Equity Based Compensation

A discussion in CiteHR http://www.citehr.com/284260-design-equity-based-compensation-start-up.html

The compensation of company is driven by several factors including market competitiveness, cost containment, internal equity, transnational mobility and compliance. The performance of company directly depends on the performance of its assets. Hence, designing an empirical compensation structures which would drive performance. This structure is known as Equity Based Compensation. This allows an employee to opt for the stock options. This program ensures an equal distribution of profits between the shareholders and employees.

The steps to design it begin with setting a time-limit, such as five years during which the employee needs to work in an organization. There would be a cap to the equity, mentioning the percentage for each role and level. The rewards for performance achievements in a year need to be designed in it. For e.g. : there can be a Business Performance Equity  designed at 12 % of the market rate or share price  valuation of the company  ,which needs to accumulates for five years for the employee to claim it. In addition to this, a solution Equity is designed , for the employee  ,to  target any  remarkable service or solutions offered to the company, such as new product designed or gross sales increase and etc. The solution equity would be defined by a specified percentage of the fixed salary, e.g. 120% of the base salary or basic. The roll out for the incentive can be directly tied to the cash-flow cycle of the company to negate the strains on it.  As defined by Thomas J Hackett and Donald G McDermott, “The plan detailed specific goals for company revenue, earnings before interest and taxes (EBIT), and profitability. Based on the plan, the sooner the company achieved its EBIT targets, the sooner each executive  entitled to a percentage of the EBIT generated. The executives could then choose to receive payment in either cash or additional equivalent shares of company stock based on valuation at that time.” The taxation can be set are per the compliances .Generally an employee do not get taxed when the shares are credited. It would become taxable when the employee  sells it, strictly according to the taxation guidelines. The structure needs to be deigned keeping the International mobility in mind. A hybrid form may be introduced in case the employee is put into the expat program. The employee would become taxable as per the country’s governance. Hence the structure needs to be designed so that the base salary can make up with the market competitiveness and cover the shortfall modestly.

There are different kinds of equity pay practised within the industry. Disney restricts the option and sets vesting dates against S&P 500 .Microsoft offers performance oriented equity award, where the incentive for three years is attached to the customer and customer satisfaction. Whereas Cisco practice market based valuation option. Nokia exercise performance shares to maintain focus on performance for  long term incentives

The disadvantage to the Equity Based Compensation lies in the motivation as it may not always work in the right direction.  Using this as a retention tool often backfires as the disgruntled employee may stay till the stocks vest. This affects the employer adversely as the employee may not be completely productive and remain toxic to the environment.  As shared by Steve Robins in his working paper, Is Equity Based compensation a good thing, He quotes that Warren Buffet has a different take on it. According to him, the capacity to grow business and reinvest increases the share prices. He believes in paying bonus contingent to upon their producing actual results above ROE.

The aim of the compensation plan is to keep employees motivated and accountable to their roles. The goal is to tie the non-owner with the company for a long term to enhance performance. In the words of Warren Buffet ,“The approach and strategies are very similar in that you gather all the information you can and then keep adding to that base of information as things develop. You do whatever the probabilities indicated based on the knowledge that you have at that time, but you are always willing to modify your behaviour or your approach as you get new information. In bridge, you behave in a way that gets the best from your partner. And in business, you behave in the way that gets the best from your managers and your employees” .