Equity Incentives for Employees
Employee incentives are crucial to attracting and retaining talent within the venture. One of the key factors that makes a start-up stand out is its ability to effectively manage employee retention and keep motivation levels consistently high within the staff. Introducing equity-linked incentives such as Employee Stock Options (ESOPs), Stock Appreciation Rights (SARs) or Restricted Stock Units (RSUs) for employees are ways in which this can be achieved.
Employee Stock Options (ESOPs)
ESOPs are options given to employees or directors of a company to purchase or subscribe to shares of the company. In the Companies Act, 2013, ESOPs are defined as:
“option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.”
Under the Companies (Share Capital and Debentures) Rules, 2014, ESOPs can be issued only to permanent employees or directors of an unlisted private limited company. The following persons are NOT eligible to purchase/ subscribe to ESOPs: (i) An mmployee who is a promoter, (ii) A director who either by himself or through his relative or through any body-corporate holds more than 10% outstanding equity shares in the Company. However, this condition has been relaxed for start up companies for a period of ten years from the date of their incorporation. It is important for the Company to be registered as a start-up company with the DPIIT under the Start-Up Scheme, to avail the said exemption. ESOPS have vesting conditions after fulfilment of which, they can be exercised. These vesting conditions could be time-based, performance based, milestone based or a combination of the foregoing. Furthermore, upon the vesting and exercise of the options, employees will become shareholders and will have voting rights. They will also be entitled to receive dividends.
Stock Appreciation Rights (SARs)
SARs are options, typically settled by way of cash, where the value of the settlement is linked to the appreciation in the value of the company’s share price. SARs could also be settled in a combination of cash and stock.
Cash-settled Stock Appreciation Rights (CSARs), also known as Phantom Stock Options, provide employees with the right to receive cash pay-outs or awards for a certain number of notional options which are granted based on the value of the shares of the company after a specific period of time or based on achievement of certain milestones, as agreed upon in the grant letter. Unlike ESOPs, these can be provided to both, employees and non-employees. These options do not affect the share capital in any way as cash is the only form of pay-out. At that stage, there will be an impact in the profit and loss statement. Pay-outs are linked to the value of appreciation in the company’s shares and may be paid upon exercise of the option.Employees are at no stage considered shareholders. They therefore do not become entitled to voting rights or dividends.
Restricted Stock Units (RSUs)
Restricted Stock Units are company stock issued to employees that are restricted and do not become shares until certain vesting conditions are fulfilled. One of the vesting conditions is typically tied to a liquidity event of the company, if issued by a private company.
Similarly to SARs, RSUs too have no tangible value until they are assigned fair market value at the time of vesting, at which time they are considered income. Employees are only required to pay a nominal par value of the share at the time of vesting. The employee is assigned shares after income tax deductions, and is free to retain or sell them. Employees do not become shareholders till actual shares are issued at the time of completion of the vesting schedule, until which time they do not hold voting rights and are not entitled to dividends.
Which should you issue?
Overall, there are regulatory differences between ESOPs, CSARs, and RSUs. For instance, unlike ESOPs, CSARs are only governed by the terms of the Scheme the company adopts to administer them and the applicable grant letters. ESOPs, on the other hand, are governed by legislations like the Companies Act, 2013, the Companies (Share Capital and Debenture) Rules, 2014, and the SEBI (Share Based Employee Benefits) Regulations, 2014. In addition, in the case of ESOPs, employees will be required to pay an exercise price while exercising their options. Furthermore, they can only enjoy the monetary value of the option if they are able to find a buyer for the stock or if the company gives them an exit. RSUs fall within the category of “other general employee benefit schemes”, as described in the SEBI (Share Based Employee Benefits) Regulations, 2014, and would also be subject to by provisions in the Companies Act, 2013 and the Income Tax Act.
The ESOP price appreciates with the growth of the company, incentivizing employees to be invested in the growth of the company. Conversely, if the growth of the company is predicted to be moderately placed, employees might not see much value in holding these stocks. As opposed to this, phantom stock is risk free to employees, and there is definitive financial gain whether or not the value of the company appreciates as the employees do not pay a price for exercising them. While this may retain employees, the ability of this option to incentivize the creation of growth may be limited.
ESOPs have been the preferred form of incentive for companies in the past. For instance, Infosys, at its early stage, issued ESOPs to employees, a practice common within the start-up domain. This is primarily because ESOPs have considerable monetary and tax advantages in the long run especially for the employees. At the same time, the benefit of CSARs is that if the company feels that it will be sufficiently liquid at the time CSARs are going to be settled, it is easier to make these pay-outs than to dilute the company’s equity and complicate cap tables from the start by assigning shares, as would be the case with ESOPs. This also comes with the added benefit that companies do not need to negotiate with these shareholders at a later stage when they find the need to buy back shares. The definitive cash element when the CSARs are exercised also acts as an added incentive. The negative here, of course, is that the profit and loss statement will be affected post pay-out, as opposed to the notional expense that will be reflected in the case of ESOPs and there may be other tax and accounting implications.
RSUs incentivise the employees similar to ESOPs but are often provided only when the company reaches a scale, usually with conditions that they can be settled only at the time of liquidity events such as sale, IPO, merger etc. As such, it might not make sense in the early stages of a company.
The decision to compensate employees with any of these incentives must be made based on the financial health and projected growth of the company, as balanced against the priorities of the company. In the end, the primary objective must be to reward employees for loyalty, and not to short-change them in the future.
While ESOPs have been the preferred method of attracting and encouraging talent, especially when the company does not have enough cash flow to pay high salaries or needs to use the liquidity for building the business, CSARs are slowly gaining favour among more liquid companies. The issuance of stock options has been increasingly seen during the pandemic, as business owners foresee or are already going through a cash flow crunch. For instance, companies such as OYO and Zomato issued ESOPs for furloughed or existing employees to prevent a short-term liquidity crisis. Even the amendments made in the Share Capital and Debenture Rules were a direct response to the pandemic, allowing start-ups to maintain staff while ensuring that they are remunerated in some manner or the other. The pandemic is perhaps the perfect example of why a start-up should consider alternative means of compensation. However, it must be done so considering eligibility criteria, the stage of the company, and evaluating all risks.