Employee stock options: Day-light robbery or a distress call? (The Paytm example)

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As are hidden fees conniving from a utility bill, so are some employee stock options from an equity shareholding.

Let me explain.

First, let’s understand employee stock options (in simple terms):

Stock options are a great way of rewarding employees for their exemplary contributions to their employers (read: shareholders). When shareholders win through share price appreciation, employees also get rewarded.

How? They are allowed to exercise an option to buy the shares on the day of celebration but at a price of the past. 

How far in the past? Typically 3-4 years.  

But, do the employees know beforehand that such a reward option exists, or are they surprised out of the blue? Obviously, they know well in advance about such an entitlement.

The day the employees are informed about such a reward strategy is called the Day of Granting.

The day the employees get to use their option is called the Day of Vesting.

The price the employees have to pay to buy the shares is (and should be) the prevailing market price on the Day of Granting. Let’s call it the Exercise Price.

This way, the employees are given a set timeframe for performing, from the Day of Granting to the Day of Vesting. And it is up to the employees to see how far they can take the value of the business (reflected in the share price) within this timeframe.

How is this model beneficial to everyone?

Realize that here the company doesn’t pay employees from its treasuries. The payment comes from the stock market. Not in form of a paycheck, but in form of a profit. The employees by paying the Exercise Price (the price of the past), which is lower than the price on the Day of Vesting (celebration), get to pocket the difference. The new buyer of the shares, who is some random stranger from the stock market, eventually pays for the difference, which is embedded into his/her investment cost. 

Employees happy with their rewards.

The corporate treasury relieved from the cash outflows (for 3-4 years).

Business performance shines (during those 3-4 years).

Shareholders despite knowing that employees shall be added to the profit-sharing list are still pleased by the net positive impact computed from the rise of the price of their own shares (in those 3-4 years).

Win-win-win-win. 4 birds with 1 stone.

But…….. What if……

Scene 1: The employees fake performance reports. The stock price still rises on falsehoods. Employees exercise the options and cash out the rewards. Shareholders smile and let them. Only to get upset later at some point in time when the share price collapses like a house of cards.

Does this happen? Yes, it happens. And it is sad. This makes for a long-haul sophisticated form of deceit. But that’s not the point of this article. Let’s see something even more sinister.

Scene 2: The employees are given stock options on the Day of Granting. But not at the prevailing market price of that day. Instead, some number significantly lower than that.

Now the employees don’t need to work extra hard for better performance. They just got to ensure things don’t go downhill for the next 3-4 years. Stagnant share price all this while. And yet, they get to pocket a handsome reward when the Day of Vesting arrives. Corporate treasury doesn’t bleed. Existing shareholders see no improvement in their holdings. Incoming shareholder (yes the one who buys the shares from the employees), well good luck to him/her.       

Don’t believe me. Okay! 

One97 communication, which owns and operates the Paytm platform in India, recently IPOed.

They issued shares at Rs. 2150 in November 2021.

Since then, the shares kept sliding down.

The closing market price on 2 May 2022 was Rs. 601. (~72% down).

On 2 May 2022, the company granted 3.97 million stock options. The Day of Granting.

The exercise price, any guess? Ideally Rs. 600-630? Maybe with some benevolence, Rs. 530-550?

No! Rs 9 per share! Read here on page 2

That’s too low for an entry! That seems a gift! Now, irrespective of whether the share price recovers back to Rs 2150, stays at Rs 600, or even tanks down to say Rs 300; with the exercise price set at Rs 9, there is a clear surety of rewards to the employees under most circumstances. This reduces the incentive to perform. (Rs 601 – Rs 9 = Rs 592 * 3.97 million shares = Rs 2,333 million or Rs 233 crore in-the-money right on the Day of Granting without even moving a needle). Rather this seems like (Grant)Daylight robbery!

Who loses? Existing shareholders? Understand, that many of them might have been scarred in that 72% drawdown. Now they would have to see new shareholders added to their ‘already-gone-steadily-crumbling value pie’. By exercising the stock options at Rs 9, these new shareholders (employees) contribute hardly any fresh capital to the company. Maybe some skills, some talent, some useful business connections. Against which, they are at present, on day zero itself, entitled to a moolah worth Rs. 233 crore. But the shareholder pie (the market cap of the company) was Rs 39,000+ crore on that day. So clearly the stock option rewards are a pittance for the collective group of shareholders. Yet, it could be a fascinating sum for a small group of employees, especially if the options are granted disproportionally to a few seniors (which is not clearly known).

At a big picture level, the lack of materiality of the stock options somehow weakens the case for blatant value siphoning. Thank God. However, given the substantial share price destruction in recent times, the cash-burning nature of business operations, and the lack of visibility of the path to profitability, the questionability over the granting of such way-too-easy- incentivizing stock options still persists. This questionability wouldn’t have arisen if the company had a history of delivering consistent returns, or if the exercise price were at reasonable discount levels.

Wait. There could be another angle to these stock options. Do the easily rewarding stock options hint at something else after all?

A desperate bid for employee retention. The company conveys an open incentive on the grant day for those who make the journey from the day of granting to the day of vesting. Deal: Stick right through and take money home. 

Or, a bet on the survival of the company itself. If the business survives and stays status quo, then the eligible employees get to collect the rewards (currently valued at Rs 233 crore). Survival, but with any deterioration from the present position, shall lead to gradual deductions from the reward pool. Game on?

Either way, these eyebrow-raising stock options pose a not-so-very-good signal regarding the state of affairs of the company and its governance levels. The least they could have done better was to back this action with an explanation and/or some description of the employee pool eligible for such stock options.

Conclusion: With the rise of hi-tech businesses that are very talent/ knowledge heavy, employee stock options are becoming an important aspect of equity analysis. Reading the basic terms of stock option plans helps gauge how the firm distributes value with its employees – the quantum of dilution, the alignment of rewards with shareholder interests, and the bargaining strength of the employees, to name a few.

Disclosure – Neither my clients nor me (including my family members) hold, or intend to hold, any positions in the stock of One 97 Communications. The content presented in this article reflects my personal observations and opinions. I am not getting paid by anyone for writing and publishing this article. This article is meant for educational and information purposes only and in no way constitutes any form of investment advice.

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