The year 2021 is popularly being referred to as the Midas year for equity linked instruments (ELIs). Without a doubt, the credit for this goes to the number of ELI buybacks and initial public offerings (IPOs) the year witnessed. An Economic Times report suggests that over 40 start-up companies spent close to INR 3,200 crores to provide liquidity to holders of ELIs.
ELIs are instruments that derive value from the common equity shares of a company. They may either entitle the holder to receive a share (as in the case of employee stock options) or an equivalent amount in cash (as in the case of phantom stock or stock appreciation rights). A typical lifecycle of an ELI involves granting, vesting and exercising of such instruments. If the exercise results in the holder receiving shares, an exit event is added to the cycle to provide liquidity to the employee holding shares.
ELIs are being viewed by the employee community as wealth maximizing assets and not just wealth creating assets.
In the past two years, the perception around ELIs has undergone an overhaul. In the initial phase, companies were using ELIs as a tool to reduce cash burn and defer bonus payouts and increments. Due to the impact of the pandemic and related uncertainties, employees feared that companies would not achieve the pre-pandemic valuations, let alone the valuations that would deliver lucrative returns for them in the future. Further, daunting experiences faced by employees of certain companies (who were allegedly denied the right to exercise vested options or did not receive the full value of the ELIs held by them), dissuaded employees from accepting such incentive structures as there were apprehensions that the terms and conditions associated with such instruments were designed to short-change employees for the benefit of the founders and venture capital investors.
In the past one year, however, founders and investors have managed to renew the interest of employees in ELIs. Today, ELIs are being viewed by the employee community as wealth maximizing assets and not just wealth creating assets. Employees, especially senior management employees, are looking for packages that offer a high component of ELIs with near-time liquidity and companies are obliging, after all, they are at war to retain talent.
Over the past few months, companies have come up with different strategies to make ELIs lucrative. The viability of these strategies is dependent on several factors, including the industry in which the company operates, investors' support and availability of cash in the company. Some of the strategies being used by companies are:
Implementing hybrid models that allow employees to receive shares or cash at the time of exercise
Given the challenges associated with the exercise of employee stock options and sale of shares, many companies are adopting a hybrid model in which employees may either receive shares or cash at the time of exercise. This model is quite prevalent in the global market as it is advantageous for both employees and employers. While this model secures immediate liquidity for employees, employers prefer it as it helps them limit the number of employee shareholders and reduces the administrative inconvenience associated with dealing with former employees at the time of shareholders' meetings, acquisitions, etc.
Shorter vesting cycle to provide attractive terms to employees
A typical vesting period ranges between 4-5 years to retain employees for a longer period. Tech companies are reducing the vesting period to 2 years or lesser to give employees more attractive terms. Companies are also moving to monthly or quarterly vesting over the usually preferred annual vesting. In fact, media reports suggest that Licious (a direct-to-consumer meat and meat products brand) has launched a program of everyday vesting post the mandatory one-year cliff. While such decisions may cause administrative hurdles and result in the employees leaving soon after the expiry of the vesting period, companies are ready to bear these risks as they acknowledge the importance of making employees feel valued in an industry where attrition is notoriously high.
Providing more liquidity opportunities
Buyback or IPO are not the only strategies employed by companies to provide liquidity to employees. Companies acknowledge that near-time liquidity is the need of the hour and are accordingly reserving cash from investments to allow anytime liquidity to ELI holders. News reports indicate that companies like Licious and Teachmint have accounted for ELI liquidity in their annual budget. The liquidity price is likely to be linked to the price at which the last investment was raised. This move is targeted to allow encashment at any point and not just when a sale, IPO or investment round occurs in the company. This is a marked difference from the ELIs of the past that were linked to sale or IPO events, which only seemed like a notional/paper option if such sale/IPO did not occur.
Top-up option for employees converting Cost To Company to ELIs
Companies are also encouraging employees to convert a portion of their Cost To Company (CTC) to ELIs voluntarily. On such conversion, the total cash remuneration payable to an employee will stand reduced to the extent of the value of the ELIs. Recently, Meesho announced a programme that allows its employees to convert 25% of their annual CTC into employee stock options, subject to a minimum of INR 50,000. With an intent to sweeten the deal, Meesho also announced that it will incentivize employees opting for such a conversion by topping up the ELIs by 15-25% depending on the employee's tenure.
Facilitating exercise and payment of taxes
In accordance with Indian tax laws, employees have to pay taxes at the time of exercising their ELI options. The rate of taxation is based on the applicable slab rate and is calculated on the difference between the exercise price and the fair value of the shares.
Traditionally, the exercise of employee stock options was linked to liquidity events to ensure that employees do not go out of pocket to pay those taxes. That said, in recent times, the companies are lending interest free loans (directly or through lending partners) to both current and former employees, to facilitate exercise (as was done by Paytm immediately prior to their IPO).
The recent amendment in 2021 to the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 allow companies to: (i) engage empanelled stockbrokers to make suitable arrangements to fund employees for payment of exercise price and taxes; and (ii) adjust such amount against the sale proceeds of some or all the shares of such employees. This is aligned with the global trend of sell-to-cover option that allows employees to sell some shares to cover for the exercise price and taxes. It will be interesting to see how listed companies use this option to facilitate exercise of ELIs in the near future.
While the investor community has played a significant role in bringing ELIs back into the limelight, it is also ensuring that incentive structures are carefully analysed before being approved.
While the investor community has played a significant role in bringing ELIs back into the limelight, it is also ensuring that incentive structures are carefully analysed before being approved. Recently, ELI related resolutions at a NIFTY 500 company were rejected by institutional investors based on the advice of a proxy advisory firm. The resolution was rejected due to the uncertainty around the exercise price and it being likely to be closer to the face value. The proxy advisory firm felt that lower exercise price reduces the risk element as employees earn a decent return regardless of a drop in share price. Accordingly, in the interest of transparency and fairness, it is advisable that schemes governing ELIs reduce unguided discretion to the board of directors or compensation committees on elements such as exercise price, vesting schedules, accelerated vesting, exercise events, exercise periods, treatment of ELIs in case of termination of employment or a change of control event.
Recent media reports suggest that the IPO frenzy is set to continue this year with USD 26 billion worth of issues in the pipeline. 2022 will be an interesting year to see if companies are able to live up to the expectations set by them, the steps they take to make the ELIs granted by them more rewarding than ELIs of their competitors and the impact the IPOs will have on the ELI returns.