In some of the fast-growing industries like information technology (IT), pharmaceutical, and fast-moving consumer goods (FMCG), the turnover of employees can be as high as 30-40 per cent per annum. However, the well-oiled human resources (HR) policies of companies in these sectors keep the morale of employees high and make sure that such a high turnover is not due to any fault-line in company policy. These companies not only ensure that the salary is competitive but also look at other benefits to keep the workforce going.

The most powerful of these benefits has been the ESOPs. As this practice of rewarding the employees is becoming very popular, the Sebi guidelines have come at a right time. Some companies have decided to extend the scheme even to employees of their subsidiaries read Global Telesystems plan announced recently.

Anything and everything a company does should finally result in maximisation of the shareholders' wealth. Does ESOP satisfy this test? Does it not have a hidden cost to the shareholders? The accounting standards issued by the Institute of Chartered Accountants of India (ICAI) is silent on this issue. So far, no analyst has seriously delved into the real impact of options on corporate earnings. As the use of options is becoming pervasive, one should look at how options dilute shareholder value. Analysis in this area is long overdue.

A debate over the hidden costs of using options instead of cash compensation to employees is required. If you pay an employee cash, that cost shows up as an expense on the company's income statement. But if you pay the employee by issuing an option instead, it is "costless" compensation. But so far, stock markets, apprehending displeasure of companies, have chronically ignored the costs of employee options when valuing shares. Share options are a crucial way of attracting workers to corporates and any attempt to draw their attention to this issue is simply irritating.

So far in India, there has not been any serious study on options costs of shareholders. But a study with reference to the banking industry in USA makes interesting reading. Surprisingly, options are not nearly as important to banks as, say, technology, pharmaceutical and info-tech firms. These are the sectors with a very strong intellectual foundation and where employee motivation is critical to the success of the company. Ironically, these are also the sectors reporting high employee turnover.

Credit Suisse First Boston analyst Michael Mayo and his team of researchers recently published a report (came to be known subsequently as Mayo report) on the concealed cost to bank earnings of employee stock options.

Accounting rules in US do not force companies to take an earnings hit from employee options. But the researchers found unaccounted-for options at 47 banks caused them to overstate their 1998 earnings on average by about 4 per cent. A few major banks, including Citigroup and BankBoston, had hidden options cost of 10 per cent

The Mayo report looked at the cost of options to 1998 earnings at a select group of large-cap and mid-cap banks. The study says that if Citigroup and BankBoston had fully accounted for their options against their 2009 earnings, doing so would have reduced profits by 10 per cent. JP Morgan's 1998 profits would have taken a 6-per cent hit; Chase Manhattan and Northern Trust, 5 per cent. Imperial Bancorp of Los Angels would have seen its 1998 earnings sink 36 per cent if it had to fully account for its employees stock options. Imperial says the study did not account for the cancellation and repricing of options it did during the year, and that the study should have given it a 12.5 per cent hit to earnings.

Why should investors care about off-balance sheet options costs? The Mayo report says if the stock market endured a prolonged correction, bank executives would likely start demanding cash-based compensation instead of the now-worthless options, thus hurting the current earnings. In the event of a market downturn, all companies could end up suffering some profit pains from options anyway. A new accounting proposal now under debate would force companies either to wait six months before repricing "underwater" options, or else subtract from earnings the difference between an option's new lower exercise price and any subsequent increase in the share price.

In 1995, accounting regulators tried to force companies to expense employee stock options against profits. Companies hollered that it would be the end of Western civilisation, in one regulator's phrase. The regulators retreated, only requiring companies to disclose the "pro-forma" effect of options on earnings in a footnote.

Sebi guidelines on ESOPs assume active shareholder participation in appraising ESOP proposals. Considering the myth of shareholders' supremacy, share options put up for their approval in the annual or extraordinary general meeting would go unnoticed and would be passed in a routine way although the proposal implies equity dilution resulting in reduction in the value of the existing shareholders' shares. Indeed, to the extent options pry open a clash of interest between existing shareholders, employees and the company management, there is reason to believe that the balance of power will always be delicately balanced. But the company managements may wish to reward intellectual employee capital with equity in the company itself. The issue then is for the company management to explain to existing shareholders why ESOPs will bring in better returns and thereby deliver better value to existing shareholders.

While considering ESOPs, company managements can buy back equity in the market to compensate that section of shareholders who may dislike employee rewards proposals. Microsoft's has been following this practice of spending more than half of its retained earnings on buying back equity in the market so that it has the leeway to issue more employee options without loading the overall equity base. Globally, companies pursuing aggressive ESOPs policy are treated well in the stock markets for the simple reason that investors are assured that the company has been effectively meeting the divergent demands of employees and shareholders. Local companies, too, will have to walk the tight rope between competing interests.

There are two other issues which have to be examined before the ESOPs really take off. One is a tax-related issue. Should an employee be taxed at the time of availing the stock option plan or at the time of sale of securities? However, Budget 1999 has clarified that stock options will be taxed as a perquisite at the time of exercise of the option by the employee and subsequently as capital gains at the time of sale of the security. Internationally, options are taxed only once. Then there is the issue of differential valuation of shares given to local employees (in rupee-denominated paper) and to foreign employees, as global depository receipts or American depository receipts.