Can ESOPs be a substitute for lower cash compensation?

Employee Stock Ownership Plans (ESOPs), a form of equity-based compensation, are a variable non-cash compensation in the Total Rewards strategy. These instruments are considered variable, as their value is tied to business growth, and non-cash, as they are realized through stock market transactions, with employees benefiting from the buyer of the instrument, not the employer. This article explores the importance of striking a balance between fixed and variable pay, emphasizing the growing preference for a substantial non-cash component in various industries.

Balancing Fixed and Variable Pay

Every company aims to achieve equilibrium between fixed and variable compensation. In certain sectors, it's customary to allocate a more substantial variable component across all job levels, while others gradually evolve their compensation philosophies in that direction. However, some traditional sectors, such as Construction and Trading, continue to heavily favor fixed compensation structures. Over time, companies typically transition towards the compensation model presented here. On the other hand, in some sectors, companies often start with lower fixed cash components, gradually replacing them with cash alternatives.

The intended evolution is clear, but what does it take to make it a reality? Can a company reduce fixed pay, increase the variable portion, and replace cash with non-cash variables? In this discussion, we assume the direction is given and focus on the steps needed to get there.

1. Reshuffling Variable Pay

The initial step involves reallocating variable pay by increasing the non-cash (ESOP) portion while reducing cash bonuses. At first glance, this shift seems straightforward because both types of compensation are linked to company performance. However, a deeper examination reveals key differences between the two.

• Performance bonuses offer immediate cash rewards to employees, while ESOPs start as options, convert into shares, and eventually yield cash. The transition from option to share requires an employee payment, and converting shares to cash assumes a liquid market for company shares, a challenge, especially for unlisted companies. While the first hurdle of paying the exercise price can be overcome by enabling cashless exercise, ensuring liquid market for the shares (of unlisted companies) is a must to realize cash.
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• The relationship between company performance and stock price isn't always linear. While they often move in tandem, external factors can influence stock market direction, even when company performance remains consistent. In such cases, employees have limited control over share liquidity or market behavior, making them cautious about taking risks.  

Nevertheless, employees have shown a preference for ESOPs, especially in unlisted companies where valuations have soared, as these instruments can surpass the capped performance bonuses linked to fixed pay.

2. Reducing Fixed Pay

Reducing fixed pay and expanding the non-cash variable portion, though beneficial, can be challenging. It may impact on the monthly take-home pay of employees, particularly at lower levels. Such shifts are typically more feasible at senior levels, where the sensitivity to a reduced monthly income is lower or where ESOPs are nearly equivalent to cash in terms of certainty.

Overcoming Challenges

ESOPs can effectively reduce cash compensation if companies address the concerns related to liquidity of share market and exercise price being too high to reduce the possibility of paying upfront. Ensuring share liquidity is crucial, especially for unlisted companies, and can be achieved through company buybacks, investments from existing or new stakeholders, IPOs, or cash settlement of options. While the lack of a direct correlation between performance and stock price movement is a reality, employees should be adequately informed about this risk. Offering a safety net mechanism is an option, though subject to debate.

Globally, ESOPs have proven instrumental in reducing cash compensation. In India, companies that have implemented ESOPs for 7-10 years have witnessed employees enjoying significantly higher cash-in-hand benefits compared to standard performance bonuses. Consequently, the answer to whether ESOPs can replace cash compensation is not a simple "yes" or "no." Instead, it's a nuanced consideration of possibilities and achievements in aligning employee rewards with organizational success.