Trouble with stock options: ESOPs draw institutional investors' ire

Several resolutions on stock option grant see overwhelming 'against' votes by institutional investors

India Inc and institutional shareholders are increasingly finding it difficult to be on the same page when it comes to the issuance of employee stock option plans (ESOPs). In recent months, several resolutions floated by listed companies on the issuance of stock options to their staffers have seen pushback from institutional investors.

Companies — such as Asian Paints, Mindtree and Khadim — have seen between 56 per cent and 100 per cent "against" vote by institutional investors on such resolutions. But none of these resolutions has got defeated, thanks to "for" votes from promoters and other shareholders.

“There is a disconnect in the way companies approach ESOPs and how institutional investors look at them. For companies, ESOPs are deferred payouts. For investors, ESOPs are pay-at-risk — employees should make money only if share prices move up. So if the issuance is not close to the market price, we are seeing institutional investors voting against such resolutions: The voting pattern is clear evidence that institutional shareholders do not like to see ESOPs issued at a steep discount,” said Amit Tandon, founder and MD, Institutional Investor Advisory Services (IiAS).

ESOPs are a tool available to companies to reward their employees without the need to pay cash upfront. They are seen as win-win as ESOPs give ownership interest in the company and encourage employees to do what’s best for the company and its shareholders. Every company chalks out its own stock option plans, with different lock-in or vesting periods. ESOPs also provide employees with an opportunity to buy shares at a discount to the market rate.

Experts say increasingly companies are moving towards a pay structure with low fixed salaries and high stock options.

“India is mirroring global compensation structures wherein top management payouts are being increasingly linked to the overall value creation. The palpable shift is from a large fixed salary structure to a significant variable pay model. There have been instances where CEOs of established businesses have been awarded less compensation than those who lead relatively smaller groups and have been able to demonstrate unprecedented growth in their businesses,” said Prashaant Vikram Rajput, partner, White & Brief Advocates and Solicitors.

Given the increasing reliance on ESOPs, Rajput said minority investors must understand the right context when they vote on such resolutions. "Although Indian promoters are heavily financially invested in their businesses, they strongly rely on the capabilities of a professional top management. It is in the interest of the business that the top management including the CEOs are integrated in the value creation process."

What has made the situation tricky is the sharp rally in the stock markets. Market watchers say if employees are offered to buy shares at the current elevated levels under the ESOP plan, they may feel discouraged and there is also a risk that they may end up in losses. On the other hand, issuing ESOPs at a steep discount means drawing the ire of minority investors.

“A middle ground is difficult to envisage but one possible way may be to link compensation to clearly disclosed performance targets. But until then, companies will need to issue ESOPs at market price,” said Tandon.

Typically, an ESOP scheme needs to be passed as a special resolution — meaning 75 per cent "in favour" votes are required for the resolution to pass. Industry players say if ESOP-related resolutions start getting defeated, India Inc may be forced to come up with a workaround.

“An alternative worth considering here is phantom stock options —  phantom stocks are being used as forms of employee stock incentives in other countries but are yet to gain prominence in India. Phantom stock options involve cash payouts to employees linked to the appreciation in the share price of the company. Thus linking individual performance to company growth,” said Sumithra Suresh, Partner, L&L Partners Law Offices.

Phantom stock options are akin to paying cash bonuses to good performers. While this can address the issue around conversion price or equity dilution, it may require companies to dig into their cash pile.