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Employee Stock Options for Employee Compensation

  • Written Written by Equity team 02 February 2023 | 4 min read
  • Editor's Note :

    This article is intended to provide an overview of employee stock options and helps to carefully consider the plan's structure and potential risks.

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Employee Compensation is always a sensitive topic to talk about for many employers. This is because many companies have yet to figure out how the right compensation plan especially wrt to the Stock Options portion for their employees. When done correctly Equity compensation i.e. stock compensation can be very lucrative and can be more than the salary that an employee generates.

An employee stock option is a plan that gives you- the employees- the right or benefit to subscribe to or purchase the shares of the company at a predetermined price (the strike price) on a future date. It is defined under Section 2(37) of the Companies Act, 2013. The procedure is regulated by Rule 12 of Companies (Share Capital and Debentures) Rules, 2014.

Before we go into understanding the types of Equity compensation available. Let’s delve a little into why ownership is shared by organizations (If you are not doing this, then you can consider it for the following reasons).

Why Share Ownership as Employee Compensation?

Long answer short- it is a motivation tool. It is a great tool to attract and retain employees and make the business perform better by linking incentives to the performance of the business. This vested interest is one of the reasons why more than half of people under the age of 35 rate equity compensation as “important” when considering a job switch. Some other reasons might be to have tax benefits, raise capital, and have an ecosystem of shared entrepreneurship.

Understanding the types of Equity Compensation

Equity compensation or Stock Compensation normally is considered to be of three types. Incentive Stock Options, Non-Qualified Stock Options, and Restricted Stock Units. These three types mainly differ in when you have to pay taxes and whether you have to purchase the shares, but the concept of stock options is common among all of them.

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types of Equity Compensation

Incentive Stock Options

As the name suggests, these types of stocks have an “incentive” in the form of tax breaks at the time of exercising the stock i.e. at the time of actual buying of the stock (though you may owe alternative minimum tax, also known as AMT). But I need to pay taxes at the time of selling the stocks. Some companies allow “cashless exercise” which means that you can sell a part of your shares at the time of exercise instead of paying money for the entire lot, but this may result in losing the tax advantage and being treated like NSOs.

Non-Qualified Stock Options

With NSOs, you get the option to buy stocks at a given price i.e. the strike price. But are taxed twice, once at the time of exercising the stocks i.e. buying the stock where the difference between the strike price and the fair market price at which you exercise your options. The second time, on the profit you made by selling the options, short-term or long-term capital gains tax would depend on when you are selling the stock before or after a year.

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Restricted Stock Units

These are the most common employee compensation plans offered by startups. Like stock options discussed above, RSUs vest over time but need not be bought separately by the employees. After the vesting period is done, they are automatically converted into shares i.e. they are no longer restricted and can be treated similarly to the shares that are bought in the open market.

One less risk, RSUs have when compared to stock options is that you won’t incur loss unless the stock price has been reduced to zero. For taxation purposes, the value of the shares at the date of vesting is taxed as ordinary income for RSUs.

If you think that the forms of equity compensation are limited to these three, then you are wrong. There are multiple other formats that are used:

Phantom Stocks

These are phantom stocks or “shadow” in nature i.e. they are not actually issued but mostly settled in cash. In this rather than getting physical stock, the employees receive mock or shadow stocks. These stocks follow the price movements of the company’s actual stock, therefore receiving the resulting profits. If this results in issuing shares, they are treated as Restricted Stock Units.

Stock Appreciation Rights

SARs mainly deal with the appreciation of the stock price during a predetermined period. The advantage that Stock Appreciation Rights provide lies in the fact that employees need not pay any exercise price for buying the stocks, instead they receive the sum of the increase in stock or cash. This also provides an additional advantage to the employer as the share price needn’t be diluted by issuing additional shares.

Sweat Equity Shares

These are similar to ESOPs. But, Sweat equity is the direct allotment of shares at a discount or for consideration other than cash. It is not an option for exercising shares like ESOPs. Also, there is a minimum locking period of 3 years between the issue of shares to the exercise and the definition of employee is different for both.

For many people, stocks can be an intimidating area. But if companies are offering stock-based compensation as part of their package, participating could lead to amazing financial returns. But always do your research beforehand. And for all the HRs out there, do provide all the necessary information for your future employees to take a learned decision.

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