What is equity compensation?

As of November 2022, over 80,000 startups recognized under Startup India created over 8.6 lakh jobs, data from the Department for Promotion of Industry and Internal Trade (DPIIT) shows. These jobs aren’t just about salary, though. One of the major differentiators in working in the startup ecosystem is the ownership instilled in employees, especially early talent through equity.

It is especially crucial to remember that early startup employees usually forego their high salaries and risk their livelihood with the belief in the startup idea. Hence, creating ownership via equity as compensation for their effort and risk is a well-proven formula.

In this blog of ESOP101, a series we introduced to dive deep into various equity-related incentive plans to benefit companies and their employees, we will dive deeper into equity compensation. Equity compensation is fundamentally a non-cash incentive offered to employees as ownership in the company.

It is seen as a reward to employees for their long-term association with the company, thus, acting as a great talent acquisition and retention method. In addition, this type of compensation is typically offered to key employees, executives, or directors of a company to align their interests with those of its shareholders. And the impact equity compensation can create on wealth generation is well-recorded. As per a report by Inc42, in 2022, Indian startup employees made over $196 million through ESOP buybacks.

There are several forms of equity compensation, including Restricted Stock Units (RSU), Stock Appreciation Rights (SAR), Employee Stock Option Plans (ESOP), and more. We will see the pros and cons of each now.

Employee Stock Option Plan (ESOP)

Simply put, ESOPs are the rights granted to employees to purchase the company’s equity shares at a predetermined discounted price on a future date. ESOPs are vested over time as a reward to the employee for their long-term association with the company, thus acting as a great talent acquisition and retention method. These ESOPs are granted out of an ESOP Pool, which the company’s board must approve. We wrote about it here.

Pros:

• ESOPs improve employee retention as the offered ESOPs are vested over time and stop at the cessation of employment.
• ESOPs also help employers reward hard work in equity rather than cash, thus saving the need to cause an immediate cash outflow.

Cons:

• The performance of the company affects ESOP share price. Without sustainable earnings, the company’s ESOP value declines (ESOP share annual value), which might cause the ESOP share price to change.
• There is no guarantee of positive returns for the employees. If the company performs poorly and the share price drops below the exercise price, the employee might face losses rather than incentivized returns.
• Exercised options by distraught employees can lead to a crowded cap table for the company.

Employee Stock Purchase Plan (ESPP)

ESPP is an investment plan allowing employees to purchase their company’s stocks at a discounted price, typically 5-15% less than the security’s fair market value. The employers provide this scheme to help the eligible staff to contribute to this scheme to ensure time-to-time investments.

The participating employees invest in the stocks through regular payroll deductions, determined based on the difference in the prices between the date the plan is offered and the date it is purchased.

Participation in ESPP is voluntary, so companies commonly allow employees to withdraw, even during an offering period. Most plans also allow employees to withdraw during the purchase period. Any contributions are then refunded, and the employee can choose to enrol again during the next enrollment window.

Pros:

• ESPP programs typically run over several years (vesting period), meaning employees who partake must remain in place for a specified time before accessing the funds, thus helping in employee retention.
• Allowing staff to invest in your company is a great way to show them they’re appreciated and create an ownership culture.

Cons:

• There will be an increased workload and additional spending, such as legal and administrative costs, plus any employer’s contribution.
• Depending on the type of ESPP chosen, you may be required to be compliant with security and tax laws, and there is also the potential that the share price will decrease.
• Running an ESPP requires a specialized skill set. It’s not something you’ll manage on a spreadsheet without allowing errors, so taking a DIY approach will generally cause significant problems in the long term.

Stock Appreciation Rights (SARs)

SARs can be offered to employees or independent contractors. SAR allows an employee/contractor to receive the increase in value of a company’s stock over a set time. In other words, employees do not directly own shares of their company’s stock. Instead, they can receive the difference in the value of an employer’s stock share when it increases.

For example, let’s say you were granted stock appreciation rights on ten shares of your company ABC’s stock, valued at $10 per share. Over time, the share price increases from $10 to $12. Then you’d receive $2 per share since that was the increased value. So at $2 per share, you’d receive $20 total ($2 x 10 = $20).

Also, exercising a SAR allows participants to receive the proceeds of a stock increase in cash or an equivalent number of shares without purchasing the stock.

Pros:

• It is a method to incentivize the employees without giving up equity.
• It requires less compliance than employee stock option plans or stock purchase plans.
• This scheme exhibits more flexibility compared to other options.

Cons:

• The company may require funds to finance SARs if translated to cash compensation, which may lead to liquidity issues.
• Suppose the company is unable to raise the value of its equity. In that case, SARs often may only result in something tangible if the company intends to rely on equity rewards over cash primarily.

Restricted Stock Units (RSUs)

RSU is the most common type of equity compensation and is typically offered after a private company goes public or reaches a more stable valuation. Like stock options, RSUs vest over time, but unlike stock options, employees don’t have to buy them. Instead, as soon as they vest, they are no longer restricted and are treated the same as if employees had bought the company’s shares in the open market.

In this way, RSUs carry less risk than stock options. They will always be worth something if the stock price doesn’t drop to $0. Usually, the vesting of RSUs depends on specific performance goals set by the company for the offeree employee.

Pros:

• Individuals who hold on to their RSUs until they receive the total allocation can acquire the capital gain minus any deductions for income tax liabilities. The only condition is that the company’s stock value should have risen.
• Since RSUs are not real stocks, companies do not need to expend significant sums to record and track them.

Cons:

• It doesn’t provide dividends.
• RSUs are not considered tangible property, so employees can’t pay tax before the vesting period.
• It doesn’t come with voting rights.

Sweat Equity

Sweat equity means equity shares issued by a company to its advisors/directors at a discount or for consideration other than cash for providing know-how or making available rights like intellectual property rights or value additions.

According to Section 2(88) of the Companies Act, 2013, sweat equity shares are distributed to certain directors of a given company when they have made exceptional contributions to the successful completion of a project or assignment, demonstrated expert technical skill in a particular subject or contributed significantly to the company and earned intellectual property rights.

A company can issue sweat equity of either up to 15% of the existing paid-up equity capital or shares worth Rs.5 crores in a year, whichever is higher. However, it cannot issue sweat equity shares of more than 25% of the paid-up equity capital.

Pros:

• Offering such shares may be helpful in the early stages when the company lacks enough cash flow to compensate external advisors or directors.
• It is also important to note that these shares are non-transferable and have a lock-in of three years, ensuring longevity with the stakeholder.

Cons:

• Sweat Equity comes with equity dilution for the early investors and also gives away the voting rights in the company.
• One of the biggest potential problems with sweat equity is that it can create an uneven playing field within a company and incoming investors.

There are several options available to compensate employees' hard work, hence, companies can choose what suits them the best.

‍Stay tuned for the next ESOP101 blog.