Wednesday, November 4, 2009

The Different Ways to Make ESOP work

Two different ways of making ESOPs work
by Elizabeth Flock, N.S. Ramnath | Nov 3, 2009

Read it at Forbes

Axis Bank
UTI Bank, which changed its name to Axis Bank in 2007, was one of the earliest in the banking sector to experiment with employee stock options. It launched a scheme as early as 2001, starting with the unreserved objective of covering all employees, based on performance.

Over the years, the scheme has undergone changes, teaching the bank an important lesson: Not everybody in the organisation wants ESOPs and even for those who do, the current market price is an important consideration.

When Axis Bank first designed the ESOP scheme, there was much debate about how broad-based it should be, says Snehomoy Bhattacharya, president of human resources.

The bank chose to include all employees except the poorest performers. “In surveys, we were below our competitors on cash performance bonuses. Also, we did not have an aggressive variable pay plan. So, we decided ESOPs would be a good way to compensate employees, even at lower levels,” he says.

At first, employees didn’t take well to the new plan. Only when the stock price started climbing, they saw the point and embraced the scheme. The first major change came in 2004. Axis Bank had been accounting the difference between the price at which options were granted and the prevailing market price as an expenditure on the books. “We noticed we were taking a hit,” says Bhattacharya. So, the company changed the formula for pricing the options.

It switched from the 52-week average to the previous day’s close as the basis for the grant price. This helped the company eliminate its accounting expenditure, and also wiped out the arbitrage the employees enjoyed between the two prices.

The next year dealt a bigger blow to ESOPs. The government brought them under the ambit of fringe benefit tax (FBT). Any difference between the fair market value and the vesting price came to be taxed at 33.99 percent. The industry was enraged at what it saw as an unfair levy, but the government did not budge.

At Axis Bank, the management decided to pass on the FBT burden to employees, taking advantage of a clause in the tax laws. This and the new pricing formula had a telling impact on the popularity of ESOPs. Employees have exercised far fewer options from 2005 to the present than they did in the first four years of the plan. In April 2004, more than three million options were exercised, up from one million at the start in April 2001. However, in April 2007, that number had dropped to less than 3 lakhs. The amount of wealth created had exceeded Rs. 100 crore in April 2004, but had dropped to just Rs. 10 crore in the same month three years later.

The year 2008 saw a big shift in Axis Bank’s ESOP strategy. In April, the company decided to narrow the scope of the plan to only employees in the middle management and above. Staff in the
lower rungs was excluded.

There were two reasons for this. Previously, the company was growing at an exponential rate, but growth slowed down and they could not give options to everyone anymore. Also, lower level employees appreciate a cash bonus more than an ESOP. The bank had looked at the plan as a long-term wealth creating exercise, but the employees didn’t.

Axis is now toying with ideas such as phantom stocks and restricted stock units. “These options may result in cash outflow. We want wealth creation without impacting the bank. But in these conditions, we may be forced to explore options for better compensation of employees,”
Bhattacharya says.

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