Understanding Dynamics of Equity Incentives

Introduction

Equity
compensation is a noncash compensation that represents an ownership
interest in the company. In the global environment, organizations are
increasingly making stocks offered to most or all employees and no
longer limiting it to top managers and executives.

The basic coherent for equity-based compensation is that it:

a) Better aligns individual employee objectives with organizational objectives.

b) Increases retention and reduces employer turnover.

c) Provides a prevailing tool to attract, retain, motivate and reward employees.

There
are various forms of global equity compensation. In this article, we
will be discussing essentials of common types of equity compensation.

Types of equity compensations

There are FOUR basic types of equity compensations: “Stock Options, Employee Stock, Restricted Stock Grants and Phantom Stock”

Let’s discuss

1) Stock Options

A
stock option is a right to purchase shares of a company’s stock at a
predetermined price, which is referred to as the exercise price.

Participants are given the right to purchase stock for a certain period of time – usually 5-10 years.

Participants
usually gain vesting rights to exercise a predetermined percentage of
the total stock option allocation each year. The vesting of options
over time creates an incentive for the employee to remain with the
organization to build its value.

The option to buy the stock is for a stated price (usually the stock’s fair market value when the option is granted).

In
general, stock options are a valuable means of providing the upside of
stock ownership without the participants having to invest any of their
own funds. Option holders are not stockholders and they are not
permitted to vote their option shares or exercise any other stockholder
rights.

2) Employee stocks

Employee
stock plans give employees with a means of acquiring employer stock.
The main purpose is to reward and motivate employees.

An
employee stock ownership plan (ESOP) gives employees shares in the
company. Employees can receive shares as a bonus, buy them directly
from the company or receive them through an ESOP.

In
most cases, an ESOP is given to an employee rather than purchased by an
employee. An ESOP is analogous to a profit-sharing plan. A company sets
up a trust fund, into which it contributes either new shares of its own
stocks or cash to buy existing shares.

3) Restricted Stock Option

Unlike
a stock option, a restricted stock grant does not necessitate an
employee or executive to actually purchase the stock. It is essentially
a transfer of stock or gift of stock with forfeiture provisions that
result in a potential loss of the shares if certain requirements are
not fulfilled. To elaborate on this, restricted stock plans provide
employees with the right to purchase shares at fair market value or a
discount, or employees may receive shares at no cost. However, the
shares employees acquire are not really theirs yet they cannot take
ownership of them until specified restrictions obligatory in the
contract lapse. Most commonly, the vesting restriction lapses if the
employee continues to work for the company for certain number of years,
often this time period is of 3-5 years. Time based restraint may lapse
all at once or gradually. However, in restricted stock options there is
not only time based restriction but any restriction can be imposed. The
company could, for instance, restrict the shares until certain
corporate, departmental or individual performance goals are achieved.

4) Phantom Stock

Phantom
stock arrangement are usually used when a company does not view
possession of real equity as desirable but seeks to construct some of
the incentives that go along with having participants feel aligned with
the company’s owners. This is a method for companies to give their
management or employees a bonus if the company performs well
financially. Phantom stock provides a cash or stock bonus based on the
value of a stated number of shares, to be paid out at the end of a
specified period of time.

Often
non-publically traded companies or closely held or family-owned
companies as well as employers that are not corporate entities find
that a phantom stock arrangement is a helpful means of creating
incentives for key employees. Such plans can imitate the economics of a
stock option or a restricted stock grant. Phantom stock grants align
employees  motives with owners  motives (i.e. profit growth, increased
stock prices) without granting employees an actual ownership stake in
the company.

Conclusion

Equity
as a part of employee compensation does not only ensures employee
retention but also reward them for their loyalty and efforts to make
the organization a successful entity. This write-up only highlights
basic equity plans and CFO’s of the organization in association with
Compensation and Benefits specialist and Tax Experts can create several
hybrid plans. Care has been taken to cover all essential facts related
to these equity plans. However, if readers have any concern or query or
if they need any clarification, they can write to the undersigned.

Your comments and feedback will be welcomed.

Thanks and Regards,