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1 About ESOP Direct ESOP Direct is a leading solutions company in the space of Equity based compensation. ESOP Direct is a part of the Kirtane Pandit group, in existence for more than five decades, consisting of an Accounting and Consulting firm, a Software services company and a Business Process Consulting company. As a group, we employ over 5000 professionals and operate globally through subsidiaries at US, UK, Germany, France and Poland and strategic alliances in over 100 countries. ESOP Direct is a team of 50 professionals. Our expert team of professionals brings experience in the preliminary analysis, planning, designing and implementation of ESOPs. Each of our consulting team members is a qualified Chartered Accountant/Company Secretary. The team also consists of CPAs and Management graduates including qualified CEPs (Certified Equity Professional) on board. CEP is a US qualification highly recognized in Equity based compensation space globally. About our Services Our service offerings cover the entire life cycle of ESOPs including Plan conceptualization, Design, Documentation, Plan management, Participant Services, Compliance and reporting. For More Information If you have any questions about the design, implementation, and maintenance of equity compensation programs, please contact : We are the first and the only company in India to offer a full spectrum of integrated on-line stock plan management services, including plan administration, compliance, employee communication and online transaction capabilities. This service is delivered using our proprietary platform My ESOPs. At ESOP Direct we also offer a web based platform for financial reporting of stock options which includes valuation, expensing and reporting under IFRS, IGAAP & FAS 123R. About the write-up We hope that you find the information in this newsletter useful for the understanding of adjustments of outstanding ESOPs due to Corporate action initiated by the Company. In addition, you should be aware that the information provided in the newsletter is presented in a general format and is not a comprehensive summary. With these factors in mind, it is important that you do not consider this note to be legal advice and do not rely solely on the information provided in the newsletter. We would be pleased to help you review all pertinent information and can assist you in developing a comprehensive strategy to implement Share based employee benefits plan for your employees. T: /85 consulting@esopdirect.com ESOP Direct KP Corporate Solutions Limited KPIT Cummins Campus Plot 35-36, Rajiv Gandhi Infotech Park MIDC Phase -1, Hinjewadi Pune, Maharashtra INDIA 1

2 Adjustments to outstanding ESOPs due to Corporate Actions Introduction Corporate actions can be broadly defined as those actions which impact (or have the potential to impact) the value of shareholders holdings in a company. Corporate actions affect the underlying stock price and impact the value of stock options held by the employees. In order to neutralize this impact adjustment is required to the outstanding stock options. In this edition of ESOP vistas we will discuss the adjustments to outstanding employee stock options due to various corporate actions. Legal Requirement SEBI (Employee Stock Option Scheme and Employee Share Purchase Scheme) Guidelines, 1999 required the Compensation Committee to make a fair and reasonable adjustment in case of a corporate action such as right issue, bonus issue, merger, sale of division and others requiring Companies to make adjustments to the price and the number of outstanding stock options in a manner that total value of options remains same after the corporate action. SEBI guidelines emphasized on adoption of global best practices in this area and also to keep the vesting period and life of the options unaltered to preserve employee interest. SEBI (Share based Employee Benefits) Regulations, 2014 which is effective from October 28, 2014 requires Companies to make adjustments in case of corporate action and SEBI is expected come out with further clarification on this matter. Unlisted Public and Private Limited Company ESOP Schemes are governed by Companies (Share and Debentures) Rules, The said Rules do not specify the manner in which the Companies should adjust outstanding stock options in case of a corporate action. On the whole it can be said that the current regulatory framework mandates protection of employee interest and hence Companies whether listed or unlisted should take adequate steps to preserve the value of the options by following best practices. Does every corporate action warrant an adjustment? Modification is required to the outstanding stock options held by the employees in the event of happening of following: i. Value of the outstanding options in the hands of the employees would be impinged by the Corporate action; and ii. Impact of Corporate action on the option value is material; and iii. It will be detrimental to the employee interest if no adjustments are made to the outstanding options or an alternative cash settlement is offered. Thus, for instance, if a company makes a Rights Issue at market price, there is no impact on the 2

3 value of shares and hence on Options and hence no adjustment is necessary. The norm for materiality needs to be applied based on reasonableness and other parameters usually followed. Factors to be considered while making the adjustment The Companies should deal every corporate action adjustment with proper planning and ensure following: i. Total value of options in the hands of the employee (prior to the corporate action date) should not change as a result of corporate action. ii. Vesting period and expected life of the options should be left unaltered as far as possible. iii. Rights of the employees should be protected and should not be adversely affected. iv. Provisions of ESOP scheme and scheme of arrangement (in case of corporate re-structuring) need to be reviewed. v. Fair treatment should be given to all option holders including ex-employees who are holding options thereby ensuring that the adjustments made are not selective. vi. Adjustments should be made to all the outstanding options (vested but not exercised as well as unvested options). vii. The conversion ratio should be worked out for all unique grants separately where options are exchanged with the options of another Company. (A unique grant is one where the parameters like the exercise price, vesting schedule and exercise period, grant date are same) viii. In case it is decided not to continue with the Plan as a result of the corporate action, acceleration of vesting of unvested options or cash settlement should be offered. ix. Positive Employee communication explaining the need and nature of adjustment is essential to satisfy the doubts of the employees and ensure smooth transition post corporate action. Value for Value principle in option adjustment To neutralize the impact of corporate action and preserving employees interest, value of the options in the hands of the employee should not change as a result of corporate action. This concept is known as Value for Value. This is explained in the underneath equations. i. Total value of outstanding options = Total value of outstanding Pre-Corporate action Post Corporate action ii. Outstanding options x fair value per Option = Adjusted options X pre corporate action fair value per option post corporate action The fair value of option is made of two components: Fair Value of Option = Intrinsic value + Time value of option over the remaining expected life 3

4 Intrinsic value of the options is equal to the difference between the value of the underlying shares and the exercise price of the option. This is also equal to the value realized by the option holder when the option is being exercised. Time value is that portion of option value that is attributable to the amount of time remaining until the expiration of the options. It takes into consideration historical volatility of the stock over the expected life of the options. Even though the Regulations are silent on how should Fair value be calculated, the global bestpractice is to follow value that considers the time value of options. Such a Fair value can be calculated using an option pricing model such as Black-Scholes model or a binomial model. Factoring the time value is critical since an option can be exercised any time during its maturity and longer the exercise higher is the value. Intrinsic value ignores this vital aspect of Option value. Applying Value-for-Value principle in different corporate actions It is critical to understand each corporate action and its unintended consequences in order to do the adjustments required to offset the impact. The desired adjustment can be done in following ways: i. Changing the number of options ii. Changing the exercise price of existing Options iii. Combination of (i) and (ii) Save for the above adjustment, all other terms of the outstanding options normally remain unchanged. Let s see how Companies can do adjustments under different corporate actions. Bonus issue of shares If there are say, 1000 options outstanding at an exercise price of Rs 100 each and the current market price is Rs 500. Face of value of shares being Rs 10 each. The company has issued bonus shares in the ratio of 1:1. The market price post bonus would fall to Rs 250. Since the value of options will be impacted as a result of fall in stock price to Rs 250 and also due to the number of shares in the paid up equity share capital getting doubled. The impact can be neutralized by decreasing the exercise price of the outstanding options and increasing the number of outstanding options in the same proportion in which the price has dipped/number of shares have increased. Post bonus, options will have an exercise price of Rs 50 each and number of outstanding options will be increased to 2000 options. This adjustment will ensure the total fair value of the options pre and post corporate action remains same. 4

5 Share split In the above example if there is share split where one share is split into five shares of face value of Rs 2 each. The Stock price post-split will dip to Rs 100 while the number of shares in the paid up equity capital will be five times of share capital pre-split. In this case the adjustment can be done by reducing the exercise price to Rs 20 while the number of outstanding options will be increased to 5000 options. This will ensure that the total fair value of the options pre and post corporate action remains same. Rights issue In the above example if the there is a 1:5 Rights issue by the Company where the rights are offered at Rs 400. The Stock price ex right will dip as a result of expanded equity base but may not be in the same proportion of the discount offered. The Company can calculate the fair value of options ex right and cum right and assess whether difference is material. If it is material and an adjustment is warranted, then the Company may reduce the option exercise price by the same proportion as reflected in share price dip and increasing the number of outstanding options. This will ensure that the total fair value of the options pre and post corporate action remains same. Demerger In case of a Demerger, the demerged Company should do a fair value of options pre and post demerger, the employees who continue in the demerged Company will be compensated for the reduction in the value of their options through reduction in exercise price or/and increase of outstanding options as the case may be to ensure total fair value of the options pre and post corporate action remains same. Let say the fair value of an option pre demerger is Rs 410, the exercise price can be adjusted to Rs 80 in which case the fair value per option will be Rs 328 (all other variables being same), the number of outstanding options will be increased to 1250 to equate the total value of options. Thus the total fair value pre and post corporate action will be Rs 4,10,000 {(1000x410) = (1250x328)} and would stand equated. The employees who are transferred to resulting Company and their options in the demerged company are cancelled as they are no longer in employment with the demerged undertaking will either be granted new options in the resulting Company of the same value (Rs 4,10,000) or they will be paid equivalent in cash. In this case vesting of unvested options will be accelerated before the payout. Acquisition In case of acquisition, options held in the Target Company will be exchanged with the option under the option scheme of the acquiring Company on the same lines as mentioned in the above illustration. If the Acquiring Company does not have a Plan to offer options to the employees of the Target Company the outstanding options will be settled in cash as explained in the above example. Unvested options shall be accelerated in case of cash settlement. 5

6 Prevailing practices In most of the corporate actions witnessed in India, companies do not seem to have followed the Value for Value principle. Almost all the companies (examples given below) have followed the intrinsic value method while making adjustments to outstanding options. Given the lack of clarity in the regulations, no one seems to have objected to such adjustments. The impact is more pronounced in case of mergers or demergers where companies use the share swap ratio for the Options exchange as well. The fact that a value of an option is not the same as that of a share, is completely ignored. More over different grants with different exercise prices and remaining expected life have different option values applying one share swap ratio to all will not satisfy the pre requisite that the value in the hands of the employee should remain unchanged. Some of the recent cases where companies have used intrinsic value to make adjustments are: Demerger between Polaris Financial Technology Limited (Demerged Company) and Intellect Design Arena Limited (Resulting Company) Merger of Mahindra Satyam with Tech Mahindra Concluding Remarks In sum, Companies are required to adjust outstanding stock options in case of a corporate action. They should be more careful especially when there is demerger or merger. It should be ensured that the scheme of arrangement requires adherence to Value-for-value principle. 6