It is universally acknowledged that a company in possession of good growth opportunities, must be in want of proficient employees.
In today's finicky world where an employer has to face financial and technological competition as often as blinking, he is also forced to face the uncertainty of retaining his competent workforce. The attrition rate in India is on the rise, with employees' job-hopping to the next best offer. In such dark times, it stands to reason that businesses utilize innovative ways to draw their employees like moths drawn to flame.
One such method commonly used in India is ESOP. ESOP or Employee Stock Option Scheme made its advent in India in 1990s when Infosys offered its employees once-in-a-lifetime opportunity to elevate the status of employees to owners. No longer need an employee slog his life away for somebody else's dream, instead he could happily work for his own company, build his own future as per his vision.
ESOP, to state simply, is an employee benefit plan. The principles are straightforward- the employee has a right to buy the stocks of the company at a pre-fixed price which is lower than the prevailing market price. The right to buy stocks occurs at the end of a specific period called vesting period, when certain conditions are met. These conditions are usually expressed as a percentage increase in profitability or growth. Such stocks may or may not have voting rights.
Implementation of ESOP scheme led to a remarkable change in the working of businesses. Not only were the employees more invested in the growth and success of business, their attrition rate decreased drastically and morale increased. The employers could rest happier, knowing that the employees' vision aligned with theirs and the employees were encouraged that the fruit of their hard work, perspiration and time would be enjoyed by them.
Yet, in the recent times, the luster cast by ESOP is dimming. It may so happen that the employee does not possess sufficient funds at the end of vesting period to exercise at the quoted ESOP price. To exercise, or not to exercise, that is the question that arises at such moment. Another aspect an employee has to consider is the consolidation of investment by investing in ESOP, thereby increasing the risk of one's portfolio.
Apart from this, the employee stands to lose out on his investment if the ESOP after purchase lose the value of their stock. A real case of employees losing their hard-earned money could be witnessed in Enron and United Airline’s case, where not only did employees lose their jobs but also lost much of their wealth, as the companies went into bankruptcy. This lead to stricter norms being implemented by the US Government followed by other countries.
Furthermore, the company at the time of acquisition may also find it difficult to find an acquirer willing to accept the liability of ESOP. In privately-owned or in family run companies, the majority shareholders may also be unwilling to dilute their stake for their employees as this would also result in loss of control and decision-making in the business.
These factors along with specific preferences and requirements of companies coupled with the need to evolve traditional concepts to meet the changing pace of time, have led to the introduction of hybrid incentive plans. One such plan is Synthetic Equity.
Ghost stock or synthetic equity, an alternative to ESOP is an American phenomenon that has spread globally. The reason for this traction is that synthetic equity gives a right to the holder, equivalent to that of an equity shareholder without holding the shares. The holders of such shares do not have any voting rights. Hence, there is no dilution in the ownership of management and serves the employees as a perquisite for their efforts.
A company looking to provide synthetic equity to its employees has two variants available - Stock Appreciation Rights (SAR) and Phantom Stocks.
Under SAR the employee benefits from the increase in price of the stock. It entitles the holder (the employee) to the appreciation between the exercise price and the fair market value of the stock. In other words, the employee receives bonus from the increase in value of specified share over a specified point of time. Just like ESOP, the right to exercise SARs occurs at the end of the vesting period. Phantom stock is also a promise to pay bonus by the company in the form of value of share or increase in value of shares over a certain period of time. Phantom stock, unlike SAR, also entitles its holders to participate in the earnings of the company.
It’s a win-win situation for both management and employee. Management can retain its competent workforce without dilution in its holding and employees have guaranteed future benefits with no outflow of funds. The employees work with the same zeal towards the growth of the company, as the appreciation in the value of the company is directly linked to the contributions received by them. Thus, the employee benefits from the risk of any future uncertainties.
The greatest advantage of synthetic equity? The open ends they offer. The company has a plain canvas to customize and structure the benefit on numerous basis such as liquidity, vesting rules, eligibility, right to corporate governance, right to interim dividends etc.
But every coin has two faces. The reason for this high degree of flexibility is the lack of corporate governance regulations. Companies Act, 2013, the paramount act governing the functioning of companies in India is silent on synthetic equity, quite unlike ESOP. SEBI (Securities and Exchange Board of India), which is the regulator of securities market in India does have its own regulation for issue of synthetic equity that results in creation of stock for employees. However, these regulations apply only to entities listed on the recognized stock exchanges in India. Furthermore, even SEBI is silent when the employees are given synthetic equity that culminates into monetary outflow.
From the accounting perspective, while ICAI (Indian Institute of Chartered Accountants), the national professional accounting body of India has released guidance note on the accounting treatment of SARs, the accounting of phantom stock continues to be a gray area.
From the viewpoint of the employees, the benefit from synthetic equity on receipt is taxed under the head of 'Other Income' at the highest rate. This is unlike ESOP where the employee is taxed as perquisite under the head of 'Income from Salary' at the normal rate applicable.
In the present scenario, ESOP continue to be the predominant employee benefit given by companies to its employees in India. While notable Indian companies such as DLF, Sunlife, Bajaj Alliance and Cairn India have also employed phantom stocks as part of their employee benefit plan, the penetration of synthetic equity as part of employee benefit is still limited. Given the current economic uncertainty, stock market performance and competition, a company should endeavor to tailor make its employee incentive as a combination of ESOP and synthetic equity to address the issues of attracting and retaining proficient employees in terms of performance and ownership.
As the saying goes, “A sound investor will never put all of their eggs in one basket”.
Author
Nikhil
Nikhil, is an Article Assistant and has been associated with KVA for almost a year. During this tenure, he has gained significant exposure in various domestic industries through the diversified nature of assignments and opportunities presented to him. Nikhil has a keen interest in economic and current affairs.
