The circumstances of every organization are unique, whether it is the growth prospects or riskiness of potential growth or availability of cash within the organization. Designing and implementation of any share based compensation plan (such as Employee Stock Option Plans (ESOPs) or Stock Appreciation Rights (SARs) or issuance of Restricted Stocks Units (RSUs), etc.) should therefore be based on the principle of aligning interests of shareholders and employees, taking into account the particular circumstances of the organization.
Despite this, we see many organizations focusing mainly on accounting, tax, legal and administrative considerations in implementing a share based compensation plan. Undeniably, accounting, tax, legal and administrative aspects are important factors which an organization must consider but focus on these factors alone does not necessarily result in the best alignment of interests of different stakeholders involved.
In our view, aligning interests whilst designing a share based compensation scheme, which in turn determines whether an organization actually achieves its goals from implementation of such a scheme, is the most critical part of implementing any share based employee compensation plan. This approach in turn results in optimizing the:
• shareholding pattern / capital table for the organization;
• potential wealth creation in the hands of the employees; and
• year-on-year charge to the Income statement.
The design stage typically involves the organization incurring a choice around the form of potential grant, the size of potential grant and the key terms of the potential grant.
In this article, which is first in a series of articles exploring a structured approach to designing and implementing a share based compensation plan, we explore the first of the three key choices i.e. the ‘Form of the Grant’.
Note that the approach in this article is based on the framework adopted by our firm. Any other approach may be considered equally valid and an organization must choose the framework that they find most suitable for their needs and goals.
The first decision an organization needs to make is choosing the form of the share based compensation plan. The choices available to an organization for this purpose may be divided into two broad categories:
1. Equity settled schemes, wherein the employee ultimately gets the shares of the Company. Under this category, an organization typically has the following choices:
- Employee Stock Option Plan (ESOP)
- Restricted Stock Units – equity settled (RSU – equity settled)
- Employee Stock Purchase Plan (ESPP)
2. Cash settled schemes, wherein the employee is paid in cash but the amount of payment is linked to the share price of the organisation. Under this category, the Company may choose between:
- Share Appreciation Rights (SARs) or Phantom Stocks
- Restricted Stock Units – cash settled (RSU – cash settled)
Note that each of underlying choices within the two categories (i.e. equity-settled and cash settled) differ in their risk-reward characteristics, as can be seen from the below chart:
As can be seen from the above chart, the key decision items in deciding the form of grant are cash vs equity and risk vs return. Let us understand each of these tradeoffs:
Tradeoff 1: Risk vs. Return
Typically, employee stock option schemes (and its cash equivalent SARs) tend to be in the nature of ‘high risk-return’ schemes. This is because such schemes enable an organisation to put, for a given charge to income statement, a potentially much higher reward in the hands of employees. At the same time, there is a possibility that employees may make no gain at all if the stock price falls below the exercise price.
On the other hand, restricted stock units (both equity settled and cash settled) offer assured reward to the employees as they are certain of receiving the shares (subject to fulfilling the vesting conditions). Thus, unless the share price drops to zero, a certain level of positive inflow to employees is always assured in case of RSUs.
Tradeoff 2: Cash vs Equity
In case of cash vs. equity, the tradeoff is one of assessing whether or not an organisation is generating sufficient positive cash flows to be able to offer a cash settled scheme. Usually in case of high growth start-ups, an organisation is generating revenue and experiencing high growth but the net cash flows are negative, in which case equity settled schemes are the only option. In case of organisations generating sufficient positive cash flow, Stock Appreciation Rights (or cash settled RSUs) could be a good way of aligning variable pay of employees with creation of shareholders’ wealth without dilution of shareholder equity.
In our view, the decision on the form of the scheme should be primarily linked to optimizing the above tradeoffs, which in turn is linked to the growth stage and risk-return profile of the organization itself. Effectively, the Company must choose that scheme whose risk-return as well as cash flow profile matches with the risk-return and cash flow profile of the Company itself.
This principle results in aligning the interests of the employees with the shareholders by ensuring:
• That the organisation is passing the same level / nature of reward and corresponding risks to the employees as the shareholders themselves bear;
• That the share based compensation plan does not become a financial burden for the organisation; and
• That the employees are motivated to work towards maximizing the return for the organisation (for a given level of risk) so as to maximize their own wealth.
The table below indicates how the risk-return profile of an organisation may change as the organisation grows from a start up to a mature organization and hence how the choice of the share based compensation plan would also change to reflect the growth.
As can be seen from the above table, as an organisation moves from being a start-up to a mature organization, the risk-return profile of the Company changes from being ‘high risk-high return’ to be ‘low risk-stable return’. Consequently, the nature of the share based compensation schemes offered should also change to match the risk-return profile of the organisation and ensure the employees returns are aligned with that of the organisation.
For instance, organizations in the founding to early stage (as described in the above chart basis their revenue, profit and cash flow position) would be categorized in a relatively high risk-return stage. As such, these organisations would find it better to offer equity settled schemes to their employees to avoid creating cash flow pressures for the organization.
Further, within equity settled and for a given level of charge to Income statement, the firms may prefer granting stock options (i.e. ESOPs) over restricted stock units. This is because for a given level of charge to the Income Statement, the organisation would be able to offer higher number of options to its employees, thereby giving them a potential for maximizing earnings by working hard for the success of the startup and ensuring that the stock price increases considerably compared to the exercise price. This of course comes with a risk of startup not taking off and consequently the share based compensation plan creating no (or little) wealth for the employees. The risk-reward profile of options, thus, in such a case would match that of the Company.
Similarly, medium to large organisation can consider both equity settled and cash settled schemes, depending upon the cash flow position of the organisation. Further, organisations in this stage may have a higher preference for offering a level of assured benefit to the employees and may to that extent prefer restricted stock units (cash or equity settled) over ESOPs or SARs. This may be particularly true for large listed companies where offering ESOPs would expose the employees to market volatilities (in particular, the possibility of market crash) during the exercise period, which could result in lower creation of wealth for employees than that may be intended. This may cause employee dissatisfaction as despite the Company performing well, they would have been exposed to a high market risk and the possibility of a very low or even zero wealth creation. RSUs in such cases would mean that the employee is assured of a certain return irrespective of the market position.
As can be seen above, a key decision for an organisation is the type of shared based compensation scheme it should implement. This is an important decision, as the form of the design will impact both employee motivation as well as the cost to the company in sponsoring such a scheme.
In our view, the Company should choose that scheme which aligns the nature, riskiness and cash flow profile of the Scheme for the employees with that of the organization. This approach results in harmonising the interests of the employees with that of the shareholders and ensures that the scheme so launched actually achieves its goals from implementation of such a scheme.
We hope that you found this article useful. Please feel free to share any feedback you may have on the above article. Our next article in this series will focus on the question of the ‘size of grant’ that a company should make when implementing any employee stock option scheme. This includes making decisions on aspects such as the size of the employee stock option scheme pool and the actual size of current and future grants to selected employees.
Disclaimer: The above content has been furnished solely for information and must not be reproduced or redistributed. It should be noted that we are not soliciting any action based upon it. Also, it does not constitute any recommendation. In particular, the information above is for general purposes only and is not an advice on employee stock option solutions valuations or preference of one scheme over another. The information given above is in summary form and does not purport to be complete. We have reviewed the above and in so far as it includes information or facts, it is believed to be reliable though its accuracy or completeness cannot be guaranteed.
The information contained in the above report should be construed as non-discretionary in nature and the recipient of this material should rely on their own investigations and take their own professional advice. Neither Veritas Actuaries and Consultants nor any person connected with it accepts any liability arising from the use of this document. The recipient(s) before acting on any information herein should make his/her/their own investigation and seek appropriate professional advice and shall alone be fully responsible / liable for any decision taken on the basis of information contained herein.