start-up companies that are
does not exercise his right to buy the shares within this constantly facing liquidity problems. These shares can be
exercise period, the option lapses. Also, if an employee allotted either free of cost or at a discount on the existing
quits the job before the vesting period is over, then the market price.
option automatically lapses.
Sweat equities are almost similar to ESOPs in most
In short, if a grant offer states that the ESOPs have a aspects such as being a motivational tool, having a lock-
vesting period of 1 year and an exercise price of Rs 500, in period, a vesting period, not being transferrable, etc.
it simply means that the employee has been granted the However, there is a distinct difference between the two.
option to buy the shares of the company after a period of While ESOPs just confer the right to acquire the shares of
1 year at a price of Rs 500. the company at a predetermined price on a future date to
an employee, sweat equities on the other hand are actual
TO BUY OR NOT TO BUY IS THE QUESTION shares that are allotted to employees/directors upfront.
ESOP is a right and not an obligation to buy shares. The While ESOPs can be a great money-making product, if a
decision to exercise the option to buy ESOP shares lies huge portion of a person’s remuneration is in the form of
solely with an individual as an employee. ESOPs instead of salary, it could be a risky proposition.
If the company runs into losses and becomes bankrupt,
If a person feels that the exercise price is way below the the individual would be left with nothing but useless
prevailing market price, he can comfortably exercise his paper. So people must take their decision wiselY.
Beyond Market 22nd Jul ’10 It’s simplified... 43
REDUCED TO PIECES The collapse of the Barings Bank in 1995 can be
attributed to the unauthorized trading carried
out by the bank’s head derivatives trader
Nicholas William Leeson aka Nick Leeson
T
he fall of the Barings Bank is an apt case of where it was available for a cheaper price and was simul-
how risky a small miscalculation can lead to a taneously selling them on the other exchange that
series of events that can eventually lead to the commanded a higher price for that contract. Since the
collapse of a well-known banking giant. price differences were not high, the arbitrageur would
have to trade in high volumes in order to make a signifi-
Barings Bank, England’s oldest merchant bank, was cant profit.
started in 1762 and gained a lot of fame through the years
amongst the rich and the famous of the English society. It Arbitraging is not considered to be risky in practice as
was the personal bank to Queen Elizabeth II. It survived risks are hedged since the security is purchased and sold
through the two World Wars and the Great Depression almost at the same time. Concurrently, Leeson was also
of 1929. This further strengthened the faith that people speculating on the future direction of the Japanese stock
had in the bank. In fact, during World War II, the British markets, holding a longer position and thus hoping to
government used the Barings Bank to liquidate assets make supernormal gains.
around the globe to help finance the war.
Leeson had been carrying out unauthorized trades on the
The bank finally collapsed in 1995 due to unauthorized SIMEX from 1992. He held proprietary positions on both
trading carried out by its head derivatives trader Nicholas - Futures and Options contracts. He lost a lot of money
William Leeson aka Nick Leeson. During the time of the right from the start. Still his seniors in London consid-
collapse, it is alleged that Leeson was arbitraging, ered him to be the magician who was responsible for half
seeking to earn profit from the price difference of the of Barings Singapore’s profits in 1993 and half of the
Nikkei 225 Futures contracts that were listed on the entire company’s 1994 profits. They held him in such
Osaka Securities Exchange (OSE) and also on the Singa- high regard that the management proposed to pay him a
pore International Monetary Exchange (SIMEX). bonus of US $7,20,000.
In effect, he was buying the contracts on the exchange Leeson held two designations at Barings Bank. He was
Beyond Market 22nd Jul ’10 It’s simplified... 45
both the floor manager for Baring’s trading on the between SIMEX and the Osaka Stock Exchange as
SIMEX and also head of settlements operations. Effec- reported by Leeson. All these cross trades were open
tively, he reported to himself therefore having autonomy positions that were subject to market fluctuations and had
without any supervision from London. Hence, he was not been closed out by corresponding opposite transac-
able to make ostensibly small speculations and report his tions. Authorities at the Barings London office believed
losses as profits to the London office. He altered the the bank wasn’t exposed to any risk as Leeson claimed he
bank’s error account bearing number 88888 to prevent was executing purchase orders on behalf of a client.
his superiors in London from accessing the daily reports
on trades, prices and status. He also used this account to By December ’94, Leeson’s practices cost the Barings
execute unauthorized trades in the Japanese government Bank £200 million. But, he reported a profit of £102
bonds and Euro-Yen futures and Nikkei 225 options. million. Had the bank tried to unmask Leeson’s hideous
Together these trades were so large that they ultimately practices, the collapse could have been averted as
broke Barings. Barings Bank still had £350 million of capital.
Using the 88888 account, he traded aggressively in F&O Following this, “the man who broke Barings with a
on the SIMEX. Although Leeson’s decisions always billion dollar gamble” flew to Kuala Lumpur on 23rd Feb
resulted in losses, he continued trading, even using the ’95. Leeson sent a written confession to the chairman of
money that the bank’s subsidiaries had entrusted. He also Barings Bank – Peter Barings. Almost at the same time,
falsified the trading records and used funds kept for the banks auditors had discovered the fraud and soon
margin payment for other trading activities. However, on realized that Leeson’s activities had caused a loss of
17th Jan ’95, an earthquake hit Japan causing a plunge in around £827 million which was twice the bank’s
the Asian markets. Leeson thought that Nikkei would available trading capital. The bank’s collapse cost
recover soon, but the same did not happen. another £100 million.
Leeson also traded in straddles, which means he sold Put The Bank of England unsuccessfully tried to bail out the
and Call Options with the same strikes and maturities. bank. Barings Bank was declared insolvent on 26th Feb
The strike prices of most of Leeson’s straddle positions ’95. After the Barings’ collapse (and realizing he was
ranged from 18,500 to 20,000. For things to work in his certain to be jailed for his actions), Leeson booked a
favour, the Nikkei 225 had to continue to trade in the flight to London where he intended to surrender to the
range of 19,000 to 20,000. On 17th January that is, the British police in the hope of serving prison time in the
day of the earthquake, the Nikkei 225 was trading at UK as opposed to Singapore. However, he was detained
19,350 points. When the Nikkei fell by 7% in a week, the by German authorities when he landed in Frankfurt and
Call Options he had sold became worthless, but the Put deported to Singapore. Leeson was eventually sentenced
Options would have turned out to be profitable to the to six-and-a-half years in prison in Singapore.
buyers if the Nikkei had continued declining.
While in prison, he wrote his autobiography titled
Seeing his losses grow, he requested for additional funds “Rogue Trader: How I Brought Down Barings Bank and
from the bank to continue trading with a hope of untan- Shook the Financial World” which was, in 1999, made
gling himself from this mess by trying to make a profit on into a film. He was released early in 1999 after being
following deals. He felt that there would be a diagnosed with colon cancer.
post-earthquake bounce back. But there was no rebound
and the losses kept mounting. In 1995, ING – a Dutch bank, purchased all of Barings
assets for a nominal sum of £1 along with the bank’s
Leeson suffered severe losses on these trades and the liabilities and created ING Barings. Consequently,
settlements staff was asked to divide all the contracts into various arms of the erstwhile Barings Bank were broken
various other trades and change the trade prices to reflect and sold off to other financial institutions. In 2001, the
profits that would be credited to the arbitrage accounts American division of the erstwhile Barings Bank was
and losses to be charged to the error account 88888. On sold to ABN Amro for $275 million and the rest was
one hand, these so-called trades appeared on the retained as the European banking division.
exchange as authentic and on the other hand, they were
shown as pairs of transactions in the books of Barings In 2005, the remnant that is the asset management
Futures Singapore. division – Baring Asset Management (BAM), was split
into two. BAM’s investment management activities and
All these cross trades exposed Barings Bank to a lot of the rights to use the Baring Asset Management name was
market risk since they were counterparty to several of sold to MassMutual and Northern Trust acquired BAM’s
their own trades. Thus, these arbitrage trades were not Financial Services GrouP.
46
Beyond Market 22nd Jul ’10 It’s simplified...You can also read
