1. INTRODUCTION:

1.1 Employee Stock Ownership/offer/option Plans have a fairly long history in the Western market economies but are of a very recent origin in our country. Every since Luis Keslo structured an employee ownership plan in 1957, acquiring external funds for employees to purchase new equity, Stock Options have come a long way in their variety as well as their intensity of application. In the U.S. it is estimated that 9% of all stock is held in different forms of ESOP. The National Centre for Employee Ownership, estimates a total value of $800 Billion in ESOP with over 10 million participants in 10,000 plans in the US alone. The ESOP became fashionable in the UK during the late seventies and have been steadily growing. Though similar data is not available in respect of other countries, it is estimated that several transitional economies and the NICs have found Stock Options a useful instrument serving multiple objectives. In USA, ESOP is not equivalent to the stock option plans that we normally refer to. However, considering the popularity of the acronym itself in India, one may ignore the technical difference at this stage. More recently, the SEBI guidelines have used terms Employee Share Option Scheme (ESOS) and Employee Share Purchase Scheme (ESPS) which in due course may gain ground replacing the mistaken acronym.

1.2 In India, though a few companies have claimed that they have been using this method, for employee retention and compensation, form the mid-80s onwards, it is only during the last few years that there have been any acknowledged and legally sound versions of Stock Options. Of course, there have been several one-time offers to employees while raising equity but these are mere precursors to more advanced and structured plans that we notice now. Prominently quoted examples of such structured plans are those of Infosys Technologies, Global Trust Bank, Satyam etc. There has been a discernible concentration of the I.T and Finance/Banking companies in this experimentation so far, due to the special manpower and compensation dynamics that they have been passing through. However, several in the manufacturing, both in the private and the public sector are evaluating the merits of this instrument which appears an inevitability. The reference to stock options in the last two Budget presentations by the Finance Minister has sparked a surge in the interest of corporates, both public and private sectors.

1.3 Companies in India which had introduced Stock Option plans and their variants during the period `94 till `99 had to innovate mechanisms for establishing them under fairly inhospitable legislative structures.

1.4 The guidelines issued by the SEBI , despite several contentious issues, have come as a good step in the direction of promoting stock option plans. The amendments to exchange control regulations of the RBI and guidelines in respect of stock options linked to ADR/GDR issues have also contributed to the swift progress in the spread of this knowledge and technique.

2. SELECT RESEARCH FINDINGS:

2.1 Experience in India being rather limited and recent, there have been no research findings as such. Also, companies are yet to find comfort in sharing information that would help research. The country is at a stage of experimentation and learning - emulation by our corporates is primarily on the basis of faith than validation. On the other hand, research from the West has been substantial, even if inconclusive, on several dimensions. The gist of the research particularly can be summarised to say that:

2.2. Overall, there is little doubt that stock option plans serve the employees and corporate interests in several ways. The caveat, as normal, is that they need a good fit with the strategy on one hand and on the other, the design and administration ought to be dynamically effective. In most market economies, the question is no longer whether to introduce a stock option plan or not but as to when, which type and to what end. In India, the development has been recent but discernible - Stock Options are in the vogue, they are flavour of the season, if you will, but importantly, they are irreversible as a trend.

3. DEFINITIONAL ISSUES:

3.1. The term 'ownership' plan is the broadest concept in this family. It suggests any type of plan by which the ownership of the enterprise is turned in favour of employees through stock holding. Such stock holding could be a one-time plan or a complex option. Thus a 'phantom share' is not an ownership plan but a compensation plan. A stock option plan given to a select categories of employees having the primary objectives of employee attraction, retention and compensation are obviously not aimed at 'ownership'.

3.2. While an offer plan may mean a simple offer of a right and its acceptance or rejection, an option plan is a more complex instrument "A stock option is an opportunity to buy stock at a set price, sometime in the future… The term 'stock option' means the right or privilege to buy stock under an offer continuing for a stated period of time. Thus if the objective can be achieved through a simple compensation mechanism or an offer plan, there will be no need for a complex option.

3.3. The recent plans in India have preferred usage of generic terms such as Equity Scheme/Offer Plans/Stock Participation but can be treated as stock options. As most such plans are restricted to a few employees, it may not be prudent to call them employee ownership plans. (In this paper, the terms 'scheme' and 'plan' are being used interchangeably and the emphasis is on stock options than mere one-time offers).

4. OBJECTIVES OF STOCK OPTION PLANS:

4.1 The objectives of stock option plans have been multiple and diverse. In some instances, while the initial objectives could have been one type there could be emergent objectives consequent to internal and external changes either replacing/modifying the initial objectives or adding to them.

4.2 The objective of one-time offers (the magic 200 shares in our case) is primarily to pass on the benefit of possible capital appreciation on a firm basis to employees. In the process, it widened the employee ownership of the company immediately on the one hand and possibly, saved costs in divesting this lot to general public. However, the object of widened employee ownership, if that indeed is the case, is not necessarily achieved if the employees traded the stock through innovative mechanisms during the lock-in period or soon after its conclusion.

4.3 The predominant object of an Stock Option Plan is obviously to promote corporate performance on a sustainable basis and improve share-holder value through increased market rating of its shares. The very fact that share prices are the locking mechanism underscores these predominant objectives. This apart, the other objectives of a stock option plan, could be a combination of the following:

a) Employee commitment and a feeling of ownership
b) Creating additional wealth for employees.
c) To supplement retirement/social security benefits.
d) To attract talented/highly valued professionals or scarce skills. Especially if it is the industry norm (i.e., to ensure that absence of stock option plan is not an entry barrier).
e) To retain employees or specific skill groups among them, in the face of apprehended high turnover.
f) To introduce a Performance Management System without incurring full cash outflow and/or lessening possible individual differences in the immediate cash bonus.
g) To improve relations with Collectives and pursue common corporate targets.
h) As a possible hedge against hostile controlling interests/takeovers (in future).
i) To reinforce the 'contestability' mechanism in corporate governance.

4.4 There is little debate on the validity of the predominant objectives related to corporate performance and share-holder value. However, there is no direct evidence to ascertain the validity of the other objectives in advance, as that would be case-specific.

4.5 The objective of improving the employee commitment and ownership is a universal one though difficult to achieve. Though a stock option plan by itself cannot guarantee employee commitment, it can be stated that the stock option plan would be a strong input in the process. There is hardly any substitute to this input and the decision here should be on the basis of the cost-benefits of such a plan than any misgivings about the objective itself.

4.6 The object of creating employee wealth has been achieved well in a few firms in the I.T. sector. In India, it is reported that Infosys, Wipro and ZEE have created dozens of millionaires through the stock option route. However, the expectations connected with this objective also carry a serious threat of disenchantment under adverse conditions of capital markets and corporate performance. It is known that most of these companies did not have the objective of creating a wnidfall for their employees as primary but appear to have stumbled into that prospect.

4.7 ESOP can be fitted well as an additional retiral/social security measure in combination with other objectives. As most schemes have a vesting period and are also tied with grade levels and length of service, they serve similar purpose as social security benefits. However, there is no such interest among the private sector which appears to have given more weight to other objectives. The public sector companies, on the other hand , have designed models that appear to have social security as an objective. Innovations are also possible to link savings plans with acquisition of stock options. (The scheme by the MUL which has been advocated by the DPE appears to be close to this objective).

4.8 Industry practices in compensation designs have been undergoing major changes and these are being aimed at attracting and retaining special talent. In this context, insular/rigid policies will bring about a serious barrier for entry of important skills in addition to the flight of current talent. The sheer progress of stock option plans in other countries and the competitive sectors in the private fold in India must be seen as precursors. It is a fact that certain skills are far higher in market value than the others. This market differentiation has no connection with perspectives of internal equity or the traditional job evaluation. Though markets may go through the cycles of valuing some skills unreasonably high at one time vis-a-vis others, this differentiation needs to be acknowledged by the corporates. Equity is a dynamic and relative concept and employee perceptions change depending on one's current position/interest than by any specific logic. Thus, several companies may need to establish stock option plans both to attract highly valued skills as well as to retain the existing ones.

4.9 Concurrent with the above is the other aspect of equity pertaining to performance related payments. Stock option plans are a good mechanism for administering Performance Management Systems and several companies have this as an important reason for choosing the stock option route. The increasing differences in individual performances and acknowledgement of uneven returns from human resources to corporate competitiveness, result in commensurately increasing differentials in performance related pay. As huge differences in cash compensation are unwelcome and also are not necessarily tax-efficient, a good stock option plan may supplement the performance pay as also compensation per se.

4.10 Some plans have the implicit objective of improved relations with collectives. It is intuitively felt that widely administered stock option plans would increase the areas of cooperation, focus on corporate performance in the long run and give other connected benefits. The important caveat for the workability of this objective is the faith that can be evoked from the employees in this system. If there are contentious issues ab initio, there could possible be adverse trades-off. There is, in fact, a fear of worker militancy at AGMs even where stock has been bought by the employees in the market. Mature companies which have developed a good internal culture may find no reason to fear this and would possibly find abundant benefits. The prospect for this objective is rather doubtful in the private sector at this point in time. However, the Public Sector corporations may have to debate the merit of this objective and the existance other ambient conditions to achieve it good measure.

4.11 In USA, the ESOP have been used to prevent hostile takeovers with the employees tending to support the existing managements. Though such a possibility in India is remote, it is nonetheless an important emerging objective for some. The issue of the ""Public trustee"" requires to be resolved in the case of Trusts which act as Special Purpose Vehicles. Where the SPV is being used, employees whose options are not yet converted to shares or whose shares are not yet transferred in their favour, do not have the right to vote in the AGM. Connectedly, the concept of contestability would be furthered if the ESOP is an active one. Contestability refers to the possible pressure (primarily by large institutional stake-holders) on existing managements to perform well with the implicit threat of change of under-performing managements. Though no stock option plan may have an explicit objective of contestability, it is possible that this could be a supplementary one in future.

4.12 The set of objectives would obviously be different from one organisation to the other. If research in the West shows diversity and occasionally unimpressive conclusions on stock option plans, it only points to the need for proper choice of objectives, design of the plans, and their alignment with corporate strategies. Stock option plans indeed increase the flexibility and repertoire of corporate tactics to meet the new economic compulsions and have little substitutability. It may be affirmed that stock options will soon be a norm in several progressive companies for differing sets of objectives.

5. TIMING OF STOCK OPTION PLANS:

5.1 A stock option plan can be established any time but there are several legal provisions that would restrict or govern them. For instance, a publicly listed company will now be governed by the new SEBI guidelines or by the earlier ones pertaining to preferential allotments. As a company cannot purchase its own shares at present for this purpose ( it is allowed to but for the purposes of extinguishing the shares), there is no way it can structure an internally administered scheme except as laid down by the SEBI guidelines in this respect.

5.2 It is possible to establish a stock option plan either at the initial public offering stage or at any time thereafter. The new SEBI guidelines allow for free pricing of the options but there is a disincentive to the company if it offers them at less than the market price as the difference has to be booked as an expenditure towards compensation in its accounts. The Finance Act also has now clarified the Income tax aspect for the employee. The difference in exercise price and the market price has to be deemed as taxable for the employee. In the case of public enterprises, the process of disinvestment by the Government may be a good time for establishing a stock option, in any case.

6. STRUCTURE OF THE PLANS:

6.1 The Indian practice so far has been to create Trusts (Special Purpose Vehicle) and issue either shares or detachable warrants. The warrants may have some perceived initial advantages due to the low cost of funding required for the trust. There are, however, some difficulties that need to be overcome such as the difficulty in apportioning the value of bonus, rights and dividends till such time as they are converted. Some proxy / indexed type of adjustments are envisaged in these cases. Further, warrants have a problem of 'rollability' as they are to be converted on the stipulated date. The share route has meant funding the trust to enable it to subscribe to the preferential allotment made by the company.

6.2 In either case, typically, a Trust is formed under the Indian Trust Act with the company as the settler and with independent trustees. Depending on the intended beneficiaries and volumes of allotment along with the time horizon, the financial needs of the Trust will be determined for administering the plan. Though a company may give soft loans from its own funds to meet the entire requirement of the Trust, there are possible advantages of the Trust rising loans through other sources with the support of the company (company's guarantee or back-to-back arrangements or a combination).

6.3 In these cases the Trust acquires the shares/warrants with the funds so raised. The allotment of shares to the individual employees would be on the basis of recommendation by the committee/advisory board named by the company. The Trust would typically make an offer to the employee concerned giving him/her time for accepting the same. Some schemes provide for exercise of the option within the stipulated exercise period (which could be a few months to two years or so). The Trust may have the provision for collecting part of the amount due on acceptance of offer. The earmarked or allotted shares/warrants will be held by the Trust in the beneficial interest of the employee concerned. Typically, there is a lock-in period of 3 to 5 years with the provision that if the employee separates from the service of the company (except in the case of death, medically certified disability or other discretionary conditions) the shares/warrants would be forfeited and reverted to the Trust. As the shares are not physically transferred to the employee, there is no stamp duty at this stage. Even where the warrants/shares have been transferred in the name of the employee on exercise of option (which could be earlier than the lock-in), there could be a separate agreement/documentation to ensure that the lock-in period is fulfilled.

6.4 The Trust rules would state as to the manner in which the bonus shares, rights issued and dividends will be passed on to the employee concerned. Rights issues for the unallotted portion of shares will require further funding of the Trust if the income accrued is not sufficient.

6.5 After the shares are transferred in favour of the employee on his/her fulfilling all terms and conditions, the employee may decide to sell the same in the market. Such sale will attract capital gains tax provision.

6.6 For discussion purposes, considering the schemes in vogue, stock option plans may be fitted into a typology as follows:

Options, Shares, Warrants:

One - off, Uniform
This will be an offer plan and decisions may be made whether the company would exclude non-performers, trainees and those with little service. Other than that it would be a one time allotment of equal number of shares or warrants to all at the market value. The new SEBI guidelines in respect of Employee Stock Purchase Plans permit allotment of options below the market price for the shares, subject to accounting for the differential, in the books of the company.

One - off, Differential/Discretionary
While the earlier one can be administered easily, this version has some sensitive decision points. This also would be a one-off scheme but may differentiate allotments by grades, seniority or market value for special skills. If other factors like achievements, potential, loyalty, hard work and contribution to corporate performance are also considered, the discretionary element would go up commensurately.

On - Going Schemes
These serve multiple objectives. They can use a combination of uniform, differential and discretionary allotments dynamically. They may be warrants or shares and can be issued as a "sign-on" bonus, on confirmation, on promotion, on superannuating, on recognition of outstanding contribution, as performance pay, in lieu of compensation and other such conditions. Such award may be to some or all individuals. These type would have a combination of objectives in mind and hence are structured to enable flexibility. A special purpose vehicle like the Trust becomes almost unavoidable in such situations for many reasons.

Proxy Shares/Stock - appreciation Rights/ hantom Shares
These are notional units apportioned to employees and are best described as productivity/contribution linked incentive programmes than a stock option plan. Typically, an employee is allotted notional units/shares of the company based on certain criteria at a set price. The employee will be required to exercise his option within a given period, say two years. The employee may exercise the option when the share price goes up fairly high and will be eligible to draw the differential or the whole in cash (as per the design), on deduction of tax. It is reported that some MNCs have been using this in India. Also, if in a regular stock option plan, a provision is made to enable the employee to decline the shares and opt for the cash differential between cost of exercise and market price, it would have the effect of a stock appreciation rights / phantom share. There can be several versions of such schemes.

6.7 The Indian experience is rather limited and yet presents innovate forays into establishing stock option plans. There has been a general euphoria with the schemes so far and indications are that there will be great variety and wider usage in the coming years. This is true of both public as well as the private sectors. Select schemes, some operating and others proposed, from both the sectors are summarised in the following paras to get a flavour of the range.

6.8 In a one-off uniform scheme, a company ( a subsidiary of a DFI) made a special offer to employees of one thousand shares each, at face value, with a lock-in period of 3 years or 10 years of service with the company whichever is earlier. If the employee separates earlier, he/she is obliged to sell the shares at par value to any individual nominated by the Board. Appropriate documentation was required to be executed by the concerned employees to enable the company enforce the lock-in provisions.

6.9 One PSU had contemplated formation of a Trust to which a fractional portion of the paid-up capital will be transferred at an institutionally determined price. Out of this lot, some portion would be credited to the employees' accounts giving due weight to the grade, length of service and performance. Employees, whose performance is not upto the norm will be denied the benefits of the scheme for the year. The lock in period would be three years from the date of transfer of shares to the Trust. The Trust would be funded with suitable assistance from the company. The proposal envisages a part of the shares for implementing general welfare schemes for employees. The employees will have no right to the shares credited their account till superannuation or death. For earlier separation, there is a graded vesting schedule of total forfeiture for less than 5 years service to full rights for 10 years and above. The vesting schedule would be different for superannuation if earlier than the lock-in period. Further, the employees would be given provision for drawing a portion of shares under certain conditions like children's wedding, medical emergencies, construction of house etc. This proposal has not yet been implemented

6.10 In another company, a one-off type was introduced enabling employees to purchase the stock offered by the company at the set price giving them a soft loan with an elongated repayment schedule and keeping the shares as security. Lock-in period is of 3 years and separate documentation / agreements were entered into with such employees.

6.11 In another instance, a Trust was contemplated by a company with an initial grant to enable it to acquire shares. A preferential allotment was made. Also, the Trust was vested with the right to purchase stock from the market or employees if required in the future. Allotment to employees was to be considered differentially among employees on considering several factors. The price of the shares would be variable from year to year. The employees are required to remit a token sum while accepting the offer and keep the option alive. He/she may exercise the option after three years. Dividends are retained by the trust while the employee would be eligible proportionately for rights issue, if any, in future. The major objective behind this scheme is to improve the share holder value.

6.12 A company in the private sector formed a plan allocating warrants to the freshly created welfare Trust. The major objective of the plan is to attract, retain and motivate the best talent. It also created an advisory Board with external members to choose employees and make recommendations to the Trust. Though all full time employees are eligible, the selection is to be based upon performance, grade level, length of service and potential. On recommendation of the advisory board, the Trust would transfer warrants to the employees at a nominal sum. These are held in the Trust for their beneficial interest. The employee is entitled to one-equity share of face value of Rs.10/- each per warrant at an exercise price of Rs.100/- or such amount as may be decided from time to time. In the event of bonus shares, the exercise price was subject to adjustment in the case of those holding warrants (as warrant holders will not be eligible). The exercise period is 12 months to 60 months from the date of issue of warrants. The exercise date has been specified within each year. On conversion of the shares after exercise of the option, the shares will be locked-in for a period of five years from the date of issue of the warrants. As a share holder, the employee will be eligible for dividends, bonus and rights. In case, the employee separates from the company, he will forfeit his rights. He will also enter into a specific agreement with the Trust to transfer the shares held by him back to the Trust on such forfeiture and for the same consideration as he has paid for the shares. During the lock-in, the shares registered in the name of the employee would be kept in the safe custody of the Trust.

6.13 In another instance, the company formed a Trust prior to the initial public offering giving a loan to enable the Trust to apply and own shares on a firm basis. Subsequent to commencement of operations, on the recommendation of the company, all employees would be offered shares reckoning the grade and skill sensitivities. This would be soon on their joining. Subsequent allotments would consider performance and potential. A lock-in period of 5 years is stipulated and the employee does not make any payments till the time of exercising his/her option. The employee will exercise the option on completion of the lock-in period and remit the face value. Though initial allotment would have a 5 year lock-in, subsequent allotments and in special circumstances, shorter period of two years are considered. During the period, the shares are held by the Trust in the beneficial interests of the employees. The latter would be eligible for dividends, bonus and right issues. On forfeiture by employees, the shares will revert to the Trust to the pool of unallotted shares. The Trust would pay back the company as and when it collects money from employees on exercise of their options.

7. OTHER MAJOR ISSUES :

7.1 There are several other issues connected with the roles and liabilities of the trustees; whether they should be outsiders or company executives; interface with the multitude of connected legal provisions and guidelines; confidentiality versus transparency in all such schemes; the explicit and implicit cost of the plan; the dynamics of employee motivations etc. These are issues that need examination in the specific light of the company's objectives and broad choices but illustratively the last three may be explored here.

7.2 Most of the existing plans have treated the information on allotments as confidential. A one-off scheme which is uniform is not sensitive but a differential and discretionary plan would raise concerns of confidentiality. It is the feeling in most companies that perceptions of fairness and equity would be disturbed if information is freely transacted. In fact, it is their belief that the objectives of employee commitment, motivation and retention could be adversely affected if there is a feeling of relative deprivation, even if there has been a net benefit in itself. Contrary to this, several firms in the West clearly state in the Annual Report, the share holding of the employees including outstanding. Even the new guidelines of the SEBI require that the Share-holders approve the ESOS/ESPS schemes. For this purpose, details are required to be given such as the maximum number of options to be allotted to an employee, the classes of employees covered, details of the terms and conditions and the like. The disclosures and accounting standards require transparency and this seems to have been an important consideration in framing the guidelines.

7.3 The cost of establishing a stock option plan are negligible in administration terms. The legal fee, the costs of running the office etc., are small and normally picked up by the company itself. The real cost of the plan is related to the concession that the company wants to pass on to the employee. There are two situations here. One where there is a Trust (SPV) and where options are being given to employees directly by the company under the enabling guidelines of the SEBI.

7.4 As a Trust might not be in a position to raise its own resources the company may either give a soft loan or offer subsidy and/or a security to the financing body. If it is a soft loan directly given, there would be a cost (average cost of funds minus interest charged). On the other hand, if a third party like a Bank or a financing company were to fund the Trust, there could be a cost to the company as a guarantor especially if the repayment schedules agreed upon do not match with employee payments to the Trust in future. Some plans envisage soft loans to the employees to buy the shares or exercise their options. The obvious cost here is the implicit subsidy in this after deducting its trade-off, if any, with other compensation that may have been due. Many companies need to subsidise the Trust and the employees in some form or the other covering for the downside risks. Further economics are related to deductibility of loans, grants etc. from the pre-tax earnings of the company now and with future changes in law. The other situation is when options are given to the employees directly - there has been a view that these are "no free lunch" at all as assumed and that short-sighted accounting practices , in fact, mask the enormous risk that the company would be attracting.

7.5 The most tenuous aspect of stock option plan is the estimated response of employees to different schemes and at varying points in grant-exercise-market value differentials. For instance, if the employee believes that allotment of shares has a hefty trade off with direct compensation, there would be obvious resistance from those whose present value of the option is low due to the likelihood of their separation from service. Further, if there are risks of stock prices falling below the set price, and if the exercise is well before the service lock-in condition passes, then again there would be reluctance.

8. CONCLUSION
It may be concluded that stock option plans are a necessary instrument both as a modern method as well as for strategic reasons. They have a strong philosophical backing, share-holder value and intuitive appeal. It is possible that some of the present hype is more than the hope. It is also true that we do not yet have enough research data to affirm that stock options, indeed, serve the purpose for which they are established. And yet, developments over the years in other countries indicate that stock options are indeed irreversible as a trend. It is new faith. And baptising is surely by fire for many.