Employee Stock Option Plan, Essays (university) of Finance

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Course BAFI Assignment Assignment 3 – Individual Research Project Student’s name Bui Khuong Duy Student ID s Lecturer Fitriya Fauzi Word Count Research paper: 2121 Industry reflection: 212

TABLE OF CONTENTS

II. Industry Reflection……………………………………………………………………………………. 13

THE IMPACT OF EMPLOYEE STOCK OPTION PLAN (ESOPs) ON

EMPLOYEE’S BEHAVIOR AND THE STOCK MARKET

Khuong Duy Bui School of Business and Management, RMIT University, Ho Chi Minh City, Vietnam. Abstract This paper aims to convey the theoretical mechanism of employee stock option plan to see how it navigate business performance and employee’s attitude. By breaking down further, the ESOPs was justified to incentivize worker commitment in terms of intrinsic satisfaction – where participants are better off with financial rewards while being influenced by psychological ownership at a high sense of self-actualization. Research also indicated that businesses could take advantage in terms of market optimism since endogenous capital structure is consolidated. However, a change in capital structure might spark unfavorable impacts on stock price due to the dilution effect on equity.

1) ESOPs Explanation Employees Share Ownership Plans is now a prevalent concept in many industrialized countries. This term is constructed as the right of employees to possess part of the company shares in which they become shareholders. Its nature provides employees with specified privileges to which are disparate from what is generally expected as an ordinary worker. These are the privileges to benefit from a company’s profits, ingress into financial information, and the privilege to participate in decision-making process (Rousseau & Shperling 2003). Empirical studies suggested that such standardized contracts would be a trade-off among risk and motivation. Quintessentially, firms in uncertain conditions usually abandon the idea of relying on incentive-based remuneration as a result of rising risk aversion (Bloom & Milkovich 1998). Nevertheless, Prendergast (2002) postulated a direct proportion between risk and motivation at an extent where businesses can distribute liabilities to the agents, and that those delegations facilitate the need for motivation. At this stage, controversial issues have sparked on the impacts of ESOPs on employee productivity, the enrollment of workers in managerial mechanisms, the implication on trade unions, and how it drives business outcomes (Hammer 1982; Long 1981). 2) Variables of ESOPs ESOPs are versatile in abundant forms, but the conventional methodology can be broken down into 3 foremost fragments. The first approach is throughout company donation or the acquisition of share by the company from secondary market on behalf of the employees, quintessentially adopted by the UK derived from its Approve Profit Sharing Scheme which lasted from 1978 to 2002 (KPMG 2017). The second route is from individual payment, especially with favorable shares and known as Contributory Scheme. This policy allows beneficial tax concessions and the ability for firms to link employee contributions with marginal shares issued. The last approach proposes that employees can obtain shares via optional payment with a predetermined price and day in the future (NCEO 2020). As a result, employees can either

forego their opportunity to acquire shares, sell it for arbitrage, or retain a certain amount for speculation. III. The Impacts of ESOPs on employee’s attitude A primitive rationale of Employee Share Ownership has been its indisputable competency to influence employee behavior and attitudes (Klein 1987). Empirical studies in the US and UK since the 1970s announced a positive correlation of the ownership scheme to an enhance in worker satisfaction and commitment, and against their turnover intention. 1) Intrinsic satisfaction Klein (1987) laid the groundwork for this idea as he proposed financial reward is one of the contributing factors driving employee’s fulfillment and that income also manipulates the extent of participation in the ownership plan. There has been a significant divergence in ESOPs involvement as managers have tremendous awareness to participate compared with other low- skilled and middle-skilled employees. As their income is not resilient but destined to the company’s performance, the desired to take responsibility and assurance from their own decision is likely to emerge. Meanwhile, ordinary workers can be flexible in financial portfolios with a neutral tendency to be involved in ESOPs if not appealing. An additional aspect to be considered is the degree of employee saving’s centralization. Statistic conducted by Pendleton (2006) pointed out that roughly 20% occurring ESOPs hold up to 50% of participant’s saving at that time, specified in the one with beneficial taxation and despite contingent risks, which strengthen the role of financial reward of ESOPs in employee’s behavior. In some cases, the outcome is not always prospective in terms of leveraging employee engagement if motivations are insufficient. Theoretically, although participants gain benefits from contributing to organization prosperity, what they genuinely receive is just trivial fractions due to constraints in equity proportion, compared to other compensation packages and cash- based incentive policies. Research developed by Prendergast (1999) further indicated a high propensity to create free riders whose contributions are insignificant but being treated

shareholder’s equity and market confidence. The majority of literature reviews assumed that the result is caused by deliberate concealment of disadvantaged news which ends up being disclosed publicly after a procrastinative period. An explanation of Li, Sun & Yu (2019 ) of how ESOPs can significantly hamper this risk at a definite spectrum will be presented as follow. Stock price plays a vital role in determining ESOPs characteristics, it influences the participating decision of non-ESOPs employees and turnover decision of current members. A successful publication of ESOPs carries out a signal effect to the market as it implies positive performance verified by internal shareholders. Gordon & Pound (1990) has found a positive correlation in manager’s ESOPs value and company performance, which can be explained from a view of interdependent interest and the fact that leaders perceive minuscule risks within the ESOPs. Moreover, the adoption of an ownership plan requires transparent disclosure from the board of directors and employee’s identity, which avoid any effort to manipulate financial information. Hence, an ESOPs announcement sustains the company’s trustworthiness regarding future movements, facilitates market optimism from the lens of insiders’ obligations, and mitigates stock price crash risk as it is apprised by a sudden withdrawal of participants. 2) Changes in capital structure Whenever an ESOP is launched, the company must consider whether borrowings are made or not to fund the program. The ownership plan should also be decided to implement under shares repurchase or from issuance of new shares. Smith (1986), in a study of determining impacts of capital structure on stock price changes, stated that exercising loans is not likely to affect equity value. Meanwhile, repurchasing shares would enhance share value and new share provision will lead to a decrease in share prices. A negative relationship between the issuance of new shares, either common or convertible preferred shares, and the stock market reaction has been found by Linn and his colleagues (1988). As they assumed, the agency cost consequence is triggered if the company’s management over free cash flows is accumulated by issuing shares. The circumstance happens for non-leveraged ESOPs as it can substitute cash incentives and leveraged ESOPs if the

manager’s behavior is not influenced by ESOP borrowings. Another mechanism causing stock price devaluation is when the company issues share with a lower price than the market as previous shareholders may experience a decrease in equity value on the exercise of their primitive options. Lambert et.al (1989) also demonstrated a decrease in dividends payment attributed to increasing shareholders is intertwined with lower market expectation after ESOPs practice, which further exacerbates the over-retention issue. An alternative option is by transferring cash into ESOPs, from which shares will subsequently be repurchased on the secondary market. Even though theoretical studies have justified positive stock price changes whenever ESOPs repurchase transactions occurred, the informational impacts are likely to restrain the reaction of share price in practice. This referred to simultaneous transactions of repurchasing shares and spontaneously sold to ESOPs has triggered no substantial fluctuation in equity, accompanied by little asymmetric information to impact equity value. In short, the theoretical scenario merely comes into play when the board of directors is not capable of selling ESOP shares to recover the cash flow rapidly. V. Limitations and conclusion

1. Limitations Despite the use of empirical studies in this literature review, there are several limitations that need to be considered. At first, none of the studies mentioned have compared among the attitudinal impacts in variable forms of ESOPs such as share option or direct ownership. The majority also exert the simplistic approach of ownership to classify subjects, for instance by asking if employees are shareholders or not, while a few emphasize the size of employee’s stakes. Secondly, the extent to which condition employee share ownership has lucrative impacts on worker behavior is vague. Even though at some points they should coincide with the company’s practices, such as being involved in the decision-making procedure, but most of the cases are undetermined and ambiguous. In the end, although employee’s participation in

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Pendelton, A, Erik, P & Kaarsemaker, E 2009, ‘Employee Share Ownership Plans: A Review’, Working Paper, no.44, The University of York , viewed 15th^ September 2021. Pendleton, A, Wilson, N & Wright, M 2002, ‘The Perception and Effects of Share Ownership: Empirical Evidence from Employee Buy-Outs’, British Journal of Industrial Relations , vol.36, iss. 1, pp. 99-123, viewed 16th^ September 2021. Pierce, J, Kostova, T & Dirks, K 2003, ‘The State of Psychological Ownership: Integrating and Extending a Century of Research’, Review of General Psychology , vol.7, iss.1, pp.84-107, viewed 14 th^ September 2021. Pinegar, S 1988, ‘The effect of issuing preferred stock on common and preferred stockholder wealth’, Journal of Financial Economics , vol. 22, iss. 1, pp. 155-184, viewed 17th^ September

Prendergast, C 1999, ‘The Provision of Incentives in Firms’, Journal of Economic Literature , vol.37, no.1, pp.7-63, viewed 15th^ September 2021. Prendergast, C 2002, ‘The Tenuous Trade off between Risk and Incentives’,‐ Journal of Political Economy , vol. 110, no.5, viewed 14th^ September 2021. Rousseau, D & Shperling, Z 2003, ‘Pieces of the Action: Ownership and the Changing Employment Relationship’, The Academy of Management Review, vol.28, no.4, pp.553-580, viewed 14th^ September 2021. Smith, C 1986, ‘Investment banking and the capital acquisition process’, Journal of Financial Economics, vol. 15, iss. 1-2, pp. 3-29, viewed 16th^ September 2021.

capital such as passive income as we are no longer able to continue our manual jobs. Mr. Tan also differentiated between financial securities and financial wellness. While the need for financial security is fundamental, relying on covering daily necessities without taking risks, financial wellness requires a sustainable liquidity management and access over financial information. In the later part, Mr. Tan considered more into various types of investment in the market, quintessentially the stock market. He conducted a comparison between the stock market and the commodities market over the last 20 years and as he found, there were greater opportunities for investors to yields profits from buying stock rather than gold, but the risk was also more significant. A similar outcome was empirically observed as he compared stocks against bonds, which can be explained by looking at the equity market and the bonds market. While a stockholder will receive dividends based on the company’s performance (Ordinary stocks is mentioned), which may fluctuate depend on whether the company witness profits or losses, buying bonds can ensure a fixed income is paid periodically (Coupons), regardless changes in the market. Moreover, in a circumstance that the company suffers from bankruptcy, investors holding bonds will be guaranteed with the present value payment and are prioritized before shareholders. In the end, he assumed, the stock value is mismatch with the company performance in the short runs, but most likely to be influenced from the demand and supply of the market, thus the risk of being overvalued is relatively high. However, long-term investment would be a safer option when market psychology is replaced by the business performance. The industry reflection would be more insightful and constructive if Mr. Tan elaborate more on how graduated students can essentially manage their wealth, especially to which extent risks are worth to be taken and under which conditions we should not let the fear of missing out (FOMO) influence our decision. For instance, in managing our investing portfolios, what are the favorable percentages that should be allocated in venture capital and sustainable sources, considering either an aggressive investor or a neutral investor. Moreover, Mr. Tan emphasized on one of the turning points is how we recognize a potential opportunity to invest. Nevertheless, the more we realized such opportunities have been overlooked, we tend to

loosen ourselves from the initial risk-endure strategies, which may lead to tremendous losses. Thus, as a university student majored in Finance, it would be helpful for me to understand more about psychological aspect from the lens of an investor.