Three Factors That Make Employee Equity a Good Compensation Tool During These Uncertain Times

According to Forbes Magazine, the year 2020 saw one of the highest unemployment rates in the past 100 years (14.7%) and one of the sharpest falls in quarterly real GDP (31.4%).

Consumer spending, a major factor that drives the US economy, has taken a hit in several sectors, causing a drop in the revenues of businesses. In the wake of this pandemic, bleak economic environment, and dwindling business opportunities, companies need to tighten their belts in order to stay afloat. Each expense needs to be scrutinized thoroughly and reductions must be made or alternatives must be found wherever possible.

An expense that almost all businesses will have is the compensation of employees. Reducing the amount paid to them must be the last resort since it would impact the employees badly. A mechanism to ensure fair compensation to employees while being conservative in the outflow of a company’s resources is employee equity.

Employee Equity – A Win-Win Option

Employee equity refers to a method of compensating employees by earmarking a specific portion of the company’s equity or a fixed number of shares for them, in lieu of conventional cash payments or bank transfers.

Employees become part-owners of the business and their compensation is linked to the company’s performance. This incentivizes them to work towards improving the employer’s revenue and financials and conserves the company’s liquid resources. Employee equity or stock options give certain employees the option of purchasing the company’s share at a discounted rate. Equity compensation also helps in increasing employee retention.

In these uncertain times, employee equity is all the more helpful for businesses and employees since it unites them towards a single goal – maximizing the value of the company’s shares.

Why Should a Business Consider Employee Equity During These Unprecedented Times

Here are three solid reasons why most startups and even well-established businesses can consider employee equity amidst this COVID scenario:

1. Viable Alternative for Cash Payments

Multiple lockdowns, caps on capacity, cost cuts, a fall in commodity trade, and disruptions in supply chains have affected the smooth functioning of businesses. From clients who cannot pay up their dues on time to vendors who breathe down the necks of companies until there are no outstanding amounts, entities face cash crunches due to multiple reasons.

While working capital loans and overdrafts are options that can be considered, they come with a cost and impact the credit rating of a company. It is prudent to explore internal options for an organization to conserve its cash reserves.

One line item to consider while reducing the cash outflows is salaries. If the cash component can be reduced, it can greatly help the company’s liquidity. One way to do this is to compensate employees via employee equity. It does not involve any payment yet ensures adequate compensation to its employees.

2. Tax-Friendly Option

Stock options are tax-friendly both for companies and employees. For an employer who uses employee equity as a compensation tool, the contribution made to an option, either by way of issuing new shares or cash contribution, is tax-deductible within specified limits that are a percentage of the company’s earnings.

A company sets up an employee equity trust, which can borrow money to buy the company’s shares. These contributions are also tax-deductible. An S company wholly owned by stock options does not have to pay income tax on its profits. An S company at least 30% owned by options need not pay tax on 30% of its profits.

Employees do not have to pay tax on the equity contribution. For an employee, these are taxed in two instances.

1. At the time of allotment of shares
2. At the time of exercise of the option or sale of shares.

At the time of allotment, the difference between the Fair Market Value (FMV) and the Exercise Price is considered as a prerequisite and taxed accordingly.

Employees have the chance to plan their exercise and sale such that their tax liability is minimized, which is not possible if they are compensated in cash. For employees of C corporations where the aggregate equity is at least 30%, the tax on proceeds from the sale of shares that are reinvested in other securities can be deferred.

These tax savings for both employers and employees are a much-needed breather in the face of unexpected financial crunches due to COVID-19.

3. Opportunity to Understand the True Value of a Company

In light of the pandemic and its adverse financial impact, valuing a company is extremely important since the revised valuations capture the effects of the pandemic on the company’s revenue, profitability, financial statements, and value of equity. This will reveal the company’s true value to the management, which can help in decision-making and steering the company towards improvement. However, companies may not be able to do so since they might prioritize other activities.

By opting for employee equity as one of the reward mechanisms in the compensation package, a company automatically indulges in a valuation exercise on an annual basis since this is mandated by the Internal Revenue Service (IRS) and the Department of Labor (DOL).

According to regulations, an independent valuer who does not have any vested interest in the company’s value must be hired to perform the valuation. The IRS has defined the Fair Market Value of a share and prescribing guidelines for valuation.

Interim valuations are encouraged so that companies know where they stand and employees know the updated value of what is offered via equities.

Employee equity is an excellent way to reduce the load on the cash outflow of a company while ensuring fair compensation to its employees. To know more about rolling out employee stock option plans, click here.  

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