How should companies structure employee incentives?

This week’s management debate centres on whether equity-based compensation can play a role in retaining talent


(From left) LinkedIn CEO Jeff Weiner, Microsoft CEO Satya Nadella, and LinkedIn chairman and co-founder Reid Hoffman.
(From left) LinkedIn CEO Jeff Weiner, Microsoft CEO Satya Nadella, and LinkedIn chairman and co-founder Reid Hoffman.

This week’s management debate centres around whether equity-based compensation can play a role in retaining talent and the best ways to use stock options to retain employees. The debate is based on Microsoft Corp.’s acquisition of LinkedIn, in which employees had generous stock options.

Marketplace for buying and selling of vested stock needed
Kevin Freitas, global head of rewards and recruiting, InMobi

Long-term incentives (LTIs) have now become an essential component of executive pay. To a large extent, the history of expensing of options and the laws governing managerial remuneration are responsible for driving the trend in most countries and sectors.

In India, the limits on managerial remuneration are defined in the Companies Act. This definition does not cover stock option grants, so many companies and banks in the early 2000s in India leveraged stock option plans to reward their management personnel and managing directors. While expensing and the limits on managerial remuneration could have helped this trend, what’s helped it even more is the seemingly large risk-reward relationship at play since early 1990s, and that was when technology and free trade opened up large businesses to disruption. To reward risk-takers, there had to be a better way to distribute wealth and create ownership of results, and a stake in the business seemed to be the apt way.

LTI coverage

Organizations these days empower employees at the middle level too and seek their participation in achieving set business goals. As a result, there has been an increasing trend of expanding the scope of rewards for employees at these levels by offering LTIs. This not only increases their potential to earn more but also drives a sense of ownership. There are companies that give stock to every employee and that is in line with their compensation philosophy. Others give it to only those bands or grades or levels of employees that value it more. Neither is incorrect. It is the organization that defines the standards here.

Preferred LTI vehicles

A company should evaluate the LTI vehicles in response to its needs. From an employee perspective, it should be easy to understand, easy to communicate value and have low risk. From an employer perspective, it should be performance driven, retention driven and generate high returns for shareholders with low dilution. Restricted stock units, with or without performance conditions, meet the requirements of both stakeholders.

Effectiveness of employee stock options

To make LTIs more effective in a start-up environment, there must be liquidity. Just because something is given, does not mean it is necessarily valued by the receiver. In India, few start-ups have had any financial exit, and so stock has not really caught the imagination of employees beginning their career. In an environment, where every company is offering stock options, it is not a retention tool, as the individual can hop from company to company by trading the notional value of their existing stock programme. Only companies that provide an exit or perception of value through repeated fund-raising at a higher valuation seem to have effectively used stock for retention and reward. Obviously, this cannot be sustainable for every company. I have seen stock programmes being more effective at middle and senior management, when they are granted stock at a multiple of their salary at two events, when they join and when they perform.

For LTI to take off in a big way in future, in any country, there must be a secondary marketplace for individuals to trade their vested stock in unlisted companies. These marketplaces can be created by existing or new venture platforms. They need to be easy to use and adopt for any company. Today a lot of unlisted companies are unable to communicate the value of their stock to their employees and use the last funded event to propagate an understanding of price. With so many unlisted companies beginning to use stock as a compensation component, having a marketplace for buying and selling of vested stock gives the company and stockholder liquidity and makes the stock programme much more valuable.

Over-reliance on long-term incentives can create challenges
Shatrunjay Krishna, director (rewards, talent and communication), Willis Towers Watson India

In the last decade, long-term incentives (LTIs) have been embraced universally, across the spectrum, especially as part of executive pay. Start-ups and hi-tech companies led the march but there is no sector that is left untouched. And this is a good development as it creates a win-win for all stakeholders—shareholders, top executives and the company itself.

We see in India that equity-based compensation is becoming an important part of the remuneration and at the CEO level it is almost 40% of total remuneration. At the CXO level this would be around 30%, which is still a significant part of the total remuneration.

Preferred LTI vehicles

At a broad level, LTI vehicles are either equity-based (like stock options/restricted stocks) or cash-based (that is, plain deferred cash, stock appreciation rights settled in cash). The vehicle chosen is dependent on the objectives that an organization wants to drive and also the company life cycle.

Stock options are used in an organization that is growing rapidly and wants to reward employees based on increases in company stock value. Options are high-risk, high-reward and they can mean nothing if they go underwater. In case of restricted stock units, one at least has some value of the stock even if at times it is lower than expectations.

Some companies offer phantom stocks that are essentially paid in cash, while equity is used as an underlying asset to calculate the value appreciation. Cash-based plans are simple but they may not drive a sense of ownership.

Effectiveness of employee stock options

There is no doubt that start-ups use stock options across levels as a tool to attract and retain talent, which they may otherwise not be able to afford. However, their effectiveness at junior/entry levels (which is very prevalent these days) is questionable as employees at these levels have very limited control on overall performance of the start-up.

Also, companies have to be watchful as over-reliance on LTIs can create challenges in terms of their valuations, dilution that investors would want and inherent cost of this kind of compensation. Though it appears that cash is not changing hands immediately, but rules are clear that there are expenses that have to be accounted for in order to reflect the true balance sheet and financial statement.

As far as the level of liquidity or ease of cashing out in a start-up ecosystem is concerned, it is relatively less liquid as compared to mature organizations and is dependent on factors like increased valuation and buy-back, merger-acquisition scenario or an initial public offering. This remains a major challenge for start-ups and at times can hamper talent attraction.

Anticipated innovations

Human resources (HR) is going through a revolution in the sense that employees are increasingly seen as consumers and not passive recipients of HR programmes. In that sense there is a lot that could happen in this space. In case of LTIs, it would mean that companies work out the cost of the plan and employees can create their own portfolio of options, restricted stocks, appreciation rights, etc. It would give them greater control and also they will be more involved in the process. There will be obvious challenges but with the help of technology those can be tackled. But this area is waiting to be disrupted and we can already see some action.

Equity-based compensation works when the base compensation is good and the equity acts as icing on the cake

Professor Abhoy K. Ojha, Organization Behaviour and Human Resources Management area, IIM Bangalore

This week’s management debate centres around whether equity-based compensation can play a role in retaining talent and the best ways to use stock options to retain employees. The debate is based on Microsoft Corp.’s acquisition of LinkedIn, in which employees had generous stock options.

Many companies have used equity-based compensation to attract and retain talent. For example, LinkedIn, as a startup, had relied on it to attract and retain key talent, says Ojha.

But with share prices not doing well, it was pushed into being acquired by Microsoft to avoid employee attrition, among other issues.

“Now Microsoft will have to ensure that share prices continue to improve, and probably address many other factors, to retain the talent in the acquired company,” says Ojha.

“While the arguments in favour of equity-based compensation seem quite simple, it is often not very successful in getting the desired result,” says Ojha.

First, much of the success is based on the assumption that the value of a firm’s shares will increase in the future, Ojha says. “If that does not happen as expected, the organization faces retention issues, as in LinkedIn,” he explains.

Second, the compensation system is based on the idea that employees work for the monetary outcomes and little else matters.

“However, in the modern economy there are huge retention issues even if monetary outcomes are favourable, as the employee, particularly the knowledge worker, is motivated by many other factors,” points out Ojha.

“Now, Microsoft will have to deal with those factors to address employee attrition, despite retaining the equity-based compensation system.”

At the heart of equity-based compensation is Agency Theory. “A fundamental assumption of the theory is that agents (employees), who are supposed to work in the interest of the principals (shareholders), are not likely to be motivated as their interests are not aligned. Advocates of equity-based compensation suggest that unlike other forms of compensation such as fixed or variable pay, equity aligns the interests of the employees with those of shareholders by making them co-owners. This will motivate them to work for shareholder value. While, I agree that there is the potential for misalignment and there may be a need to increase alignment, I have reservations about relying too much on equity-based compensation,” Ojha says.

All employees, particularly knowledge workers, are motivated by many aspects of their employment. The first is their passion for the purpose of the organization. For example, volunteers work for Wikipedia, despite not being compensated, because they are passionate about the idea of making available knowledge accessible to all. Secondly, employees are intrinsically motivated if they have fulfilling roles and a work climate that respects them as individuals.

The professor says Southwest Airlines is known to be good in this aspect.

“I suspect that LinkedIn provided both sources of motivation to attract and retain employees, besides the compensation. However, now Microsoft will have a challenge providing these two motivators within the larger organization setup.”

He also believes that the purpose of LinkedIn might be a little diffused now that it is part of Microsoft, and the work climate might be less attractive as Microsoft might have to make some efficiency-oriented changes to integrate the acquisition.

Finally, employees are motivated by extrinsic factors of which compensation is a key part.

“Assuming that purpose and intrinsic motivation are in place, a high fixed salary component can contribute to greater motivation for knowledge workers as they do not have to worry about what they take home in an uncertain market.”

He adds that in situations when the relationships between effort and outcome are more predictable, a high variable pay component is likely to be suitable.

“Equity-based compensation works when the base compensation, whether fixed or variable, is good and the equity acts as icing on the cake. However, if equity forms a high proportion of the compensation, as in LinkedIn, and the shares do not appreciate it leads to low motivation and attrition.”

The professor believes that the flawed compensation system was the cause of LinkedIn’s retention problems.

The professor says that equity-based compensation is not a panacea for attracting and retaining employees in the knowledge economy.

It can, however, contribute to motivation if the organization already has an inspiring purpose and an employee-friendly work climate, by allowing the employee to participate in the success of the company, after an assured base level compensation that is based on fixed and/or variable components, says Ojha.

(Arundhati Ramanathan)

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