How stock-based incentive plans work

Keep in mind the vesting, exercise and lock-in periods. Also remember that such plans are taxed in two stages

Equity-based compensation or stock-based incentive plans are widely used by organisations worldwide for their perceived benefits in the long run to both employers and employees.

EY India recently conducted a stock-based incentive survey for its Indian and multinational clients. The survey results bring to the fore how organisations view stock-based compensation, as a tool to retain and attract talent as well as to create wealth for their employees.

Stock-based incentive plans have multiple and diverse objectives. They serve as an important tool in retaining employees, linking employees' performance with that of the organisation, creating wealth for employees and generating an entrepreneurial spirit among them. The combination of ownership and participative management is a powerful tool, inspiring accountability in employees when treated as business owners.

Today, employees negotiate salary packages, which include stock-based incentive plans when joining an organisation or continuing with an organisation. Therefore, to distinguish themselves from competitors and attract and retain talent, organisations roll out stock-based incentive plans.

Different organisations adopt different types of stock-based incentive plans:  The Employee Stock-Option Plan (ESOP), the Employee Stock-Purchase Plan (ESPP) or The Stock Appreciation Right (SAR) Plan. While both ESOP and ESPP entail allotment of shares and result in dilution of share capital, SAR plans are generally settled in cash and do not result in such dilution. Further, since ESOP has a vesting period, it is used as a means of retention, whereas ESPP is mostly used to reward performance. Unlike ESOP and ESPP, a SAR plan does not involve cash outflow from employees. It gives an employee the right to appreciation in the stock price without paying a price. A SAR plan is of advantage to an organisation by not diluting equity and, simultaneously, offering the economic value of equity to employees.

The EY Survey results show that Indian organisations still prefer the conventional ESOP.

The tenure of a stock-based incentive plan comprises a Vesting Period (a minimum period to gain entitlement to convert options into shares), an Exercise Period (during which one can convert the vested options into shares) and a Lock-in Period (when the sale of such shares is restricted). Typically, a stock-based incentive plan runs from five to 10 years, during which an employee earns the stock income. The EY Survey revealed that 88 per cent of the respondents have a vesting period of one to five years, during which the stock options vest. To exercise this right, an employee normally gets one to five years. Several companies do not have a lock-in period for shares, post allotment, which allowed employees flexibility to sell their shares.

An exit strategy is necessary for the success of a stock-based incentive plan since an employee should be able to encash his/her stock options. With listed companies, employees can sell shares on a stock exchange. With unlisted companies, promoter buyback is the most prominently used method.

While rolling out a stock-based incentive plan, organisations also need to be cognizant of regulatory requirements.  Companies listed in India are guided by The Securities & Exchange Board of India (Employee Stock-Option Scheme and Employee Stock-Purchase Scheme) Guidelines, 1999, which have been reviewed time and again.

Recently, Sebi prohibited listed companies (through an Employee Welfare Trust or otherwise) from buying/selling its own securities in the secondary market for the purposes of a stock-based incentive plan.

According to the provisions of the Indian tax laws, under a stock-based incentive plan, a two-staged taxation arises in the hands of employees. First, at allotment of shares and second, when such shares are sold. The taxable value on allotment is the Fair Market Value on the date of the exercise less the price paid to acquire the shares, if any. Such a gain is taxed as a perquisite in the hands of the employees.

On the sale of shares, the gain is taxed as short-term or long-term capital gains depending on how long such shares have been held. The taxable value is the excess of the sale price over the Fair Market Value on the date of exercise. If the shares are transacted /sold on a recognised stock exchange in India and the Security-Transaction Tax has been paid, long-term capital gains are exempt and short-term capital gains are taxed at a concessional 15 per cent. Long-term capital gains arising from the sale of shares of companies not listed in India are taxable at 20 per cent and short-term capital gains are taxable at applicable rates on income slabs.

Before rolling out a stock-based incentive plan, organisations need to align the interests of employees and the organisation taking into consideration industry and market trends.
The author is Partner & National Leader - Human Capital Services, EY (Shalini Jain, Associate Director - Human Capital Services, EY, contributed to the article) (The views expressed are their own)