Home / Money / Personal Finance /  Know about four types of share-based employee incentives

It is the sort of feel-good stories that everybody likes: employees becoming millionaires after their companies list on the stock markets. It happened recently with the stock market debut of Zomato and US-based Freshworks, with those holding Employee Stock Ownership Plans (Esops) becoming rich overnight. Esop is a share representing the ownership of a company that is given to employees at a price lower than its fair market value (FMV). Even well-established companies, such as Infosys and HDFC Bank, have created wealth for their employees by issuing Esops. While there are enough examples where Esops have not worked (as in the case of Yes Bank), one cannot deny that Esops are a great way to create wealth for an employee. However, Esops are not the only way companies incentivize employees.

Here, we look at four types of employee share-based payments that come under the purview of the Securities and Exchange Board of India (in case of listed companies) and/or the Companies Act (both listed and unlisted companies).

Incentivizing with ESOPs

Esops are the most common way of incentivising employees in order to retain them. Say, for example, on 1 April 2020, ABC company told its employee Ria that she could purchase 100 shares of the company after two years at 10 per share, a 90% discount from the market value of 100 per share as on that day.

The two-year period that Ria has to wait to purchase the shares granted under Esop is called the vesting period. If she leaves the company before that, she wouldn’t be eligible for it. Esops are also contingent upon on the performance or the output targets set by the company.

“The vesting conditions are linked to either time or performance or a combination of both. As you move up the ladder, performance conditions become more common. These could be related to individual’s key performance indicators (KPI) or the company’s performance," Bharath Reddy, Partner at Cyril Amarchand Mangaldas.

 

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The period after the vesting period is called the exercise period. 1 April 2022 onwards, Ria can exercise her rights under the Esop by buying the shares for 10 per share, or holding it until the maximum time period permitted by the company.

“If the shares are not bought within the exercise period set by the company, the right under the Esop lapses and effectively becomes null and void. The right under the Esop is personal to the employee and not transferable," added Reddy.

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The tax under Esop comes into the picture when Ria buys the shares. The difference between the cost of purchase and the FMV of the shares is considered a ‘perquisite’ under the Income Tax Act, and gets added to the salary income in the year of purchase.

Say, Ria exercised her right and bought 100 shares for 1,000. If the market value of those shares is 11,000 ( 110 per share), the difference of 10,000 will be considered as a ‘perquisite’ for taxation purposes.

The shares Ria bought might be subject to transfer restrictions, especially in case of unlisted companies.

The second incidence of tax comes when the shares are sold. If Ria sold the shares at 200 apiece , the difference of 9,000 {( 200 – 110)*100} will be treated as capital gains. capital gains are determined on the basis of the holding period – 12 months in the case of a listed share and 24 months for an unlisted share.

Stock appreciation rights

Stock appreciation rights (SAR) is the second most commonly used method to incentivize employees. Focus on the word – ‘appreciation’. The benefit under the scheme is equivalent to the value of appreciation witnessed in the share price of the company between the date of the issue and exercising the SARs.

For example, Ria was issued SARs of 100 shares on 1 April 2020, with the market value at 100 apiece on that day with a vesting condition that it can be exercised after two years.

After two years, if the market value of the share is 150, then Ria will be entitled to 5,000 ( 150- 100).

The company can choose to give the value of appreciation either in the form of cash or in the form of shares. When 5,000 is given in cash, it is called cash-settled SARs. It would be called equity-settled SARs if shares worth 5,000 are given to Ria.

There can be instances where exercising the right might result in loss. It is called ‘underwater’ stock options/SARs. “Companies also have the ability to reprice those options or to change the exercise price to make it employee-friendly, subject to shareholder approval," pointed Reddy.

In the case of cash-settled SARs, the appreciation value paid out in the form of cash is taxed as perquisite in the hands of the employee. For equity-settled SARs, the taxation is similar to that of the ESOPs.

ESPS

While Esops and SARs are a way to incentivise employees to retain them, the Employee Stock Purchase Scheme (ESPS) is a mechanism to reward existing employees for their past performance. The company allots shares upfront to employees at a discount to the current market price. Unlike Esops or SARs, this plan does not have any vesting period.

The only condition as per the share-based employee benefits regulations governed by Sebi is that the listed shares allotted under ESPS plan cannot be transferred for one year. “The one-year lock-in period is only for transfer/sale of share but doesn’t require the individual to continue with the company," added Reddy.

For taxes, the difference between the market value of shares and the amount paid is taken as perquisite in the year of shares allotment. Capital gains—the difference between sale value and market price on the share allotment day—are taxed in the year of sale of shares by the employee.

Sweat Equity Shares

Under this plan, shares could be allotted to employees at a discounted price or for no consideration as well, for the services rendered to the company. This can including transfer of know-how, intellectual property rights, or any other value addition. There is a lock-in period of three years for transferring the shares.

To allot shares under sweat equity shares plan, “The company needs to obtain a valuation report valuing the employee’s effort. Against such a valuation, remuneration paid to the employee has to be deducted to arrive at an amount against which shares can be allotted. It is not an easy valuation exercise and is often the main hurdle in implementing sweat equity benefit plan" added Reddy.

Here, too, employees given sweat equity shares will be liable to pay taxes at two instances, like Esops.

Factors to keep in mind

Share-based payments could be a good way for creating wealth while working with a company. But, there are certain points one needs to take into account when accepting them as part of compensation.

One must thoroughly go through the terms like vesting conditions, exercise period, rules when exiting the company, sale restrictions, etc.

Share-based payments are illiquid in nature in the case of unlisted companies. It also requires cash-outflow when purchasing the shares as Esops and ESPS cannot be issued below the face value of share. Also, the taxation on the purchase of shares makes it a little unattractive as one has to pay taxes on notional profits even before realizing any gains.

Anjali Raghuvanshi from Randstad, a job recruiting company, says that the employee should account for the higher risk of equity while accepting shares and ask for shares worth higher value than the cash component that one is letting go. In case of unlisted companies, one can refer to the latest valuation reports available to determine the value of the shares offered.

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ABOUT THE AUTHOR

Satya Sontanam

Satya Sontanam is a senior content creator at Mint with a keen interest on data crunching, analysis and the story behind trends. She writes on personal finance including investments, regulations and data stories. Before joining Mint in December 2021, Satya worked as research analyst and also a personal finance writer at The Hindu BusinessLine. Satya is a qualified chartered accountant. In her free time, she enjoys doing yoga and listening to podcasts.
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