The outbreak of the pandemic has made businesses see it all. The big fall in spending and demand because of no or lesser incomes in hand, in turn, leads to loss of sales and other business opportunities. With this fall in revenue, to make sure the business still remains profitable. It retains the same market share; the only resort that remained was to cut out on the internal direct and indirect expenses, which led to many employees being fired from their jobs. Now let us analyze if this was actually a good option?
No, because, even though retention could have been slightly expensive from the company's point of view, it would not just give them higher credibility and a good brand image, but it would have made the people stay. Because this was the time everybody was suffering, this empathy and stable income would have made them even more loyal towards the company. And we all know a company is made by its people. People on board satisfied, less employee turnover, and encouragement to put in their best efforts to hold and justify their position in the company, truly a win-win situation.
Now since we have established the fact that employees have to be retained, let's not forget to look at the company's fundamentals. The liquidity and cash flows are the worst hit because there is a fall in demand which means less inflow, but outflow is constant due to principal and interest on borrowings, fixed expenses, and payments to vendors. Does cash outflow through salaries seem to be a viable option in this situation?
Now we have understood the narrative, so equity compensation comes into the picture.
What is equity compensation?
Through equity compensation, employees are given a right to share on the company's own instead of a payment in cash through stock options and restricted stock and performance shares.
Why equity compensation and not cash payments?
It kills multiple birds with one arrow:
- As discussed above, a company's liquidity is the worst hit in the uncertainty because of lesser and variable inflow but more and fixed outflow. Talking about startups, the major part has to be spent on expenses and investments. Very little working capital leads to a cash crunch to give out more salaries to attract and retain talented people. In situations like these, the most appropriate option is reduced outflows, and liquidity is maintained. Inequity compensation, unlike salaries, has no outflow of cash, so a company doesn't have to worry about its liquidity position when it exercises these options. Neither is the employee compensation unfairly affected.
- This acts as a link between employees' compensation and the company's performance. This would encourage them to work harder for the company's growth and returns, to increase the market value of the shares, which he wouldn't have if he weren't going to share the company's ownership and returns. A personal interest would encourage him to understand the working of the company better, the vision, goals, and objectives of the company, and he would take further steps to help achieve them faster and better. With capital appreciation, he would be able to share in the profits of the company, and would this look for strategies to increase the profits of the company as a whole.
- This would make the employees stay in the company i.e.employee retention, and lower turnover. Options like ESOP usually have a vesting period attached to them which means that employees have to be in the company for a certain time to exercise these options at a discounted rate which is lower than the prevailing market value of the share. The company can retain the loyal and talented key employees through equity compensation because they have personal benefits attached as well like a) tax benefits, b)right to shares are a better option than less salary or even none c) discounted rate time if they bought the same share from the open market it would have cost them much more than the exercise price.
- The options are tax-deductible as per the provisions of The Income Tax Act up to a specified limit and can be appropriately planned by the company and the employees. Also, whenever a company goes for equity compensation, it has to get itself evaluated to determine the fair exercise price, which could be a regular exercise, in case it is common for the company and the true value is always known to it.
Ways of equity compensation
Stock options: An offer is given to the employees to purchase a specified number of shares later, at a discounted price determined now lower than the prevailing market value of the share, known as the exercise price. The right only vests and becomes exercisable after employees are with the company for a specified period of time, after which they can either buy, sell or transfer this option. Employee stock option plans are the most widely used options for employee retention.
Nonqualified stock options and incentive stock options.: NSOs and ISOs are also some great ways of equity compensation. In NSOs, whenever the employees receive this option, they do not have to report this outright, and in ISOs, they enjoy tax advantages.
Restricted Stock: Here, the company promises its employees to pay shares as per a specified vesting schedule. The ownership rights are awarded to the employees only after the shares are earned and issued.
Performance shares: As the name says, these are based on specific performance metrics. Only after specific metrics are fulfilled, such as return on equity, earnings per share, etc., are the shares given to the employees.
Having known about the advantages and different types of equity compensation, we have made up our minds in its favor but let's not forget to look at the drawbacks to make a fair decision. The major drawback is that when these aren't properly planned and either the assumptions are defective or improper, the founders may end up giving too much equity to its employees, which means less voting power in their hands and more people to be considered while making decisions which wouldn't have been the case in case power was concentrated and decisions would thus have been fast.
The employees who are risk-averse might be firm in believing that salary is better because they are certain to receive it in hand, and only when they are made aware of the benefits of these options can this be successful.
Considering the unstable, unpredictable, and uncertain market conditions, equity compensation looks like a good idea to stabilize the liquidity position and retain the organization's people to all the companies, especially startups. But everything is only successful when it is strategized, planned, and implemented well. Evaluate the pros and cons, the fundamentals of the company, and the employees to retain the best people and not give up too much of the ownership in these options.
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