A key decision in launching an ESOP scheme is the price at which you should offer your shares i.e., the Exercise Price. It is the price the employee will eventually pay to receive the shares and monetize the gain on their ESOPs.

A simple google search of what should be your exercise price philosophy will give you a plethora of material on keeping it as low as possible vis-à-vis the share price. Many market participants swear by keeping the exercise price equal to face value (minimum possible by law) and making the scheme as employee friendly as possible.

We only wish it was that simple!

In our view, Exercise Price, needs to be set such that it results in alignment of interests i.e., puts the employee in the same / similar position as the shareholder of the Company. In addition, the Company also needs to consider the alignment of other factors such as compensation philosophy, purpose of grant and consistency with other terms of grant in determining the exercise price.

We therefore recommend Companies to set their exercise price considering the following aspects:

Business / Purpose of Grant
  • - If rewarding past performance, such as founding team members, the Company may offer ESOPs at deep discount as reward for their role in building the Company 
  • - If incentivising future growth, the discount may be limited to create an incentive for employees to work towards increasing the share price, else their ESOPs would be out-of-money 
  • - For regular retention or annual appraisal linked grants, the approach needs to be aligned with grant frequency, grant size, company and industry specific factors
Alignment with Compensation philosophy
  • - If using ESOPs to compensate for CTC reduction, offer ESOPs at face value to minimize the dilution whilst maximising employee’s wealth creation 
  • - If using ESOPs as additional reward over and above CTC, follow the ‘incentivising future growth’ principle highlighted above
Is dilution a concern?
  • - For granting a given value of ESOPs, lower the exercise price, less the number of ESOPs that would be required to be granted 
  • - Thus, exercise price can be lever when dilution is a concern
Is the P&L hit acceptable?
  • - Higher the discount, higher is the P&L charge for the Company. Don’t go by benchmarks, get the mathematics right for your Company!
  • - Many start-ups begin with their ESOP journey by offering ESOPs at face value and continue the same approach even when they scale up. By the time their ESOP charge starts biting them (easily running into 100s of crores for large companies), they find it hard to pass the message of increase in exercise price to the employees.

Lastly, it is important to have an overall balance between discount (or lack of it) on exercise price vis-à-vis the vesting conditions set. Avoid making the double mistake of keeping exercise price low and offering service based monthly / quarterly vesting without any performance linkages.

Should you have any comments or thoughts or feedback, please feel free to share write to us. We would love to hear from you!

Vichitra Malhotra, FIAI

Founder and Consulting Actuary

v.malhotra@veritas-india.com

+91-9372876627