Equity-Linked Incentives: Tool For Talent Retention Amid Start-Up Growth

By Vinay Joy, Srishti Ramakrishnan, Aditya J Nair

In today’s competitive job market, the paramount concern for many employers is the retention and motivation of talent. Equity-linked instruments have emerged as a powerful tool, particularly within the dynamic start-up ecosystem, offering innovative ways to attract, motivate, and retain talent. Recent incentives by companies like Zomato and Swiggy highlight the growing popularity of these instruments, underscoring their effectiveness in enhancing employee engagement.

Equity-linked incentives are compensation tools designed to align employees’ interests with those of the company and its shareholders by tying a portion of their compensation to the performance of the company’s stock. These incentives aim to align the company’s growth and value creation for both shareholders and employees, serving to attract talent, motivate employees, and enable businesses to retain high-level employees.

Typically, when employers consider equity-linked instruments, the first thing that comes to mind is Employee Stock Options (ESOPs). While ESOPs remain a favoured option for many businesses, new instruments like phantom stock options and stock appreciation rights are gaining traction.

ESOPs refer to incentives where employees are granted ‘options’ which can be exercised to acquire shares in a company. Such options are granted over a period such that a limited number of options may vest with the employee each year depending upon the completion of certain identified factors (e.g. completing certain tenure with the company or achievement of identified performance metrics). Once vested, the options may then be ‘exercised’ by making payment of an exercise price and such exercise results in the company granting shares to the employee.

On the other hand, phantom stock options or stock appreciation rights typically refer to options that, when exercised, do not grant employees shares in a company but rather allow them to receive monetary payouts linked with the company’s share price. These are akin to notional instruments that will enable cash payouts.

A Shift In Compensation Practices

In recent years, the proliferation of startups in India has resulted in a shift in employee compensation preferences, with prospective employees increasingly valuing equity participation as a component of their overall remuneration. This transformative shift can also be attributed mainly to the remarkable success of trailblazing startups such as Zomato, Ola, Swiggy and Flipkart, which have embraced these schemes, generating substantial wealth for their employees. The allure of these schemes is further amplified by headlines showcasing the emergence of a new generation of millionaires thanks to employee stock options. However, not every ESOP program guarantees long-term success. Companies must navigate several practical challenges to ensure equity-linked incentives fulfil their intended purpose.

Key Considerations And Challenges:

1. Educating Employees: While the 'pay at risk' reward structure is increasingly recognised as a potent tool for attracting and retaining talent, its success depends heavily on clear communication and employee education. Organisations must effectively explain how equity incentives function, the associated risks and potential rewards, ensuring employees have a realistic understanding of their benefits.

2. Regulatory Limitations: One of the challenges faced by organisations is incentivising consultants and promoters through stock options and other equity linked schemes. For instance, consultants who are associated with the company but are not on the payroll are missing out one these incentives as Indian law only allows for grants of stock options to be made to employees and directors. Similarly, company promoters are unable to receive equity incentives as the current regulatory landscape imposes barriers to them receiving equity-based incentives. Moreover, the absence of equitable compensation mechanisms for these essential stakeholders undermines morale and may ultimately hinder organisational growth and performance in the long run.

3. Liquidity Challenges: Employees may face financial difficulties when exercising stock options, particularly when the company has not undergone a liquidity or exit event such as an IPO or sale of the business, etc. In addition to the exercise price, employees are required to pay taxes on the difference between the exercise price and the stock's fair market value, which creates a significant financial burden.

4. Regulatory Framework: The Companies Act, 2013 prescribes certain conditions that limit the flexibility in structuring ESOPs. For example, employees need to wait for a period of 1 year before vesting any options that have been granted to them. Additionally, companies cannot grant shares for free unless the same is set up via a trust structure.

Future Outlook And Practical Strategies

Despite these challenges, equity-linked incentives continue to thrive. Companies are experimenting with complex structures to tailor incentives based on roles and performance metrics to motivate employees to perform better and get bigger payouts.

Employment incentives, while potent catalysts for both individual and collective success, must be accompanied by a clear-eyed realism. Amidst the numerous success stories surrounding such equity instruments, it is important to remember that these schemes also carry risks and not every incentive scheme yields real money to the employees. Therefore, knowledge of the workings of such schemes is key to ensuring employees have a balanced understanding of such equity instruments, enabling them to make the best decisions for their financial future.

The authors, Joy, Ramakrishnan, and Nair are partner, principal associate, and associate of Khaitan and Co, respectively. Views expressed are personal.