ESOP Academy 12: 9 Equity Management Mistakes to Avoid as an Employee
9 mistakes employees make when managing their ESOPs
Equity compensation comes in many forms. You may receive a portion of your compensation as equity in a form of options or RSUs. It’s also possible you receive a grant of restricted shares. In these scenarios, your equity allocation is determined as part of your total compensation. If your equity compensation is calculated as 10% of your base salary (e.g. $1,000), are you limited to receiving $1,000 in cash and $100 in equity?
If you truly believe in the potential of the company and want to maximise your exposure to the upside by increasing your equity stake beyond the set limit, how could you go about it? There are a number of ways to do so, and this in some circumstances can be done by converting your salary into equity. This can be achieved via specifically designed mechanisms and dedicated share plans, as well as through less obvious methods. Companies can also pull levers available to them to get creative in managing their cash burn in tough times by utilising equity compensation. Let’s explore all options that may be available to you.
This may seem like a straightforward answer, but not necessarily an obvious one. When receiving an employment offer or undergoing your performance review, you may be advised of your cash and equity split as party of you compensation. Have a chat with your employer if it’s possible to change things up.
Some organisations may even prompt you to evaluate a couple of alternatives. They realise that they are dealing with candidates with various risk profiles and may provide them with the choice of not just the equity instruments (options vs. RSUs is a common one), but also the split of their total compensation between cash and equity. You may be presented with a compensation slider where you will be able to select from a number of options (e.g. high salary & low equity vs. moderate salary & high equity).
Equity is a risky investment. For that reason, you should not assume that $100 in cash should directly correspond to $100 in equity. Just as any investor, you should expect to be compensated for the additional risk you are taking on and look for an equity multiplier greater than 1.0x.
Initial offer negotiation is a perfect time to fine tune your equity exposure and ensure your compensation suits your goals and risk profile. Depending on circumstances, there may not be much room to change your compensation structure (e.g. in larger companies and for junior roles), but it never hurts to ask and explore.
What about asking your employer if you can simply buy more of their shares? Often this is actually not as simple as you might think it should be for a few reasons that we will explore.
First one to highlight – if you are working for a startup that is not listed on a securities exchange, there is no liquid market where you can go and easily buy shares of your company. Unlisted companies would need to jump through a number of regulatory and administrative hoops to allow you to acquire shares.
If you are working for a listed company, especially a large global corporation, you are more likely come across Employee Share Purchase Plans (ESPPs). These plans are specifically designed to allow you to purchase shares in your own employer. But instead of sending your cash to your broker to buy these shares, you employer facilitates the purchases for you by using a portion of your salary.
If you choose to join your company’s ESPP, you agree to sacrifice a fixed potion of your regular pay for it to be used to buy company’s shares. These deductions are often called your contributions to the plan. You can expect for the pay to be deducted at the time of each payroll run, and the accumulated balance of cash used to acquire shares on a scheduled basis (which can range from monthly, quarterly, to bi-annually). Most plans have minimum and maximum limits of much you can contribute.
Note that in some countries employers don’t have the right to deduct a portion of your pay for the purchase of shares. There are workarounds, but we won’t go into too much detail here, as I am keen for you to understand the high-level mechanics.
An important question you should be asking if you join an ESPP is whether your salary will be sacrificed on a pre- or post-tax basis. In countries where income tax is withheld by your employer before you receive your pay, will your employer deduct tax first before using your contributions to purchase shares? Let’s have a look at two examples to better understand this.
Illustration: Salary $1,000, deduction of $100, tax of 20%.
Pre-tax: $100 is taken from pre-tax salary of $1,000, tax of 20% is deducted from remaining $900. You end up with $100 worth of contributions that will be used to buy shares, and $720 in cash after your post-tax salary is paid.
Post-tax: Tax of 20% is withheld on pre-tax salary of $100. $100 is deducted from post-tax amount of $800. You end up with $100 worth of contributions that will be used to buy shares, and $700 in cash after your post-tax salary is paid to you.
Seems clear that with pre-tax contributions to ESPP you end up with more contributions to buy shares, and more cash in hand. Why would you want to participate in a post-tax share purchase plan? Doesn’t seem like there’s much benefit. Why wouldn’t you just go to your broker and buy shares directly?
The questions above are valid ones. For that reason, ESPPs are often designed to offer employees some of the below benefits:
If you purchase shares via a broker, you may be charged various fees (e.g. brokerage, FX spread). Many employers pick up the bill and allow you to acquire shares via ESPP without worrying about any transaction fees on purchase. This is not a requirement for all ESPPs, so be sure to check the plan rules.
Company’s trading policies are often very strict when it comes to employees trading in shares of their own company. ESPPs are often exempt under securities trading policy of the companies, removing the need to pre-clear purchases and worrying about blackout periods.
Many tax regimes across the world allow ESPPs to be offered to employees with a key benefit of being able to pay a reduced purchase price. Discounts vary - plans like US 423 allow discounts up to 15% from the market price. Additional lookback provisions can make this even more attractive. Check the plan rules to understand what purchase price you will be required to pay.
Where no discounts to purchase price are offered, companies may instead offer matching shares. How does that work? For every X number of shares you purchase using your salary contributions, your employer will purchase additional Y number of shares for you. The ratio varies. Generous matching ESPPs offer 1:1 ratios, meaning for every share you buy, your company buys another one for you. You will need to note that matching shares usually come with restrictions – you will be required to wait for a couple of years before they vest. And if you sell your purchased shares during this window, you will likely forfeit your matching shares.
Different treatment of purchase and matching shares makes sense conceptually – shares you buy with your own money are yours to transact on as you wish from day one, but for matching shares you receive as a nice little benefit, your employer will want something in return (i.e. your continuous employment over the vesting period). The key here is to understand the rules and be mindful about the conditions attached.
Join the plan and you are done – your payroll will take care of salary deductions, and your HR and finance teams will manage the entire purchase processes. Sometimes it’s nice when things get done with minimal effort and involvement on your side. Sit back and watch your share portfolio grow over time - hopefully not just in terms of quantity of shares, but also their value!
In summary, ESPPs allow you to join a scheme where you give up a portion of your cash salary to allow your employer to buy shares for you with potentially some tax or financial benefits, with your company taking care of all the admin of it all.
As always, check the plan rules, but as a rule of thumb, since ESPPs utilise your contractual compensation, any unused contributions deducted from your salary will be returned to you. Similarly, purchased shares generally don’t have any forfeiture risk. You purchase those shares using your own money, so for that reason they are yours from day one, and generally don’t come with any vesting periods or restrictions. This applies to both a scenario where you decide to stop participating in the ESPP, or leave your employer (employees automatically cease participation as soon as they leave the company).
Note: there is a chance you may still lose your contributions and/or purchased shares in case of fraud or gross misconduct. But let’s hope it doesn’t get to that!
As mentioned earlier, matching shares are treated differently. As those are a nice bonus/benefit provided by your employer, they are often treated just like any other restricted/deferred share award.
With the above information in mind, ESPPs can be a good way to increase your equity stake and accumulate shares over time, potentially with some nice benefits offered by your employer.
Beyond ESPPs, salary sacrifice concept can be implemented in other ways. Your salary could be sacrificed into different equity instruments – most commonly RSUs or Share Rights. The easiest way to think of this approach is as a blend of negotiating your cash/equity split and ESPP.
In certain situations (like economic downturn, or after a poor year in terms of company’s financial performance), your employer may be considering ways to manage their cash outflows, and employee compensation may be one of the key areas they look into. Employers may opt to convert cash bonus into deferred equity awards, or even give you an option to sacrifice part of your pay into equity to manage their costs. If that’s the case, instead of receiving a certain cash payment, you may be allocated an award of equity instrument often subject to relatively short vesting periods – enough for company to turn things around and get on top of their cash outflows. Downside of this? Your take home pay may be reduced in the short term, but you may get the benefit of share price upside following the vesting of your additional equity awards in future.
However, this approach is not only used when things are not going well. Salary sacrifice into equity are used in other circumstances, too. This is a common approach for remuneration of non-executive directors. The sky is the limit for equity plan design (but the sky in the world of ESOPs is generally represented by the tax law and regulatory requirements). Don’t be surprised if you start seeing your current and future employers getting more and more creative with their equity compensation packages giving you a greater freedom of choice. The world of ESOPs is constantly evolving.