Equity based compensation during the global liquidity crunch

Four months into the pandemic, the economic effects of the global shutdown and travel restrictions coupled with the regional lockdowns have become discernible. Many companies have had to let go of a major part of their workforce due to the cash crunch. However, with such hardships, innovations in employee compensation have increased. While salary cuts have become a norm, many employers have offered ‘non-cash’ compensations and incentives, such as medical insurance, free data (enabling them to work from home), sweat equity and stock options. The issue of decreasing liquidity has been felt worldwide as companies and legislators around the globe are trying to tackle this problem and looking for ways to alter employee compensation plans.

Why equity-based compensation?

Equity-based compensation has gained significant popularity in the start-up space. The main advantage of equity-based compensation is that it does not involve cash outflow. Thus, in cases of cash crunch and poor cash inflow, equity-based compensation models support the financial structure of the organisation. This is imperative because young companies need to retain talented manpower and keep them motivated. In the past, start-ups like Hatch Apps have tried to articulate attractive equity compensation packages so that lack of liquidity does not become a roadblock into hiring highly skilled manpower. Granting equity of the company to the employees means sharing ownership of the company with them which motivates them to work harder.

Many companies and start-ups in the USA and Europe are also focussing on equity-based compensation as a tool to tackle the current global financial crunch. A survey conducted among the Federation of Indian Chambers of Commerce and Industry (“FICCI”) member companies has revealed that the cash reserves of almost 80% of the companies have dwindled due to the pandemic. This will compel employers to venture into compensation schemes that do not have a high cash component.

Sweat equity and Employee Stock Option Plans (“ESOPs”) are the two most famous methods of attracting and retaining a talented workforce. Sweat equity refers to the shares given to the employees against their intellectual property, technical know-how and skills without any lock-in period. However, an ESOP is a right given to the employee to purchase the shares of the company at a predetermined concessional rate after the specified lock-in period has passed.

This gives the employees a stake in the company which motivates them to work harder for it as rising stocks will also lead to greater monetary benefits for the employees. It is viewed as a tool to align the interests of the management and the workforce of an organisation.

survey conducted in April by the National Association of Software and Service Companies (NASSCOM) concluded that 70% of Indian start-ups will run out of their cash reserves within three months into the pandemic. Therefore, the sudden increase in offering of ESOPs to employees comes as no surprise.  Cars24, an online marketplace for used cars, announced that it will introduce voluntary pay-cuts to invest in ESOPs which will be double the amount they invest. Similarly, travel service provider Ixigo also announced that it will offer 2.3% shares of the company as ESOPs to all its employees at discounted rates with a lock-in period of a year. Other start-ups such as OYO, Grofers, and Zomato have also resorted to ESOPs to compensate their employees and manage the cash flow amidst the current economic crisis.

Legislative provisions easing issue of equity-based compensation

In India, special provisions have been carved out for start-ups as they will have a tough time surviving this economic downturn. The Ministry of Corporate Affairs amended the Companies (Share Capital and Debentures) Rules, 2014 (“SCD Rules”), increasing the limit of five years to ten years for issuing sweat equity by a start-up after its incorporation (Rule 2(ii)). Therefore, more start-ups can now issue sweat equity as the time limit has been increased.

Moreover, the 2020 Union Budget deferred the payment of tax on exercise of ESOPs for employees of start-ups taking into account the liquidity issues caused because of the pandemic. Thus, the tax will have to be paid when they exit from the company or after five years of allotment of shares or when the shares are sold by the employee. These legislative changes suggest that the government is assisting the start-ups in remaining overboard amidst the current crisis and encouraging equity-based compensation plans.

Issues related to equity compensation

As discussed in the preceding sections, ESOPs and sweat equity are a great measure to ensure that the employees of a company have “skin in the game”. However, there are certain issues with ESOPs in the current scenario.

ESOPs offered earlier, which now vest with the employees are now burdened with the plight of share valuation. Rule 12(2)(j) of the SCD Rules governing unlisted companies and Regulation 17 of SEBI (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”) regulating listed entities, both require a company to value the shares prior to the plan being approved by the concerned authority. The majority of companies in India and around the world that issued stock options prior to the pandemic are now facing ‘Underwater Stock Options’.

An Underwater Stock Option is a situation where the current market price of the shares is lower than the exercise price, thus rendering it detrimental for the employees to exercise their options. The economics of listed companies which are publicly traded can be easily observed through the market indices, unlike the unlisted companies which now face issues with valuation of shares.

Further, ESOPs which are being offered as a component of compensation due to Covid-19 are essentially “feel good” ESOPs. The catch here is the minimum lock of a period of one year provided under Regulation 18(1) and Rule 6(a) of SBEB Regulations and SCD Rules, respectively. The average vesting period of ESOPs ranges from 3-5 years, and they mostly yield returns in the longer run.

Outlook for the future

The current abysmal situation of the economy compels many companies to reconsider their ESOP policies. A company with significant Underwater Stock Options traditionally has four strategies at their disposal: firstly, to wait for the stock options to become viable again, secondly, to provide supplementary cash compensation, thirdly, to provide additional equity compensation, or lastly, to restructure the underwater options. These strategies have time and again been used by businesses, even during the 2008 crisis, to cope with Underwater Stock Options.

The first two strategies are ineffective in the present case, as the market continues to be extremely volatile for an unforeseeable future and companies are low on their cash reserve. The next strategy would require the company to look at its ESOP pool. If the company can accommodate additional equity grants, they might consider taking this road as more equity would benefit employees in the longer run. The restructuring of underwater option seems like the most viable strategy.

It can either be done by option exchanges or option repricing. Option exchanges refer to an employee agreeing to forfeit his option in lieu of new equity compensation. Considering the recent regulatory changes, companies can opt to exchange underwater options with sweat equity. Sweat equity vests with the employees immediately and would continue to retain workforce in the company. Option repricing is when a company reduces the exercise price to match the market price or fair value of a share.

The 2008 crisis witnessed an increase in the popularity and an upturn in equity-based incentives and option repricing in the US. A decrease was observed in cash-based compensation with increased equity usage. Around a hundred companies in the US had repriced its underwater stocks during the 2008 crisis including Google, Starbucks, and eBay. In India, companies had to seek permission from SEBI to reprice their options. However, it is pertinent to note that now SEBI allows repricing of options, even in case of a listed company, by way of shareholder approval.

Both the approaches to restructuring can be applied to listed and unlisted companies. However, for an unlisted company, the value of shares is not determined by market forces, like that of a listed company. Therefore, it is imperative that the fair value of shares is first determined by an independent valuer before addressing the underwater options. ESOPs which are valuated annually in USA, are now looking for an interim valuation (mid-year valuation), to ensure fair pricing for future issues. Indian companies can follow suit, by determining the fair value before restructuring their ESOPs and issuing further equity.

ESOPs may not seem to be an attractive option anymore for employees during 2020. The employees who need liquid income right now might not wish to opt for ESOPs, but then considering that a bird in the hand is worth two in the bush, an employee would still be better off if they do opt for it.

This article has been authored by Sridutt Mishra and Medhashree Verma, students at National Law University, Odisha.

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