Equity incentives: To give or not to give
Recently, the booming startup ecosystem in India has invited media headlines on equity incentives, commonly known as ESOPs, leading to large windfalls for employees. With Flipkart leading the pack, several other startups like Zerodha and Rivigo have also been in the limelight for creating “overnight millionaires” and having a life-changing impact on many employees’ fortunes. This may paint a broadly lucrative picture of equity sharing within India Inc. but the reality is far from it. Mercer’s 2019 Total Remuneration Survey (TRS) shows that less than one-third of private Indian enterprises grant equity awards – and those that do, extend them primarily to senior management. In comparison, the prevalence of such awards in developed markets like US, UK and Japan ranges from 50-65% and often also covers middle management. In India, cash has been the primary instrument of compensation historically for a vast majority of companies as it is simple, tangible and effective. But cash has its limits.
Consider a rapidly-growing company that uses fixed pay and annual bonus to compensate all employees. While its revenues and market cap grow exponentially, average employee remuneration rises only moderately through low double-digit salary increases and bonuses that cap out at 30% of fixed pay. Soon, the high-performers are poached by larger competitors with more lucrative offers resulting in high attrition and drawn-out salary negotiations with those at flight-risk as well as new-hires. Business momentum suffers and the company gets derailed from achieving its long-term objectives.
Another oft-seen scenario is a mature, well-funded company attracting best-in-class talent by providing fixed pay at the 75th percentile of market along with a modest bonus kicker. However, due to unforeseen industry cyclicality, company performance deteriorates drastically and cost-cutting takes priority. The above-market guaranteed compensation leads to overpayment to employees, thus impeding efforts to attain fiscal discipline at a critical juncture. Furthermore, the cash program does not offer sufficient upside to employees for restoring company performance to pre-downturn levels.
In both the above cases and numerous other instances, utilizing cash compensation exclusively fails to serve the evolving business needs and sometimes directly hampers progress on strategic priorities. Can equity incentives fill the void left by a ‘one-size-fits-all’ cash compensation program or do they unnecessarily complicate the rewards structure without adding much value. This is the first installment in a three-part series to explore this highly debated topic by Boards, CXOs and rewards professionals.
Equity – A Unique and Potent Tool in the Rewards Portfolio
Create an ownership culture by sharing company equity with those who help create value. This is the greatest differentiator of equity versus cash compensation. An owner works for herself while an employee for her boss. An owner is intrinsically motivated to realize her vision while an employee may need extrinsic reward & recognition to realize others’ vision. An owner has real say on crucial policy matters while an employee can only share views if asked. Most importantly, an owner takes full accountability for results and consistently goes above-and-beyond to improve the group’s performance while an employee focuses primarily on enhancing individual capabilities. Hence, creating an ownership mindset among employees drives behaviors required for continuous improvement and holistic success of the company. By recognizing employee contributions through a fair share of value that they help create, it conveys that the founders/investors consider talent not only an important asset but a true partner in the company’s journey toward fulfilling its purpose.
Support the attraction and retention of best-in-class talent. The top talent within any industry or function generally receives the best opportunities. So, even if a few companies in the market grant equity incentives, the best talent would eventually gravitate towards them given the owner-status and uncapped upside from share appreciation. It may be argued that risk-averse individuals would prefer guaranteed cash over equity incentives. However, it may also be risky to presume that such individuals represent the talent best suited to thrive in today’s VUCA environment of rapid technological advancement and disruptive innovation. Also, equity is usually not a substitute but rather incremental to fixed cash compensation and annual cash bonus. It then stands to reason that an organization providing equity incentives has a greater competitive advantage in attracting and retaining talent (all else equal). While this is especially true for intellectual capital-intensive sectors such as Technology, BFSI, Pharma and Professional Services, it applies to many industries today given the scale and ubiquity of digitization plus the advent of multifunctional technologies such as AI, blockchain and IoT.
Promote focus on long-term sustainable value creation. Equity incentives typically have multi-year vesting and performance horizons. This fosters employee retention and drives behaviors required to spur enduring growth/returns while curbing short-termism that could lead to long-term pain for the company. For example, if an IT firm decides to forego critical R&D investments only to meet quarterly profit goals or a manufacturer delays the CapEx required to maintain the equipment reliability, it can jeopardize the long-term health and sustainability of the business. Moreover, strategic initiatives that enhance a company’s competitive edge typically experience long gestation before these investments start paying off. In that regard, equity incentives complement cash compensation – by ensuring that the company’s vision is not compromised in a bid to achieve near-term milestones. Companies can also implement share ownership guidelines or holding period to encourage long-term shareholding by employees, which in turn can increase the ownership stability required to execute a long-term strategy.
Rally employees to achieve the company’s common goals and vision. If a company is a team striving to achieve the overarching purpose for which the organization exists, then equity is the glue that can bind that team together. Fixed pay and cash incentives often beget silo mentality to the extent where the group’s interests are compromised as employees lose sight of the forest for the trees. For instance, when two standalone business verticals act as two siblings vying to prove themselves more worthy of their parent’s admiration, then the internal competition can cause much harm. It can hinder collaboration and synergies that may be gained from sharing talent and technology or cross-selling to customers. In such situations, equity can be the common currency that emphasizes the importance of team-mentality by linking employees’ personal rewards to the organization’s fortunes and success. Thus, equity incentives can drive solidarity by compelling employees to believe that ‘we are all in this together’ so there is a strong sense of winning and losing as a team.
Better align company performance and employee reward outcomes. While cash-based incentives help create some directional ties to performance, the degree of alignment is not as strong as that from equity incentives. The reasons are twofold. First, performance-based equity incentives produce a multiplier effect through linkage to both operational performance and share price while cash incentives solely to the former. Second, as equity awards are typically monetized over a longer period than cash awards, share price changes impact the value of multiple equity awards and hence a larger portion of employees’ net worth. Suppose a mature retailer has recently transformed its business model from brick-and-mortar to omnichannel, which leads to doubling of sales and 500 bps improvement in net margin over four years. Consequently, cash incentives are earned at maximum although employees still feel underpaid as they receive only a small fraction of the incremental value created in terms of market capitalization. Consider a flipside scenario – an NBFC that has undergone a precipitous decline in company value due to a rise in non-performing assets and recent lapses in corporate governance. While employees forfeit their latest cash incentives, the prior awards remain intact so there is limited accountability, at least from a rewards perspective, for those responsible for the performance deterioration. In such situations, the amplified linkage of equity incentives to company performance, through the multiplier effect and impact on overall net worth, can act as a strong motivation to drive business transformation and as a self-regulating mechanism to prevent undesired behaviors.
Improve financial efficiency of the total rewards program. As a non-cash expense, equity incentives free up liquid capital that can be utilized for core business activities. This is evident from the high usage of ESOPs by cash-tight startups that need substantial capital for product optimization and scaling objectives. Free cash is also a boon when companies have to repay debt obligations, pursue M&A opportunities, or return capital to shareholders. Another key feature of equity-settled awards is the fixed accounting treatment where the recognized expense is set at the time of grant, with limited variation in certain instances. Conversely, the expense for cash-settled incentives varies in the company’s books until final settlement. This enables companies using equity incentives to mitigate volatility in their compensation expense and obtain greater visibility into future performance. Lastly, equity incentives are highly advantageous in a growth environment since the upside for employees is funded by the market through share appreciation, foregoing the need for companies to expend additional cash to finance such gains. Collectively, these tailwinds can help organizations improve the bottom line and maximize the ‘bang for the buck’ of their employee compensation program.
Democratized ownership is beneficial for the social and economic fabric of society. Many sources claim that India is one of the most unequal major economies when it comes to wealth distribution, with the top 1% owning around 50% of the country’s total wealth. High level of wealth inequality can be a hotbed for corruption, infringement of human rights, polarization on key issues and other societal dysfunctions. A stark ‘haves and have-nots’ environment has historically been one of the foremost reasons for social and political instability that hinders nations from unleashing the full potential of their human capital. Broader equity ownership in India Inc. can help alleviate this inequality. Besides social benefits, equitable wealth distribution also has trickle-down economic impact as new shareholders gain higher disposable income. This generates a ripple effect on domestic consumption levels to fuel economic growth and raise per-capita income in a more inclusive manner. In turn, this can preempt the need to redistribute wealth by raising tax rates for the country’s top earners, which generally exacerbates the class divide. Finally, equity ownership can enhance post-employment financial savings needed to maintain reasonable living standards during retirement. Given the fading Indian joint family system and lack of financial safety net for retirees, this is a crucial need of the hour. Perfect equality is a myth but we can still strive to create equal opportunity for everyone to pursue their financial security and independence and, in the process, foster a truly democratic society.
While equity incentives may not be a panacea for all the talent challenges that India Inc. faces today, they present a simple and effective way to create “skin in the game” for employees in a way that cash compensation cannot. Recently, Saugata Gupta, MD, Marico, was quoted in the Economic Times saying that “In a large company, risk-taking is often lower. We need to create that environment internally. To achieve that, Marico needs to be a scaled insurgent with executives operating with an owner’s mindset”. And what better way to achieve that than by making employees actual owners!
Notwithstanding the above benefits, we have come across numerous equity incentive plans that fail to achieve the desired outcomes due to various reasons. In our second installment, we will discuss the key considerations when designing such plans as well as potential pitfalls to help companies avoid the unintended consequences of certain plan constructs.