Issue 4 (dated 16 January 2014). Contact us at

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1 In our last newsletter, we elaborated on good governance practices in the light of the RBI Master Circular on Corporate Governance. This month we take a closer look at Employee Stock Option Plans approach to issuing shares to employees, and technicalities involved. Employee Stock Option Plans/ Schemes (ESOP/ ESOSs) & Employee Stock Purchase Schemes (ESPSs) are employee benefit plans which make employees the shareholders in their company. For the sake of continuity we will refer to ESOP/ ESOS as ESOPs throughout this newsletter. ESOPs are an alternative to cash incentives and build loyalty, thereby facilitating employee retention. ESOPs are becoming a popular means for MFIs in India to retain employees. Several MFIs feel that staff are better inclined to think about long-term sustainability when they have a stake in the institution s success. Out of 28 MFIs comprising ~60% of India s MFI loan portfolio in FY 13, 15 institutions have already issued ESOPs to employees, either directly or through an Employee Welfare Trust. These institutions range across Tier 1 MFIs (>Rs. 1,000 cr portfolio) to Tier 5 (<Rs 100 cr. portfolio), indicating that ESOPs are relevant to MFIs across the board. Size of employee stake-holding is widely varied, ranging from 0.3% to 18.7%. As the sector moves into a high-growth trajectory, ESOPs may prove an attractive mechanism for keeping employees motivated and aligned to institutional goals. The following are the legal statutes relating to ESOPs The Companies Act, 2013: Issuance of sweat equity shares or formulation and implementation of Employee Stock Option Plan ESOP by Unlisted Companies (public or private) is primarily governed by the relevant provisions of Companies Act and Issue of Sweat Equity Shares Rules, 2003 issued under the same Act. Securities Exchange Board of India (SEBI) Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, 1999 (applicable only in case of listed companies, but open for unlisted companies to comply voluntarily) Income Tax Act, 1961 Foreign Exchange Management Act 1999 SEBI Guidelines define ESOPs as a scheme under which a company grants an option to employees, i.e. the benefit or right to purchase or subscribe at a future date the securities offered by the company at a

2 predetermined price. Stock options are therefore instruments that are offered to employees, allowing them to buy a certain number of shares in the company at a specific price. If this price is lower than the current market price, gains are immediate. If the price is the same as market price, future rise in the share-price will accrue as profits to the employees. A company has the freedom to specify how many shares an employee gets, which employees get them, and when the ownership is actually transferred. We will now elaborate on a few aspects of ESOPs, namely 1) Eligibility 2) Issuance process 3) Taxation implications and 4) Accounting and Reporting requirements. 1) Eligibility: ESOPs can be availed by employees specifically designated by the Compensation Committee of the Board, where employee would be defined as: a) A permanent employee of the company working in India or abroad; or b) A director of the company whether a whole time director or not Some MFIs provide ESOPs to all employees. If an MFI is looking to reward only a selective set of employees, it may use some of the following criterion to identify them appropriately: Performance - ESOPs can be used to reward excellence by linking performance with the allotment of stock options. In this way star performers become shareholders as well. Length of Service - Taking seniority as the criterion for ESOPs can be a reward to loyal employees. The length of service is important in client-relationship focussed industries like the microfinance sector. Criticality of Employees- Criticality and the market value of both the position and the individual may be taken into account when picking whom to reward with ESOPs. Below are a few points regarding framing of an ESOP, focusing on only those points pertinent to majority of Indian MFIs (which function mostly as unlisted, private limited companies): 2) Framing of an ESOP scheme - Important points to remember are: A. An unlisted company cannot issue equity under ESOPs for more than 15% of total paid up equity share capital in a year or shares of the value of 5 crores of rupees, whichever is higher, except with the prior approval of the Central Government. B. The price of shares under ESOP to be issued to employees has to be determined by an independent valuer. C. Although this can be done by the Board directly in an unlisted, private company, setting up a Compensation Committee gives more rigour to the ESOP issuance process. The committee is usually formed from among the Board of Directors and comprises majority of independent directors. It is constituted for administration and superintendence of the ESOP. The committee is responsible for formulating terms and conditions, policies and systems for the ESOP. The following aspects should be formulated prior to designing and issuing an ESOP: i. Determining eligibility criteria for employees to subscribe to shares at a future date Policies regarding promotions, group company transfers, terminations, retirement Eligibility of new joinees for ESOPs and effective date of grant of options ii. Determining the quantum of share capital to be offered:

3 Total equity share capital limit which is being offered to employees (should be attractive enough to create wealth for employees) Coverage of different levels/ hierarchy of employees (private company ceiling on number of shareholders does not apply to employees or ex-employees to whom ESOPs are being issued) iii. Determining the issue price: Fair market value - more dilution, no accounting charge Discount - less dilution benefit buffer with accounting charge to the P&L Companies have freedom to determine the exercise price of options under ESOPs, subject to the condition that the company conform to the accounting policies prescribed in the SEBI Guidelines. If the exercise-price is at a discount to the market price, the discount will be treated as a cost. The price should be determined keeping in view the objectives and rationale for the ESOPs. If offered as rewards, the company should offer ESOPs at a discount, so that their gains are immediate. Options which are not exercised (irrespective of whether they have been vested or not) can be re-priced by the company. This is subject to the approval of the shareholders and provided it is not detrimental to the employees' interests. iv. Decision on the vesting period: Time based or performance based Standard across the board or different for key people Yearly/ half yearly quarterly grants v. Decision on lock in period for shares issued in pursuance to an employee s exercise of options (can be more than the stipulated minimum of 3 years) vi. Design of exit mechanism or liquidity options to the employee after exercise of shares how the employees can convert the allotted shares into cash. Liquidity options available to the employee include: Can be purchased by investors, subject to Board approval Employees Welfare Trust can buy on behalf of the employees and then sell shares to promoters or investors There are two modalities for issuing ESOPs:

4 Advantage of constituting a Trust includes providing an exit for employees (in case of unlisted companies the Trust can buy back shares from an exiting employee) and providing administrative convenience. Process of issuing ESOPs: Departments involved in the process of issuing ESOPs: 3) Taxation implications A. Benefits derived from ESOPs are taxed as perquisites and form part of salary income. The perquisite value is computed as the difference between the Fair Market Value (FMV) of the share on the date of

5 exercise and the exercise price. An employer is required to deduct tax (TDS) in respect of any tax liability arising from perquisites. B. Capital Gains Tax is charged under the following circumstances: The difference between the sale consideration of the shares and the Fair Market Value (FMV) on the date of exercise is chargeable to tax under Capital Gains in the hands of an employee. For Unlisted companies, the FMV is determined by a Category I merchant banker registered with SEBI. In order to compute capital gains, the FMV on the date of exercise becomes the cost of acquiring such shares. Depending on whether they have been held for 12 months or more from the date of exercise, capital gains will qualify as long term or short term. For companies which get listed in the interim, if the shares are sold on a recognised stock exchange in India, the long-term capital gains are taxed at 20% with indexation; and the short-term capital gains will be subject to the preferential rate of taxes at 15% u/s 111A of the Income Tax Act. For employees selling shares of unlisted companies, gains on such transactions would be taxed under the normal tax slabs applicable. C. If the shares are offered at a significant discount to employees, the effect on the Profit and Loss account would be considerable. While this may reduce the tax liability of the issuer without involving any cash expense, depressed profits could be viewed in a negative light. 4) Accounting implications and Reporting Requirements For Unlisted companies, Accounting Practices can be adopted as per SEBI guidelines on ESOPs, 1999 and the guidance note on Employee Share Based payments issued by the Institute of Chartered Accountants of India. The first three schedules below give details of accounting treatment and valuation for accounting. In case of ESOP administered through a Trust, the accounts of the company should be prepared as if the company itself is administering the ESOP. Following are the schedules pertaining to ESOPs. A. Schedule I: (Clause 13.1) deals with accounting treatment of options granted: Accounting value of the options granted should be treated as a form of employee compensation in the financial statement (Debit Deferred employee compensation and credit Stock options outstanding) When an unvested option lapses by virtue of the employee not conforming to the vesting condition, the value accounted as employee compensation should be reversed. Same holds in case of expiry of the exercise period of a vested option. The SEBI guidelines specify how the cost will be shown in the books of accounts. In case of ESOPs, the difference between the price at which employees can exercise their options and the market-price-on the date on which the option is granted, must be taken as an expenditure in the Profit & Loss Account although there is no actual cashoutflow. This can be spread out over the entire period during which the scheme is in play instead of taking the entire expense in one year. A guideline issued by SEBI for stock options requires companies to show expenses in either of the following ways. Show in the form of option discount [difference between market price of the share at the date of grant of the option under ESOP over the exercise price of the option (including up-front payment, if any)]

6 Or, the fair value of the option measured by the Black and Scholes model. A key disadvantage is that the Black and Scholes model understates the value of the option as it gives the liberty to the company of choosing the variables. If variables like standard deviation of the scrip and interest rate are changed, the value of option will also change. Variations in option value using Black and Scholes model - There are five variables that could change the option value. These are: Fall in the share price at the time of announcement of ESOP. Increase of the exercise price. Use of lower interest rate. Use of lower standard deviation. Use of shorter vesting period. The accounting value as measured above should be accounted as employee compensation (aggregate of accounting value of the options so granted under ESOP during the accounting period) and has to be amortised on a straight-line basis over the vesting period. The amount should be amortized as: Straight line basis, in the absence of graded vesting In case of graded vesting the vesting period should be determined separately for each separate vesting portion of the option; treating the option as multiple options and then applying straight-line method. Market experts raise questions about this form of accounting, as it does not use the time value of money in measuring the cost of the stock option. B. Schedule II deals with Employee Stock Purchase Scheme. SEBI guidelines require companies to show expenses as price discount (excess of the market price of the shares at the date of issue over the price at which they are issued under the ESPS). The value as measured above is to be accounted as employee compensation (aggregate of accounting value of the shares so issued under ESPS during the accounting period). Since this pertains to listed companies which have traded stocks, it is not elaborated further here. C. Schedule III explains the determination of fair value, which is estimated using option-pricing model. It takes into account the following aspects: i. Grant date ii. Exercise price iii. Expected life of that option: Expected life of an award of stock options must at least include the vesting period. If the company does not have a sufficiently long history of stock option grants, it can take into consideration the experience of a comparable peer group The expected life of ESOPs should not be less than half of the exercise period of the ESOPs issued until and unless the same is supported by historical evidences with respect to ESOPs issued by the company earlier. iv. Current market price of the stock and its expected volatility: If the company is not listed, then there is no question of volatility of its stock. Indian accounting guidance norms recommends unlisted companies to consider volatility as zero since there is no market price of the unlisted companies. This may however lead to

7 incorrect value of the ESOPs. The company can use an estimate based on the estimated volatility of stocks of an appropriately comparable peer group. v. Expected dividends: The estimated dividends of the company over the estimated life of the option may be estimated taking into account the mean dividend yield of an appropriately comparable peer group. vi. Risk-free interest rate: Risk free interest rate used should be the interest rate applicable for a maturity equal to the expected life of the options based on zero-coupon yield curve for govt. securities. vii. The fair value estimated at the grant date should not be subsequently adjusted for changes in any of the above factors Reporting Requirements are elaborated in the remaining schedules. D. Schedule IV i. Risks associated with ESOP (in addition to market risk) Concentration: Holding shares of a single company aggravates the risk Leverage: Any change in the value of the share can lead to a significantly larger change in the value of the option as an option amounts to a levered position in the share. Illiquidity: Non-transferability of options. Employees cannot mitigate their risks by selling a part or the whole of their options before they are exercised Vesting: The options will lapse if the employment is terminated prior to vesting. Even after the options are vested, the unexercised options may be forfeited if the employee is terminated for misconduct, or resigns and date of relieving falls within the time specified for exercising the option. ii. Information about the company Company's business (in accordance with schedule II of the Companies Act) Financial information for the last 5 years for which audited financial information is available. The last audited accounts of the company should also be provided unless this has already been provided to the employee in connection with a previous option grant Risk Factors Disclosure requirement: The option grantee should receive copies of all documents that are sent to the members of the company. This shall include the annual accounts of the company as well as notices of meetings and the accompanying explanatory statements. iii. Salient features of ESOP This contains details with regard to Vesting, exercise of options, adjustments and forfeiture. However, this is not required if it has already been provided to the employee in connection with a previous option grant, and no changes have taken place in the scheme since then. E. Schedule V contains information required to be filed with stock exchange, and is not relevant for Unlisted companies. F. Schedule VI contains the format for notification for issue of shares under the Stock Option Plans. This contains details such as company name and address, kind of security to be listed, par value of the shares, date of issue, no. of shares issued, premium, exercise price, total issued share capital post this issue. SEBI ensures that terms of ESOPs Should not be varied in any manner if it is detrimental to the interests of the employees

8 Can vary the terms only pursuant to an earlier resolution of a general body but not yet exercised by the employee (again, provided it is not prejudicial to the interests of the option holders).this should again be approved by the shareholders by way of special resolution. In case of varying the terms, full details of such variation, rationale for the same and the details of the beneficiary employees should be disclosed. Since the Microfinance Debt Fund soon to be launched by IFMR Investments will be extending long-term debt to MFIs, retention of staff at all levels is an important aspect of the underwriting criteria, given that MFIs are highly dependent on their human capital. We hope you found the update useful. You can reach us at contact.investments@ifmr.co.in for further details. Best Regards, Suchindran V. G.