- Commercial Law Advisors
Legal Structuring of Pay and Equity Incentives
Fair compensation is the cornerstone of an economically productive system. Without the assurance of equitable pay, incentives and allied privileges, a smooth business environment and high performing employees are unimaginable. In addition to salaries, bonuses, commissions, allowances etc., offering equity and stock options in the company has become common practice to provide employees with deeper performance incentives. Thus, structuring employment contracts becomes crucial and merits careful consideration.
Basic Fixed Pay
Market pricing, forms the most common method used by companies to determine base salary structures. Market pricing necessitates massive data collection and analysis to infer contemporary industrial standards, prior to drafting the clauses. Changes can be affected into the contracts at an individual level, depending on qualifications and experience of the employee. Similarly, bonuses, remuneration for specific projects as well as emoluments of various kinds can be fixed as per performance. Generally, grants of this nature are definite and long-term, primarily designed for entry-level employees. Structuring these clauses in the contract are straightforward since the employer has greater bargaining power over prospective employees.
Commission based Pay
Commissions, on the other hand are different as they exist in atypical profit-based ventures. They are central to pay-for-profit jobs where the transactional capacity and resulting profits are directly proportional to the pay. Structuring employment contracts of such nature are slightly trickier. Industrial trends have progressed to such a stage where employees working on a commission have equipped themselves with the identity of agents rather than employees of the company. Thus, the company has limited authority and control over their conduct and assumes the role of a mere facilitator of business. Their pay is commensurate to the amount of business they bring into the firm. Theoretically, they could draw incomes in unlimited figures. The best way to restrain such unimpeded commissionaire is to cap the commissions to a reasonable limit beyond which they flow into a joint corpus. However, this brings the risk of disincentivizing the employees from conducting business after they reach the capping amount.
Employee Stock Options
Apart from the above, there exist contracts wherein payment for services is organized via issue of employee stock options (equity). This practice is mostly adopted by corporations to pay highly valued key employees who they wouldn’t risk losing to competing companies. In terms of bargaining power, the table turns in the favour of employees who prize themselves in extremely skilled and highbrowed executive positions. Issuing equity in the parent company, has thus become an accepted practice to keep prized employees in the bag.
Contracts are often designed to accommodate equity incentives as part of the executive’s compensation. Sometimes, they are offered to a group of select employees in lieu of a higher salary, especially when the business is at a nascent stage and liquidity is constrained. Likewise, profit-sharing bonuses are generally incorporated into the employment contracts to be payable on an annual or deferred basis.
Sweat Equity Shares
Sweat Equity is different from Employee Stock Ownership Plan (ESOP). ESOP gives employees or directors the option of buying shares of the company at a pre-determined price.
On the other hand sweat equity shares true to their name, are shares offered to employees or directors of the company for consideration other than cash such as their work. The critical difference between ESOPs and ‘sweat equity’ is the fact that, ESOPs are issued at the fair market value and sweat equity shares may be issued at a discount to the fair market value.
Bonus shares are the additional shares that a company gives to its existing shareholders on the basis of shares owned by them. Bonus shares are issued to the shareholders without any additional cost. Bonus shares are issued by a company when it is not able to pay a dividend to its shareholders due to shortage of funds in spite of earning good profits for that quarter. In such a situation, the company issues bonus shares to its existing shareholders instead of paying dividend. Further, since issuing bonus shares increases the issued share capital of the company, it is perceived as being bigger than it really is, making it more attractive to investors. It also decreases the price per stock, making it more affordable for retail investors i.e. individuals who invest for themselves and not for someone else. On the other hand, since bonus shares are issued from profits of the company, it takes away cash reserves (generally issuing shares brings in money but the contrary happens in this case because the company’s cash is utilized to issue shares)
It is important to remember that while structuring payment clauses, one must also place equal attention on liability clauses. Greater monetary incentives allow executives greater control in matters of management, which translates into greater liability in the affairs of the firm. The principle of joint and several liabilities is centred around this chief premise that, with greater control comes greater accountability. So, if the employees are legally provisioned and obligated to buy into the firm’s equity and cash-in profits, they are similarly obligated to factor in proportional liability. This is a crucial index to measure employee-liability in cases of insolvency and bankruptcy, which is why contracts must incorporate payment clauses in balance with liability clauses.