Employees Compensation choices: RSU vs ESOP vs SAR

Having the right employee benefits plan helps companies in many ways apart from increasing employee retention. Founders can use different equity-based compensation methods to align employee and company interests.

Employee stock options plans (ESOPs), stock appreciation rights (SARs), and restricted stock units (RSUs) are all different ways of providing equity-linked compensation to employees. They help founders reward employees and keep them motivated and feel valued.

In this post, we’ll cover the difference between ESOPs, SARs, and RSUs. Before discussing that, let's first understand each of these employee compensation types and their advantages and disadvantages.

Employee Stock Options Plan (ESOP)

Employee stock options plan (ESOP) refers to an employee benefit plan under which a company grants stock options to its employees. Companies use ESOPs to attract and retain talent by allowing their employees to purchase shares of the company at a price fixed on the grant date.

You may want to familiarize yourself with the terms related to ESOP

The company grants a certain number of stock options to employees (stock grantees), which vest over a certain period.

Once stock options get vested, employees can purchase shares by paying the exercise (strike) price. The exercise price is usually lower than the market price (fair market value), which results in a notional income for the employees and taxed as income from salary.

Taxation on Employee Stock Options Plan (ESOPs)

The notional income is calculated as the difference between shares’ fair market value (FMV) and the exercise price.

Notional income = Market value of shares - Amount paid by the employee

The employees need to pay the tax on this notional income based on their tax bracket. Furthermore, when employees sell the shares, they are taxed again. This is considered as a capital gain for the period during which they hold the shares. The difference between sales value and the fair market value of the shares at the time of exercise is considered a capital gain.

Income from capital gain = Market value at the time of selling the shares - Market value of the share at the time of exercising the shares

ESOP Taxation

Stage 1: At the time of exercise

Notional/Perquisite income from options = Difference between the fair market value of stock and exercise price * Number of the options exercised Tax on perquisite income = Tax as per regular slab rate for individuals

Stage 2: At the time of sale of the shares

Capital gain on sale of shares

• Listed company

Short term capital gains when shares are held less than 12 months

Long-term capital gains when shares are held more than 12 months

• Unlisted Company (Startups)

Short-term capital gains when shares are held less than 24 months

Long-term capital gains when shares are held more than 24 months

Pros of Employee Stock Options Plan

• Aligns employees' interests with the shareholders.
• Compensate for lower salaries for acquiring good candidates, when startups have limited cash.
• Motivates employees to create value and helps in retention.

Cons of Employee Stock Options Plan

• Dilutes ownership of the founders, as the company has to create a dedicated option pool for the employees.
• Employees have to pay an exercise price.
• Employees have to pay taxes twice, first at the time of exercising and then at the time of selling.
• Can be a negative investment for employees, in case the share price goes below the exercise price.

ESOPs come with complex rules and regulations and require companies to maintain accurate records. Qapita, an equity management tool, makes it easy to grant and administer ESOPs.

Stock Appreciation Rights (SARs)

Stock appreciation rights (SARs) is another employee compensation method in which employees are given an amount equal to the appreciation in the value of the shares over a specific period.

This amount is equal to the difference between the market price on the date of vesting and the strike price and is settled in cash or shares.

For example, consider an employee who earns 1000 SARs. The SARs vest after 3 years and the price of the share increases from Rs 500 to Rs 700 during this time. Then, the employee receives an amount equal to Rs 200,000 (1000*(700-500)).

Employees do not have to pay any amount (the exercise price), and it automatically gets vested after completion of the period. The perquisite received is taxed as the salary income on the employee’s tax slab.

Taxation on Stock Appreciation Rights

Advantages of Stock Appreciation Rights

• No dilution of ownership for the founders, as a company can give cash to the employees.
• Employees don’t have to pay money to exercise it.
• It is simpler for employees because they do not need to sell the shares to realise cash.

Disadvantages of Stock Appreciation Rights

• It is taxed at ordinary tax rates which are higher than shareholder tax rates (capital gain tax). Therefore SARs results in higher tax outgo when compared to an ESOP scheme.
• Founders need to be sure that they have sufficient cash for the payouts.
• Founders need to commit to a timeline for a takeout.

Restricted Stock Units (RSUs)

Restricted stock units (RSUs) are another type of compensation benefit for employees. They are deeply discounted options usually given at the face value and often granted to the employees based on their performance.

They have a predefined vesting period or targets and get automatically vested based on their completion.

Note there is a major difference in how RSUs work in India and the US. In India, though the strike price is very low compared with the market price, employees still have to exercise the option by paying the face value of the share.

On the other hand, in the USA, RSUs are stocks that employees own as they vest. Employees don't need to purchase them. Unlike in India, it's a one-step process in the US, as there is no concept of exercising in RSUs.

Taxation on Restricted Stock Units (RSUs)

Advantages of Restricted Stock Units

• Employees have to pay very little (India) exercise price or not at all (USA).
• Encourage employees to give their best and achieve the target as it is rewarded based on performance.
• As RSUs are not real stocks, companies don’t have to expand their pool or keep track of it.

Disadvantages of Restricted Stock Units

• Employees don’t get dividends as RSUs are not real stocks.
• RSUs cannot be sold or transferred while the company is still private.
• Tax implications to the company and restricted stockholders can become complicated.
• Potential buyers of the company may not be interested in the restricted stocks.

Differences:

Thinking to Draft an ESOP scheme? Get in touch with us and we will introduce you to our ESOP experts.

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