Transcript ESOP - Intinno Paathshaala

Building a wok force as
owners
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ESOP is Employee Stock Option
Scheme wherein employees are
given an option to buy a specified
number of shares of the company at
a specified price during a specified
period.
 India Inc ESOP

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ESOPs aligns shareholder’s interest with
employees’ interest.
 ESOPs increase employee loyalty and
commitment to the organization.
 Employees become owners with a
financial stake in the company's
performance.
 Talented employees will be attracted to
the company, and will be inclined to stay
in order to reap the future rewards.
 Non-cash expenditure for the Company

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
ESOPs helps growth companies to show
a healthy bottom line. "Granting options
enables managers to pay employees
with an IOU rather than cash—with the
prospect that the stock market, not the
company, will one day pay up,"
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
ESOP is Employee Stock Option Scheme
wherein employees are given an option
to buy a specified number of shares of
the company at a specified price during
a specified period.
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Many employees cash out their shares
immediately after exercising their option.
Hence talk of loyalty goes for toss.
 stock option plans encourage excessive risk
taking by management.

› Employees who hold stock options share in the
upside potential of stock price gains, but not in
the downside risk of stock price losses. They simply
choose not to exercise their options if the market
price falls below the strike price
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
Stock options as compensation actually
places undue risk on shareholders.

If large numbers of employees exercise their
options it can collapse the company's whole
equity structure.

This increases the number of shares
outstanding and dilutes the value of stock
held by other investors.

To forestall the dilution of value, the company
has to either increase its earnings or
repurchase stock on the open market.
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
Four distinct events in ESOP process:
› (a) grant of the option
› (b) vesting of the option (the point of time at
which the option becomes exercisable),
› (c) the exercise of the option, and
› (d) the sale (if any) of the shares arising out of
the option.
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
What is vesting ?
› Vesting has two components – vesting
percentage and vesting period.
› Vesting percentage: Portion of total options
granted, which you will be eligible to
exercise.
› Vesting period: Period on the completion of
which the vested portion can be exercised.
This is the period within which an employee
decide to exercise options. This period starts
from the date of vesting.
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•The table presents an example of an employee who
is granted 200 options on January 1, 2004 with a
vesting schedule of 30%, 30% and 40% at the end of
one, two and three years from the date of grant
respectively.
•Bullet vesting — or vesting in one go — is rare
Vesting Details
Date of Grant : January 1 2004
1st Vesting
2nd Vesting
3rd Vesting
Percentage
30%
30%
40%
Date
1st January 2005
1st January 2006
1st January 2007
No. of Options
Vested
60
60
80
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No
Minimum
Limit
One Year
Minimum
Grant
Vest
Eight
Years
Maximum
No
Minimum
Limit
Exercise
Five Years
Maximum
Sale of
Shares
No
Maximum
Limit
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The act of exercise implies employee
applies to the company pays
exercise price and receives the
shares.
 Exercise can take place as specified
after vesting.
 The difference between the
strike/exercise price and the market
price at the time the options are
exercised is the employees' gain.

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Options lose their validity in certain
circumstances i.e. expiry of the exercise
period, separation, abandonment etc.
These options then cannot be converted
into shares and lose their value. Such
options are said to be lapsed.
 If exercise price is higher than prevailing
market price, then these options are
popularly known as “underwater” ESOPs.

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
The ESOP shall be approved by the
shareholders by a special resolution. The
› resolution shall contain terms and conditions of
›
›
›
›
›
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the Plan which shall include the following:
Identification of classes of beneficiaries entitled to
participate In the ESOP.
Vesting of the Stock Option
Period of exercise and process of exercise.
Exercise price or pricing formula.
The appraisal process for determining the
eligibility of employees to the Stock Option Plan.
Upper limit on the quantum of stock options to be
issued in the aggregate
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

Scrip Code:500180 Company:HDFC
Bank December, 30 2003 Subject: HDFC Bank
HDFC Bank Ltd has informed BSE the
following terms regarding ESOP IV:
› Number of options granted 68,23,400
› Each option covers one equity share. Thus
aggregate of 68,23,400 equity shares are covered
by ESOP IV.
› The employees will be entitled to one equity share
for every one option at a price of Rs 358.60/- per
option/equity share.
› The equity shares allotted upon exercise of option
will have the face value of Rs 10/- and premium
thereof shall be Rs 348.60/- per share.
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› 30% of the options would vest upon expiry of first year
from the date of grant.
› 30% of the options would vest upon expiry of second year
from the date of grant.
› 40% of the options would vest upon expiry of third year
from the date of grant.

The options granted under ESOP IV can be
exercised at anytime within a period of five years
from the date of respective vesting of options.

On December 30th 2003, HDFC Bank share price
closed at Rs. 366.35
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
Companies create trust: ESOP Trust.

The ESOP Trust receives stock either from
company by way of fresh allotment or by
purchasing from existing shareholders in open
market or the owner of the company may sell
shares of his holding to the ESOP Trust.

The ESOP trust usually obtains its funds as a loan
either from bank/financial institution or from the
sellers. The ESOP Trust then allots shares to
employees on exercise of their right in exchange
of cash and repays its loans.
Infosys and Nicholas Piramal have used trust
route.

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
Dabur India, Infosys, Wipro, Rediff, HDFC
Bank, Moser Bear, Godrej Consumer
Products, L&T, Lupin Lab etc. have issued
ESOP.
 INDIA
INC ESOP
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Suzlon energy has been a firm believer
of ESOP.
 It had ESOP even before its IPO in 2005.
It issued series of ESOPs.
 Many ESOP issues ( ESOP-2005, ESOP2006, ESOP-2007 ….) and the list goes on.
 Suzlon Annual Report 2012( pages 19-20,
75-76)

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ITC has issued ESOPs consistently from
2001 onwards.
 During the above period, it has issued
27,201,192(Annual Report FY 2011-12)
Page (70) of the annual report
 Each ESOP is for 10 shares.
 ITC Volatility calculation

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



ESOP Valuation Report 1999.
ESOP Valuation Report 2000. ( page 3)
Many amendments and the latest one
(page 12,28)
As Warren Buffett said in 1998: "If options
aren't a form of compensation, what are
they? If compensation isn't an expense,
what is it? And if expenses shouldn't go into
the calculation of earnings, where in the
world should they go?"
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
In Phase 1, companies used to expenses the
difference between the market price and exercise
price as the expenses only when employees
actually exercised. The company is used to pay FBT
on the difference between market price and the
exercise price.

In Phase 2 of ESOP expensing, the accounting
value of ESOPs granted during an accounting
period has to expensed and not when options
were actually exercised.

On the day, Board announces the ESOP, the
accounting value for the ESOP has to be
ascertained and expensed during the accounting
period.
› Accounting Value = Market value – exercise price.
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
In Phase 2, the accounting value
could be amortised on a straightline method over the vesting period,
ie beginning with the date of the
grant and ending with the date
after which the employee can
exercise the option of acquiring
shares.
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
In Phase 3, companies are mandated to
follow ESOPs fair valuation treatment.
(Page 3)
IFRS details on ESOP valuation ( appendix
B details-Pages A114)
 SEC(USA) document on ESOP valuation
( page 11)

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a) Expected life of the option (t):
Organisations need to consider the likely life
of option and not the total life of the
option.
 So, while a stock option is available to the
employee for, say, 10 years, it is possible
that the employee will exercise the stock
option at the end of, say, seven years, pay
the exercise price, take the shares and then
sell them in the open market.

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b) Exercise Price(X): Organizations will not
face any challenge in determining this
variable as the exercise price is normally
mentioned in the stock option plans.
 c) Fair value Shares(S0): For listed
companies, the share price applicable on
stock option grant date should be
considered.

› For unlisted companies, an independent valuer
may be appointed to determine the share value
of the company as of options grant date.
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
Expected volatility of share price (σ): Listed
companies can consider historical
volatility/implied volatility in their own share
prices for the period that is same as the
expected life of the option.

unlisted companies can consider historical
volatility in the share prices of other listed
comparable companies.

Volatility Calculation of Suzlon Shares
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
Historical volatility needs to be modified for
unusual spike in their historical volatility
levels (e.g. a takeover bid).

A company may need to reevaluate its
operating/financial structure (leverage) on
its expected volatility after acquiring or
disposing of a line of business that is
significantly more or less volatile relative to
existing lines or after a significant change in
its financial leverage.
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Calculation of implied volatility should be
of a point in time as close to the grant of
the option.
 Valuing an at-the-money employee share
option, the implied volatility derived from
at- or near-the-money traded options
generally would be most relevant.
 If, however, it is not possible to find at- or
near-the-money traded options, Company
should select multiple traded options with
an average exercise price close to the
exercise price of the employee share
option.

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
Expected dividend yield: Companies are required
to estimate the future dividend yield rate (i.e.
dividend per share divided by value per share).

Here, companies can take a clue from their own
historical dividend yield rate or dividend yield rates
of listed companies in the same industry.
› Start-up companies (that need capital for growth
for next few years) can consider lower dividend
yield rates or even `nil' depending on their capital
requirements.
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Risk-free interest rate: The current yield
rates in government securities (with
similar residual maturity as expected life
of stock options) can be considered.
Data on yield rates in Government
securities is widely available in
newspapers or on the Internet.
 Yield Rates from NSE WDM

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
Company A grants equity share options to
its employees that have the following basic
characteristics:
› The share options are granted at-the-money;
› Exercisability is conditional only on performing
service through the vesting date;
› If an employee terminates service prior to vesting,
the employee would forfeit the share options;
› If an employee terminates service after vesting,
the employee would have a limited time to
exercise the share options (typically 30-90 days);
and
› The share options are nontransferable and
nonhedgeable.
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Black-Scholes-Merton closed-form model
for valuing its employee share options.
 Maturity Period:

› Option has 4 years of vesting ( 25% of shares
can be vested every year) and 6 years is the
maximum period for exercising.
› Maturity Period: ((1+2+3+4)/4)+6)/2 = 4.25
years with 4 years as the lower bound.
› Option Calculator
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FAS 123 Revised, does not state a
preference in valuation model.
 However, it does state that "a lattice model
can be designed to accommodate
dynamic assumptions of expected volatility
and dividends over the option’s
contractual term, and estimates of
expected option exercise patterns during
the option’s contractual term.


Therefore, the design of a lattice model
more fully reflects the substantive
characteristics of a particular employee
share option or similar instrument “.
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
Nevertheless, both a lattice model and
the Black-Scholes-Merton formula, as
well as other valuation techniques that
meet the requirements in paragraph A8,
can provide a fair value estimate that is
consistent with the measurement
objective and fair-value-based method
of this Statement." The simplest and most
common form of a lattice model is a
binomial model.
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
Lattice model ( Binomial/Trinomial)
model is superior to Black-Scholes model
› Different interest rate can be factored into
different time period (ZCYC).
› Vesting schedule and past exercise
behaviour can be factored into into pricing (
after exercise, stock price should fall).
› Different volatility can be factored in.
› JPMorgan article.
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

Hull-White Model
The binomial and trinomial model are
methods for explicitly projecting the
stock price and due to their open-form
characteristics, can be modified to build
in assumptions related to plan features
and employee behavior. The popular
Hull-White model, published in John Hull
and Alan White's 2002 paper titled "How
To Value Employee Stock Options."
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
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
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Options can only be exercised after the vesting
period is over.
A vested option is exercised before maturity if the
stock price is a certain multiple times the exercise
price. Known as the exercise multiple.
There is a constant probability that the option will
be forfeited during each short time period in the
vesting period.
During each short time period after vesting, there
is this same constant probability that the option
will terminate. A termination in this scenario results
in a forfeiture if the option is underwater and an
immediate (involuntary) exercise if it is in the
money.
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
Because this model defines early
exercise through an exercise multiple
and a post-vesting termination rate, it
makes a reasonable attempt at
modeling the behavior of employee
stock options. This model is also
commonly used in administration
systems, so it is an important valuation
tool to understand.

EXCEL Calculator
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