ESOP: What was the trigger and When?

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ESOP: What was the trigger and When?

Today’s Midas touch? Ask the select Flipkart and Infosys employees, they will tell you without any hesitation that it is ESOPs. In May 2018, over a hundred Flipkart employees turned dollar millionaires as the company was bought over by Walmart. A few decades earlier, Infosys the IT Services company created thousands of rupee millionaires and more than a handful of  dollar millionaires.

In the start-up world today, ESOP is a vital component of the senior manager’s compensation package that often is the decisive factor in their relationship. But where and when did ESOPs start and what does it hold for its participants?

The Concept

The concept of ESOP itself has an ancient history dating back 2000 years to Arthashastra. Chanakya, the author laying down the principles for remunerating cowherds classified the herds into three categories along with three distinct compensation structures. For the super breed of cows, a fixed compensation was prescribed to ensure that the herd was not over exploited for short term gains. For the middling breed, a fixed return was provided to the owner and any excess over that was paid to the cowherd as it was attributed to their efforts. Turning to the inferior breeds, the entire income was shared between the owner and the cowherd as the role of the cowherd was critical.

The principle underlying the compensation structure was to link the income/returns to the asset quality and the role played by the employee in generating returns. Where the asset played a key role in determining the return, employees got a fixed share as their contribution was only an enabler, on the other hand where the asset quality was basic and the employees had a substantial role in enhancing the quantum of returns generated, the employees got not just a variable but also a significant share of the return.

In present times, the relationship between individual contribution and participation in ownership of the assets is very clearly visible in technology firms, where ESOPs are more pronounced in one of the three situations: businesses in their start-up phase, at senior management levels in larger companies and finally in business segments where individual contribution is the difference between success and failure, like in product companies in the tech space.

The First of First

In September 1957, five scientists and three engineers with an idea to explore and exploit- to build transistors using silicon, resigned from Shockley Transistor Laboratories and started Fairchild Semiconductor Corporation. Sherman Fairchild, an inventor and the largest shareholder of IBM, backed the new venture with a funding of $1.38 million. The eight ‘founders’ took 100 shares each and the two investment advisors who structured the deal took 225 shares, with another 300 shares reserved for key managers to be hired.

The financial investment was made by Fairchild Camera and Instruments, an established and profitable company provided for an option to the investor to buy the shares from the ‘founders’ and other shareholders at $3 million before the company earned profits of $300,000 for 3 years or $5 million if it deferred its right to buy after it earned the threshold profits. Within 2 years, the new company earned a revenue of $6.5 million resulting in the option being exercised. The team of eight got about a quarter million dollars each for their effort, a very large sum in those days, when the word billionaire was not in popular domain. This paved the way for the new form of compensation in the tech world.

ESOPs in India

Though not well publicized Wipro was the first Indian company in 1985, if not one of the earliest companies in India to introduce ESOPs. However, it was Infosys in the 1990s which brought ESOPs into public discourse with the large number of ESOP rupee millionaires and billionaires it created.

In 1990s, Income tax was a critical factor that added more sheen to the already glittering ESOPs, making it more attractive. Being exempt from tax both at the time of exercise of options and at the time of sale due to the then prevailing tax laws, the value of ESOPs doubled compared to its alternative salaries.

Despite this ‘loophole’ being plugged in early 2000’s, ESOPs continue to be attractive, as the employees get the benefit of stock ownership without making any upfront investments.

ESOPs, its Utility Today

After the dotcom and telecom bubble burst in early 2000’s, ESOPs came under enormous scrutiny resulting in the need to account for the cost of ESOPs in the books of accounts by the issuing companies. Earlier, ESOPs were considered free and companies issuing them were not required to account for the cost of options if the exercise price was at market value.

With the accounting change that required the cost of ESOPs to be accounted, established and profitable companies did not see any obvious and explicit benefit in issuing ESOPs. However, in the start-up world ESOP has retained it preeminent position and looks well entrenched for the future.

By | 2019-02-06T11:44:13+00:00 February 5th, 2019|First of First|0 Comments

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