Flynn Remedios: Many Options, Tough Choices

TEAM CD[ FRIDAY, SEPTEMBER 03, 1999 02:59:30 PM]

It's not about planning share options. It's whether you get your ESOPs right that matters. It's the soft option, right? Give your employees the share options they've been wanting, you become a great employer, the Reds love you, investors will believe your managers empathise with them, and everyone lives happily ever after. Wrong. It doesn't quite work that way. As Corporate India is discovering.In just over a month since SEBI announced its guidelines, reports of companies planning share option plans is growing almost daily. HDFC, ICICI, L&T, Dabur India, Tata Steel, Nicholas Piramal, Tata Donnelley, Gujarat Ambuja, Ranbaxy, Reliance...

Now the fun starts. Corporate India's got what it wanted - free and flexible regulations leaving much of the decision-making to individual companies. Ask R Shankar Raman, senior vice-president of L&T finance, which is structuring an ESOP for L&T. L&T's management has first to decide whether it's part of salary or a reward, then work out who gets it, top management or everyone, its HR guys have to work out how to quantify performance and link it to distribution of shares, then take into account the variable performance of various divisions, what pricing will achieve the right results, worry about shareholder dilution, and only then deal with the fineprint of accounting and taxation.

Managements are suddenly realising that freedom isn't easy to deal with. Start from choosing a type of plan. An ESOP, an employee stock purchase plan (ESPS) or phantom stocks? An ESPS is an outright sale of shares to employees at a fixed price. Phantom Stocks, are in essence compensation incentives linked to stock-price performance. There's no right answer, it depends on a company's philosophy. ESOPs are most common, and structuring and administering an ESOP is a delicate task. The critical decisions have nothing to do with regulations, or rewards. It's about strategic focus, clear and enforceable HR systems, and identifying business goals. "In India it is still viewed as a basic rewarding system - which is wrong. Companies are using it as a compensation strategy, because they are unaware of its potential as a business strategy. There is a definite nexus between goals and options," says Rajesh Dhume, director, Ernst and Young.
It's not supposed to be a lollipop for good li'l employees.It's meant to be a powerful strategic tool to activate and channelise human capital. Oops. Now CEOs are having to answer fundamental questions. Why should you have an ESOP, and what do you hope to achieve? There's no single right answer. "You need ESOPs when companies want to grow, when you need to attract critical talent from outside, and in mature companies, to incentivise top management, so that they feel like owners," says TV Mohandas Pai, CFO, Infosys, a pioneer of ESOPs.

In the first place, not every company should be handing out the lollies. ESOPs make sense in people-driven industries, in services, in knowledge businesses. Says Merwyn Raphael, of HR consultancy William Mercer, "Those in industries that do not record jumps in stock value prefer a differential bonus. Internationally, unions in industries like pharma, genetics, and even automobiles where market price is dictated by factors other than individual performance are wary of ESOPs."

The size of the company matters. Broadbased plans, where everyone gets a piece of the action, works best in smaller companies, with low equity bases, ideally start-ups. At L&T, for instance, ESOPs aren't being uniformly instituted across all group companies; it will be done gradually.
In India, most non-IT companies are already large in terms of numbers, and a broadbased ESOP would play havoc with the shareholding. It is most likely that Indian plans will choose to be selective rather than broadbased, and be restricted to top management. ESOPs can be used as part of various strategies (see page3). But plans have to be structured as part of a company's overall compensation and HR policy, which aligns with its business strategies. Otherwise, it doesn't work to increase shareholder value. "Today, in India, options are being seen as an add-on. With time, it will become part of the compensation package, especially for a company's key people," says Jairaj Purandare, managing partner, Arthur Andersen.

For recruitments, it's only for those high-flying executives you have to hire from outside, or to entice people into start-ups. In India, say experts, family-owned businesses might well want to use it to professionalise top management. And yes, as golden handcuffs, it keeps those critical people in high-turnover industries back. "But just by keeping people in the company you are not assured that their performance will be driven by it, unless you link ESOPs to performance," says Purandare.Option plans have to build in factors like feeling of ownership, link to company performance and individual performance. Performance-linking, which is being considered almost a must in India, is a fairly recent trend overseas. At HDFC, for instance, the premium is on future performance. Says Susir Kumar M, company secretary, "The scheme should drive future performance. HR has to build up a measurement against all activities of an employee, if everything is measurable, we can set targets."

Right. So you need formal appraisal systems in place, and also methods for measuring individual contribution to the company's business performance. In many Indian companies, this itself is a tall order. And in large companies, it isn't as easy as it sounds. "It is difficult to actually attribute and link the contribution of an employee, particularly at the lower levels, to stock value," says Raphael.

And after all this, it doesn't always work as it is supposed to. Option plans work fine when the company stock performs well, and rises. Suppose it falls? "It can lead to an exodus of critical talent," warns Pai. In many industries, specially cyclicals, stock prices are at the mercy of a whole lot of external factors. And even if it rises, and rises, it can have a curious effect. Ask Infosys, which has largely had a great experience with share options. "In high-growth companies, which have a high burn-out potential, an employee who makes a lot of money from options may just lose the ambition to keep on performing," says Pai. So your best talent, stuffed with options, may just decide to retire to the south sea islands.

If it's not correctly linked to performance, employees may treat options as an entitlement - defeating more than half the reasons why they're given. They are also a more complex kind of compensation, and require regular and constant administering. And finally, if EPS is badly affected, you might well have a bunch of angry shareholders baying for your blood. And behind them, employees.

- Sudeshna Sen, Aruna Vaidyanathan Seema Shukla and Flynn Remedios

PLEASE NOTE: This article was published first in Corporate Dossier, The Economic Times. All copyrights and IPR are duly recognised. The original author has re-published this piece for his personal records only.