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Negotiating your salary with your prospective employer? If you are joining a software firm, you can be sure stock options will enter the picture.

But, before you agree on the compensation package and sign on the dotted line, understand exactly what is being offered and how a stock option actually works.

In its simplest form, an Employee Stock Option Plan is nothing but a share ownership scheme offered by the employer to the employee. However, it is offered under different guises.

Either you pay for it...

That's right.

The good news is that, in such a case, the company tends to offer the shares at a discounted price as compared to the market rate. Otherwise, why would anyone opt for it?

The employer can deduct a certain sum from the employee's salary every month for a certain period known as the offering period.

The amount will go towards the purchase of the shares.

At the end of this period, the shares are allotted to the employee, assuming he does not withdraw from the plan or quit his job in the interim.

Another way this works is for the employer to make an outright offer to the employee to buy the shares at a particular rate. The shares can be bought at one go or over a period of time.

...Or the company does so

This one sounds good. The employee pays absolutely nothing and the employer foots the bill.

1. Employee Stock Ownership Plan

The employee is given an opportunity to acquire the company's stock through a trust.

The employer will create a stock ownership trust, like the Infosys' Employees Welfare Trust, to allocate shares to its employees.

The company will then make contributions to the trust. The employee generally does not pay for these shares.

The company will continue to contribute to the trust until an employee quits, dies, retires or his employment is terminated.

2. Stock Appreciation Rights

SARs happen when an employee is awarded stock equivalents at a certain predetermined price.

After a certain time period, the employee gets a cash bonus that is equivalent to the appreciation in the stock price.

Let's say Amit is given 100 SARs at Rs 50 each. The company does well and the price of the shares increases to Rs 100 over three years.

As a result, Amit will get Rs 5,000 (100 SARs x Rs 50 = Rs 5,000).

How it impacts the employee

Well, if the company is doing well, what more could you want? You will get free shares or, at least, shares at a bargain price.

But why would a company offer this? After all, there is no such thing as a free lunch.

Believe it or not, the company does gain.

i. ESOPs serve as a great motivational tool

When you buy shares, you do not invest in the market. You invest in the company whose shares you are holding. That makes you a shareholder or part owner of the company.

Owning an equity share means owning a share in the company business. And, having a stake in the company tends to substantially increase the employee's loyalty, dedication and motivation level.

After all, you are now working for your business and your company.

ii. It is a tax benefit for the employer

When stocks are distributed to the employees by means of a trust (as in the case of Infosys Employees' Welfare Trust discussed earlier), the company buys the shares on behalf of the employees. This means the company contributes to the trust so it can buy the shares from the stock market/ share owners.

These are known as Unleveraged ESOPs, since there is no leverage (debt/ borrowings) involved.

The company can also take a tax-deductible loan for this contribution. This will make it a Leveraged ESOP since they are now borrowing money.

The contribution the company makes to this trust is tax free for the employers.

The essence of a stock option

Let's see how a typical stock option works.

Let's say Amit is an employee in Company A and is offered shares at Rs 100 each. This is the exercise price -- the price at which the company promises to sell the shares to its employees.

On the day he joins, he is given the option to purchase 100 shares during a period of one year. This period (one year in this case) is known as the vesting period.

Until the year passes, Amit doesn't own the 100 stocks.

After a year, he is given the option to pay Rs 10,000 (i.e. Rs. 100 per share x 100 shares) to the company and acquire 100 shares.

Let's suppose, at the end of the year, the market price of the stock is Rs 110. If Amit exercises his option (that is, he chooses to purchase the 100 shares from the company at Rs 100 each), he can actually make a clean profit of Rs 10 per share.

All he has to do is buy the shares from the company and immediately sell them in the market.

The number of shares (100 in this case) multiplied by the difference between current market price (Rs 110) and exercise price (Rs 100) is called the value of the stock option.

The discount granted to the employee during the accounting period is treated as compensation.

The accounting period refers to the period of time during which a company publishes its financial results. Normally, it is the financial year itself -- April 1 to March 31.

In the above example, we can see that if Amit decides to exercise his option, the company will actually lose on Rs 10 per stock that it could have got had it sold the stock in market.

This discount of Rs 10 per stock, which the company gives to the employee, is recorded in the company's account books as 'employee compensation head'.

What if the current market price turns out to be Rs 90 (not Rs 110). In that case, Amit can choose not to exercise his option of buying the stock at Rs 100 from the company. Why should he when he can get the same shares from the market at Rs 90?

An alternative perspective
ESOPs may appear rosy at first glance, but this need not always be the case.

Let's take a look at the previous example and say Amit's salary structure has two parts: a fixed component (salary) and a variable component (performance linked bonus). The ESOPs are another element.

Now let's say Company A's performance is not great in the following financial year and it fails to live up to market expectations. Hence, your performance linked bonus is reduced and chances are your increment won't be too great either. The company's share price too will fall.

So you get hit from both sides -- the market and the management.

If you think this is bad, consider a scenario where both you and your spouse work for the same company and both have ESOPs.

Not only will both bonuses be hit, but your increments will be low and your ESOPs will reduce in value.

Sometimes, there is no discount

Often, during a new issue or an Initial Public Offering, the company will keep a small portion of shares aside for its employees.

This time, neither will the company pay for them nor will the employees get it at a discount.

They will get it at the same rate the public is getting the shares. The only differences are:

i. The employees will not have to bid for shares like the public does

ii. The employee is assured of an allotment, unless of course, the number of employees who want to buy the shares far exceeds what is being kept aside for them.