Increased Pay Check or Sweat Equity Shares?

 18 June 2020   |    Common Post Research

Organizations during this pandemic struggle to evaluate the cost and need to retain employees. The idea of owning an Organization’s shares in recognition of intellectual contributions of promoters and employees can provide a valuable tool to retain talent and build organizations.



 

During 2018, a study conducted by Dennis Campbell, John Case and Bill Fotsch and insights documents in an issue of Harvard Business Review reported “Companies can no longer offer the security of five decades ago but they can compensate with substantial learning’. They further in their article observed “we need to re-define what makes a blue-collar job good. The traditional job was well paid and secure. Going forward, employers should offer workers a stake in the company, reward their contribution to the company’s success, and provide opportunities to acquire portable skills.’

As the onslaught of the coronavirus pandemic continues job security across employees across various segments and roles have seen rippling emotions – of anxiety, mixed sense of motivation and overall purpose of work. As organizations struggle to evaluate the cost and need to retain employees, provide an incentive model - promotion or compelled to temporarily layoff or extend salary cuts across segments of employees or specific department, the idea of owning an Organization’s shares and holding on to it for a relative longer period of time can provide a valuable brick to build on.

Proctor and Gamble during 1997 granted its 1,06,000 employees across the globe an opportunity to buy up to 100 shares of the company’s stock. As on 1997, the management said 75% of the employees owned Proctor and Gamble stock. As on 2018, Proctor and Gamble had apportioned 10 to 20% of its shares in the hands of workers.

Internal Organic Growth Vs External In-organic Growth

The traditional way of understanding growth in any company is either they deploy strategies in synergy with internal organic growth policies wherein the Company Owners develop their own products and thereafter launch the same in market. The external growth strategies would involve acquiring new line of businesses or products and thus though faster but riskier as majority of the success depends on employee and management cooperation in acquired company. Issuing Sweat Equity shares are seen as internal policies which encourage managers and employees to innovate and research and to handle difficult situation arising out of new ventures within the Organizational set up. While as external inorganic growth strategies deploy takeover, mergers and acquisition route which can adversely impact the motivation and engagement levels of employees in the target company. However the impact may vary across sector. Example the above analysis may hold good for skilled employees in automobile sector. However an inorganic growth strategy may not adversely impact an Organization in the technology sector or technology market place (E-Commerce Acquisition).

Framework of Shared Capitalism and Employee Owned Business

The concept of sweat equity shares stems from Employee Owned Business (“EOB”) models. The entire discourse on Employee Owned Business is also mingled with available theories under ‘Shared Capitalism’. Employee Ownership is a complex phenomenon and can be analyzed using different parameters – from involvements in certain decision making, voting and veto rights to mere apportionment of shares in favour of the employees. Academic Research on ESOPs became active in United States in the late 1970s and Broad-Based Employee Stock Option Plan (BBSOP) emerged in late 1990s following high tech boom in USA.

Quoting author Dennis M Rousseau and Zipi Shperling in their research paper

‘Pieces of the Action : Ownership and Changing Employment Relationship’ in page 564 and 565 of Academy of Management Review (October, 2003)

"To successfully start new firms or enhance growth in existing ones, workers must generate value greater than their current compensation. Sharing ownership privileges can provide appropriate incentives to generate this value, particularly among highly skilled workers contributing substantially to the firm’s competitive advantage.
Bundling equity and profit sharing with financial information and participation in decision making can enhance worker contributions to the firm by creating employment relationships based on congruent psychological contracts. Such a bundle can form the basis of trust and aligned interests between workers and employer”

 

Hear the full Article

Benchmarks for Start Ups / Entrepreneurs

Post 2016, another category of Organizational Owners was introduced that is ‘start ups’ and the definition of start ups were set out in notification number GSR 180(E) dated 17th February, 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of lndia.

A start up can issue sweat equity up to fifty percent (50%) of its paid-up capital. The start ups can issue sweat equity shares upto a period of five years from the date of incorporation.

However on 5th June, 2020 - Notification Amending Companies (Share Capital and Debenture) Rules, 2014 only so far as relaxations provided to a Start Up. This period of five years have been extended to ten (10) years from the date of creation (incorporation). 

Thus, start ups can now issue sweat equity shares to its promoters and employees upto a period of 10  years from the date of incorporation. 

Taxation on Stock Redemption


Since 1998 in India the redemption of stocks was taxed as ‘perquisites’ which had to borne by employees. If shares are allotted at a price less than its fair market value, the differential amount between fair market value and allotment price will be taxed as a ‘perquisite’ income which the employee has to pay

Illustration 1

The share price of an automobile company has seen one of the widest fall in this global pandemic. Assuming the share valuation as on 2017,  Employee X was allotted 200 shares.
During the time of allottment the fair price was Rs.6000/- per share but shares were allotted to the employee at the rate of Rs.3000/- at the time of allotment. During the time of redemption, the employee may be eligible to encash the entire corpus of 200 shares at the rate of Rs.6000/- which is almost Rs.12,00,000/-. The differential amount between Rs.6,00,000/- and Rs.12,00,000/- will be taxed and such taxes borne by employees.

Post Pandemic and disruption of share market the share valuation of such company may not be higher than the allotment rate. Further, there is a possibility that the share valuation may fall further below the allotment price at which the shares were allotted to the employees.


However, after 20 years, the discourse in view of the transformational ideas on increasing the outreach, applicability and access to sweat equity shares of an Organization have increasingly trickled down to the employees of wider segment and experience level.

The way the stock option are redeemed and benefits arising from the redemption also needs re-evaluation post the tectonic shifts observed post the coronavirus pandemic.

 

Employee Stock Option Plan (ESOP) – Vs – Sweat Equity Share

ESOP provides an opportunity to all employees irrespective of whether they contribute towards value additions or intellectual property to partner with the financial outcome of the Organization (including a start-up).

ESOP will massively benefit employees wherein the Company or start up has grown financially like Facebook, Makemytrip etc. However, if the Organization or Start Ups are unable to scale up and increase its valuation ESOP may not massively serve as a viable alternative to motivate employees to work when there is a pay cut or trimming of bonuses and other perquisites.

However, in the grant of Sweat Equity shares employee contribution to the know-how, unique skill and intellectual capital are core considerations. Sweat Equity Shares are allotted upfront and there is no vesting schedule. However, the shares are subject to a lock in period of three years from the date of allotment.

'Company Owners' to whom the Rules set out above applies -

  1. Promoters of Private Companies,
  2. Listed and Unlisted Public Companies and
  3. Start Ups


The questions is can the extended time frame for start ups really drive them to float more sweat equity shares to incentive their employees. Are relatively matured companies looking to avail the option of issuing sweat equity to its employees as a dependable incentive factor to hire or retain employees?

 


Common Law Chambers Research drawn from the experience of drafting and advising on employee stock option scheme and feedbacks received from its empanelled Company Secretaries.


Important Links

  1. https://www.sebi.gov.in/sebi_data/attachdocs/apr-2017/1492085873402.pdf
  2. https://www.nytimes.com/1997/11/07/business/company-news-procter-gamble-to-offer-stock-options-to-employees.htm
  3. https://hbr.org/2018/01/more-than-a-payche
Reading List
  1. https://scholar.harvard.edu/files/freeman/files/do_broad-based_ee-profit-sharing-so_help_best_firms_do_even_better_bjir-final-ms_5-10-15.pd
  2. https://pdfs.semanticscholar.org/2582/e3b02c8553786cb3efadc5dcf0f3724dde78.pd

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