Mitigating Concerns Regarding Dilution in ESOP Plans: A Strategic Approach

Written By:
Team Qapita
October 31, 2023

Dilution is a significant concern for existing investors and promoters when a company allots new primary shares. In the context of Employee Stock Ownership Plans (ESOPs), dilution can occur in two critical ways:

Dilution in % Shareholding: This happens when new equity shares are issued upon the exercise of ESOP options, potentially reducing the percentage of ownership held by existing investors.

Value Dilution: When new shares are issued at a discount to the prevailing market price, it can erode the overall value of the investors' holdings.

However, companies have the means to safeguard their investors from dilution on both fronts by thoughtfully structuring their ESOP plans. Here are some strategic approaches that companies can consider:

A) Protection against Dilution in % Holding:

1. Phantom Plan:

One effective strategy is the implementation of a cash-settled stock options plan, often referred to as a "Phantom Plan." In this scheme, employees receive cash instead of actual shares upon the exercise of their options. Since no new shares are issued, the existing shareholding percentage remains intact, thus averting dilution.

2. Use of Secondary Shares:

Companies can also protect against dilution by utilizing secondary shares. These are existing shares acquired from the secondary market or non-promoter shareholders. When employees exercise their ESOP options, these pre-existing shares are transferred to them, ensuring that no fresh shares are created. This approach reshuffles existing non-promoter shareholding, avoiding dilution. Companies can establish a trust to facilitate the purchase and transfer of these shares.

B) Protection against Value Dilution:

1. Issuing ESOPs at Fair Market Value (FMV):

Another way to mitigate value dilution is by issuing ESOPs at the Fair Market Value (FMV). By doing so, the company receives the same amount of cash as it would from any other investor or public offering. Consequently, no dilution occurs in the existing value.

2. Performance-Linked Vesting Conditions:

ESOPs can be granted with performance-linked vesting conditions. This means that the options do not vest unless specific performance targets are met. These targets could relate to increased profitability, market capitalization, or other growth metrics. If the performance conditions ensure that the future value of 95% of the shares surpasses the existing 100% holding, investors would be more willing to accept the 5% dilution to benefit from the company's overall growth.

In conclusion, companies can strategically address the dilution challenge while implementing ESOP schemes. For promoters, the choice lies in whether they want to own 100% of a slow-growing company or 95% of a high-growth company. Recognizing that retaining key employees is crucial for sustained growth, addressing dilution concerns through these mechanisms can be a pivotal step toward long-term success

Team Qapita

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