In the early stages, company founders typically look for various ways to curb spending on labor; equity compensation may be one way to reduce ongoing costs and provide compensation to employees that is non-cash. This is an especially common practice for startups that can’t afford to pay high wages. To be more competitive and to motivate employees, they frequently include some form of stock benefits in their job offers.
Equity remuneration, also known as stock compensation or share–based compensation, is a non–cash payout to employees that can be issued in various forms. Usually, employees who receive this benefit eventually gain a stake in the company, which means they own a portion of the company and its profits. Overall, equity compensation is a great way to create a dedicated relationship with employees. For instance, in 2017, Amazon paid about USD$4.2 billion of share-based compensation to its 560,000 employees.
For the purpose of this blog post, we will discuss the most common forms of equity compensation available to private companies. These types of equity are similar but may have different consequences for your Singapore company in the long run. We will explain how they differ to help you decide on a suitable structure when incorporating your Singapore company.
Consider Singapore for incorporating your new venture, as it offers rather low corporate and personal tax rates, no tax on capital gains and dividends, and a wide range of incentive and tax relief programs.
Stock, restricted stock, and stock options
A stock is a financial instrument that represents ownership of a portion of a company. The degree of ownership is determined by the number of shares owned. Depending on the type of shares held, they may entitle the owner to an equivalent proportion of the company’s assets and profits. Owning stock may give you the right to vote at shareholder meetings, receive dividends (basically, the company’s profits), and sell your shares. If you own a majority of shares, your voting power increases. Due to these rights, the stock of a company can have value and be sold for that value.
What is restricted stock?
Restricted stock is an award of equity in a company that represents actual ownership of the company’s stock; however, it has certain limitations. Restricted stock is usually issued for the purpose of motivating employees by giving them part ownership in the company. Restrictions on ownership are usually imposed in the form of a vesting schedule or performance conditions that must be met before full ownership rights in the stock are transferred to the recipient.
Often, restricted stock is granted in the early stages of a business, when the company has not built its value yet and its stock worth is low. Once the company grows, issuing restricted stock to employees becomes more difficult and unfavorable for the company.
Why issue restricted stock?
As stockholders are not able to sell their stock before a certain event (which usually takes several years), granting restricted stock to company employees can protect you from premature selling of your company’s stock that might negatively affect your business or your control of the business.
It’s also a good retention instrument that motivates employees to continue working at the company until particular objectives are met. If an employee eventually decides to leave the company and has failed to meet the predefined company goals, s/he may have to give up ownership of the restricted stock. In this case, the company has a right to repurchase certain unvested shares at the nominal value. This legal tool will help you retain control within the company and avoid giving away ownership to former employees or third-parties who have no interest in the company’s growth.
Be careful about granting restricted shares to your employees, as they may participate in decision-making activities that may directly affect your business operations. It’s better to grant restricted stock to executive managers or directors, who are more likely to stay longer with the company than average employees.
What are stock options?
Stock options are also a form of equity compensation; however, unlike restricted stock, they give an owner not actual ownership in the company, but the right to purchase a specific number of shares at a predetermined price on or after specific dates. Employees should be working in the company for a prescribed period before they can actually exercise this stock, and they must choose within this timeframe otherwise, the option will expire. Stock options can also be granted with vesting schedules that limit the employee’s ability to exercise the stock option. Employees can use various methods to exercise their stock options.
Why issue stock options?
Granting stock options to your employees gives them certain benefits. If the company is operating well, the stock’s fair market value will be significantly higher by the time the options vest.
Stock options give the employee an opportunity to profit from the difference between the exercise price and the actual market price at the exercise date. So, if the company’s value rises, employees profit as well.
Until employees exercise their stock, they are not actually putting anything at risk, as they are not putting their money down upfront. At the same time, stock options have a high possibility of becoming worthless if the stock price remains below or declines to below the option exercise price.
One benefit of stock options for the company is that the employee receiving the option actually does not obtain voting rights or rights to any dividends, or any other privileges that may come along with usual stock ownership in a company. Any value in stock options is rather theoretical until the exercise, as an employee is not a stakeholder yet when options are granted.
Also, it does not cost an employer anything to issue stock options, while providing an incentive to the employee to accept a lower salary. For instance, employees can be compensated 70% in cash and 30% in company stock options. Using this tool, companies can free up funds that can be allocated to other needs of the business.
How do they differ?
Restricted shares and stock options are both forms of equity compensation awarded to motivate employees. Restricted shares are most often granted by established companies, while stock options are popular among startups that have not yet gone public. Restricted stock is usually issued to the company’s executives and directors, whereas stock options are more popular awards for average employees.
Key factors that differentiate stock options from restricted stock are:
- Expiration date. Stock options usually have an expiration date by which they must be exercised, so employees should define when they would like to purchase their shares. Restricted shares do not expire, since they are issued once the employee is vested.
- Exercise price. Typically the price reflects the stock’s fair market value at the time the option is granted. Basically, this is the price at which the employee can purchase shares. Restricted stock, on the other hand, is issued without a requirement to purchase, so there is no exercise price.
- Shareholders’ advantages. Unlike stock options, restricted stock may entitle the recipient to the same rights and benefits as any other shareholder, i.e. to receive dividends or voting rights, etc.
- Exercise method. This defines how employees pay for the purchase of the option in the future (e.g. cash or stock swaps). For restricted stock, this is irrelevant, as the stock is not purchased by the employee.
Example
One employee was granted restricted stock from the company that vests in 12 months. Another employee was remunerated with stock options that also vest in 12 months. The first will automatically receive the shares after one year (if the employee has remained employed at the company for one year), whereas the second employee will be given the opportunity to buy the stock at the exercise price after one year (if the employee is still employed at the company).
Which one is better for your company?
Often, which type of stock is better depends on your goals. The two driving factors for the company are (i) what does the employee or other recipient want; and (ii) whether you want this person to be a stockholder and directly take part in the company’s operations or not.
When you give someone a stock option, providing they vest through the option, they have the ability to become a stockholder if they pay money to exercise the shares. But not everyone is willing to do so. At the end of the day, you may end up with fewer stockholders, as employees may choose not to exercise their options.
This may happen when employees leave the company too early, or they may not have funds to exercise their options, or simply don’t believe in the company’s vision. If you had granted them a restricted stock, they’d basically become a stockholder and could exercise their ownership. Companies can typically repurchase some unvested shares, but whatever stock the employee has vested, he or she owns it and can easily walk away while remaining a stockholder.
About CorporateServices.com
Headquartered in Singapore, CorporateServices.com, empowers global entrepreneurs with information and tools necessary to discover Singapore as a destination for launching or relocating their startup venture and offers a complete range of company incorporation, immigration, accounting, tax filing, and compliance services in Singapore. The company combines a cutting-edge online platform with an experienced team of industry veterans to offer high-quality and affordable services to its customers. Contact Us if you need assistance with setting up a new Singapore company or if you would like to transfer the administration of your existing company to us.
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