Esops below exercise price: How companies can keep employees incentivised
The Economic Times
Tax Partner & Human Capital Leader
Ernst & Young
The global economy has gone through several highs and lows in the past few years, which has adversely affected the stock prices of many companies. This has stripped off the incentive associated with the employee stock option plans (Esops).
Esops are generally seen as a reward strategy to retain key executives of the company. However, many Esops have fallen below the exercise price at which stocks are offered to employees. These are called 'underwater' stock options, and if exercised, are likely to result in a loss. In fact, the employees would be better off if they were to purchase the stocks directly from the market instead of buying them from the employer.
An underwater stock option results mostly due to circumstances beyond the control of the employer. Many stock options went under water during the 2008-9 global meltdown, when stock prices fell significantly. This situation also arises during takeovers, when the target company is acquired at a very low price. The rampant volatility in the stock market is also one of the contributing factors.
Employees typically have a lot of expectations from Esops. They look at a stock-based incentive as an opportunity to make substantial financial gains in the future if they continue to work for the company. So, if a stock option goes under water, it shatters their dreams of wealth creation. The employee morale tends to go down when they watch their wealth evaporate.
The situation is worse if the employees have exercised the stock options in the past before these went under water. Since key employees with proven performance record are lured by opportunities tossed at them by competitors, the underwater options fail to deliver the intended motivational and retention benefits expected from Esops.
Though the conditions that result in stock option plans going under water are beyond the control of the employer, the company that intends to retain its key employees tries to bail them out of these worthless options and incentivise them through an alternative reward mechanism.
Can companies step in and deal with underwater stock options? Yes, they can, but there is no one-size-fits-all approach. A company may choose one among the various alternatives available or opt for a hybrid combination of any of the alternatives to add value to its underwater options. These alternatives include:
Make discretionary cash payment in return for cancellation of the underwater options. The payment can be made immediately or over a period of time in the future. Though cash settlement is the most tangible benefit for the employee, it does not have the potential of wealth creation in the future. Besides, it would lead to a cash outflow for the company and may not be preferred by firms that are already facing a tough time because of the economic slowdown.
The employer could also exchange the underwater options for a new plan with favourable terms and conditions. This would have to be easily understood by the employees. As an alternative, one could also explore the possibility of exchanging them with restricted stock units or stock appreciation rights. However, replacement may not be the preferred alternative among employees because after a stock option plan has failed, it is difficult to recreate the same level of confidence for a new plan.
The firm could also consider repricing the existing stock options and lower their exercise price by amending the terms of the existing scheme or plan document. The new exercise price may be equivalent to or lower than the existing stock price. This is one alternative that is easily understood by the employees and also has the potential of wealth creation for them.
Playing Santa to its employees comes at a price for the company and it may not be able to afford this due to the slowdown. It may be easier to sit back and do nothing about the underwater Esops, but in this case the costs in terms of employee morale and motivation will be much higher. This alternative could find favour in situations where the Esops form only a small part of the employees' total compensation package, or where the dip in the stock price is due to a temporary factor and there is a possibility that the stock price will revive in the future. Companies can opt for the hands-off approach when there is greater optimism about their future performance.
In recent years, companies have handled their underwater options in different ways. In the US, firms such as Starbucks and Google have proposed to replace the existing Esops with new options, which have had favourable terms and conditions. Others have either exchanged them with restricted stock rights or repriced the option with a reduced exercise price.
The strategy chosen depends on the employer's intentions and a host of other factors, such as business and HR needs, shareholder and investor views, legal, accounting and tax considerations, terms and conditions of the existing scheme and the stock price history.
Therefore, if a company elects to develop an underwater option strategy, it should carefully pick from among the various alternatives and consider the one best suited to its needs. As for a compensation plan, the key to the success of an underwater Esop strategy lies in effectively communicating the revised plan to the employees. Whatever the alternative, the company must ensure that the beneficiaries understand the message and benefits of the plan. Revisiting its Esop pricing in case of underwater stocks could really be the only option for the company.