Equity Compensation

Author: | Published: 4 Jan 2001
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Equity incentives, the seemingly standard component of any compensation package in Silicon Valley, are being rapidly adopted by companies based in Asia. These popular plans seek to motivate, retain, recognize and reward the best available personnel by providing additional incentives to employees, directors and consultants, which align the recipients' interests with those of the company, thereby promoting the success of the business. In today's tight labour market, competition for quality personnel is stiff. Without the promise of equity incentives many companies, internet start-ups and established old economy firms alike, would have difficulty attracting top quality staff. In adopting equity compensation schemes, many companies in Asia look to US stock option plans, particularly "Silicon Valley" style plans, as a model. However, differing legal, tax and accounting rules in Asian countries mean that modifications must be made to the US model.

The US Background

In the US, share or stock options have traditionally been the most common form of equity incentive. Simply put, an option bestows the right to purchase shares in the granting company at a fixed price (the exercise or "strike" price) for a specified period of time (the term or exercise period). Stock options are favoured by companies, in part, because they are understood to create a direct link between the participant and the company. Because the exercise price is typically set at the actual value of the stock at the time of grant, the employee will profit from the option only if the company's stock increases in price. The terms of equity incentives vary based on strategic goals, corporate culture and other considerations applicable to the particular company, including the need to be competitive in recruiting and retaining key employees.

Beneficial accounting treatment, as well as favourable tax and securities law treatment, have greatly expanded the popularity of stock options in the US. While the recipient of the option (grantee) receives an uncapped upside potential equal to any increase in the price of the stock, the company is not required to deduct the value of the grant from company earnings (despite a potentially negative impact on earnings per share), and the company typically experiences positive cash flow when the grantee exercises the option. To tie the grantee to the company, most options vest over a period of time and require the forfeiture of some or all of the options if the recipient's employment with the company terminates before the end of the vesting period.

The US Internal Revenue Code requires stock options to be classified in one of two categories for tax purposes: either as incentive stock options (ISOs), or as non-qualified stock options. If the options qualify for ISO treatment, the taxpayer will be allowed to account for appreciation over the exercise price as capital gains. While countries such as Singapore and Hong Kong do not impose capital gain taxes, this is significant for US tax purposes, as this reduces the holder's US tax burden on the appreciated amount from almost 40% to 20%. The taxpayer can also defer payment of this tax liability until the eventual sale of the stock. In exchange for this preferential tax treatment, the Internal Revenue Code places specific restrictions on ISOs regarding eligible recipients (employees only), exercise price, term, exercise flexibility, holding periods before a subsequent disposition of shares, and other requirements. For the majority of US companies, the regulatory restrictions and the most significant disadvantage of ISOs – the inability of the issuing company to take an offsetting tax deduction equal to the participants' gains (except in the case of a disqualifying disposition) – are tolerable in light of the tax savings and deferral opportunities afforded by US law.

Non-qualified stock option treatment allows the company to deduct the participants' gains as a compensation expense, but does not provide the attractive tax rate differential and deferral opportunities for the grantees. Non-qualified option participants pay tax at the higher ordinary tax rates on the difference between the exercise price and the fair market value of the shares when the option is exercised. Capital gains tax on any additional increase in value applies upon subsequent sale. On the plus side, non-qualified plans are not as heavily restricted by legislation in the US and so allow for much greater design flexibility. In either case, US companies have grown very comfortable with structuring plans and integrating the tax and accounting implications into their compensation structure.

Equity incentives in Asia

This sort of comfort level in structuring option plans has yet to be reached by companies doing business in Asia. Asian companies, as well as foreign multinational corporations doing business in Asia, are rushing to implement incentive plans in accordance with their own internal goals and policies and to be competitive with the perceived Silicon Valley standard. Since accounting, tax, securities laws and other regulatory factors play a very important role in the design of equity incentive plans, the specific legal and regulatory climate in each country in which a company operates and employs personnel must be examined to craft an equity incentive plan which promotes the goals of the company in that country in the most productive manner. Additionally, many companies in Asia hire US tax-paying employees who would like ISO treatment for their options. Successful companies will need to understand the implications of their local operating environment as well as their employees' needs, before adopting a Silicon Valley plan that may or may not address all of their goals.

Foreign exchange and other restrictions

A typical US plan does not contend with foreign exchange regulations; however, Asian plans may need to address these restrictions. For example, citizens of the People's Republic of China (PRC) may own options or shares of a foreign company, but exercise of the option or sale of the shares will trigger foreign exchange control issues. Foreign exchange laws also generally prohibit compensation of Chinese citizens in any foreign currency. Further complications arise for domestic companies in the PRC, as PRC law does not recognize the concept of authorized but unissued capital, and all registered capital must be paid up. These factors, combined with state-owned assets issues, make the notion of a US-style option plan difficult to apply there.

Companies are exploring trust vehicles, derivative securities such as stock appreciation or dividend rights, performance units and phantom stock, or a system providing for same-day sale upon vesting of exercise rights, as possibilities for the granting of direct share options in the PRC and other markets. Unfortunately, such alternative structures may not accomplish all of a company's goals in adopting an incentive plan, and may raise additional issues for the company adopting them that were not foreseen. For example, use of a trust vehicle may complicate registration of the underlying shares for US securities law purposes. Further, for US taxpayers, ISO qualification may be sacrificed, as ISOs cannot be granted to a trustee of a trust, and other mechanisms may fail to meet the ISO-required holding periods. Additionally, the adoption of a trust or re-sale system may result in additional administrative costs, regardless of whether the rights are ultimately exercised.

Tax considerations

One reason that the US stock option model is so successful is that tax for grantees on the optioned shares is not due until the time of ultimate disposition in the case of ISOs, or the time of exercise in the case of non-qualified stock options. This important tax provision ensures that option holders will have the means to pay the taxes due, even if some of the exercised shares must be sold to satisfy the tax obligation. Similarly, most Asian countries tax options at the time of exercise or purchase. However, when operating in a jurisdiction that imposes tax at the time of option grant, consideration may be given to a tax loan, bonus programme, or other mechanism designed to ensure that grantees have the ability to pay any associated taxes.

Local tax laws in general, and with respect to options in particular, are subject to rapid change. Many countries are examining taxation of options and making changes. Earlier this year Singapore announced its new Entrepreneurial Employee Stock Option Scheme which provides extensive tax deferral and savings opportunities to employees of certain Singapore-based companies which meet the requirements of the government-announced framework. One reason cited for this change was the need for Singapore companies to compete effectively for top talent. More countries may enact similar proposals in an effort to remain competitive.

Taxes owed by the option holder are on one side of the tax equation, while corporate taxes of the granting company are on the other. Before adopting a plan, a granting company must determine whether it will be able to deduct the grant as a compensation expense and at what point the deduction can be taken. As noted above, American companies generally are not entitled to a compensation deduction for ISOs, but are permitted to take a deduction when grantees exercise non-qualified stock options. Because tax and regulatory laws differ so dramatically from country to country, it is essential to obtain tax and legal counsel in each jurisdiction in which employees or other participants reside, before including them in any particular option plan.

Securities laws

Companies offering options in multiple countries must comply with the securities regulations in each jurisdiction. Foreign companies issuing options to people resident in the US must comply with federal law as well as state securities regulations or "blue sky laws." US federal securities laws require that the offer and sale of securities (an option is considered to be a security) must either be registered with the Securities and Exchange Commission (SEC) or be exempt from registration. A legal analysis of the plan and the pool of grantees is required to ensure SEC compliance. To ensure compliance with blue sky laws, the company should note the particular states of the US in which grantees reside. For example, when granting options to an employee in California, in addition to complying with all federal securities laws, certain filings at the state level may be required in order to qualify for necessary state securities exemptions. Failure to comply with such laws can have negative and potentially costly consequences, as the grantees may be able to rescind the options or take back the exercise price if the shares have lost value.

Accounting issues

Any company listing shares on a US stock exchange will have to deal with US accounting laws, as listing rules require that companies present their accounts in accordance (or reconciled) with US generally accepted accounting principles (US GAAP). Under US GAAP, most companies grant options at current fair market value, with a fixed vesting term, and do not record any compensation expense. The idea is that if the options are granted at fair market value, the company does not incur any expense at the time of the grant. However, when the share price increases and the option is ultimately exercised, the company would, in theory, have a large compensation expense because it must sell the option shares at a price significantly lower than the market price at the time of exercise.

US GAAP allows companies to note this difference in a footnote to the financial statements, rather than requiring the company to record an expense.

Under US GAAP, if the exercise price and vesting dates are not fixed at the time of the grant, companies must employ a method of variable plan accounting, whereby quarterly compensation charges, usually equal to the difference between the grant price and the current market price, are recorded and reflected in the income statement. Repricing and other modifications of fixed option terms can also trigger variable plan accounting. In such cases, vacillating stock prices will cause wide swings in corporate profits, making the job of predicting profits almost impossible. For a publicly traded company, this is likely to cause unmanageable volatility in the price of the company's shares. Therefore, option plan features that could result in variable plan accounting treatment should be avoided whenever possible by companies that keep their books under US GAAP.

Plans in which option vesting is dependent on the attainment of certain financial or other performance benchmarks typically require the application of variable plan accounting under US GAAP because the vesting dates of such grants are uncertain. So-called cheap-stock issues (a term used by the SEC to describe options granted to employees with an exercise price considerably lower than the fair market value of the shares at the time of grant) can also have negative accounting consequences under US GAAP rules. Local accountants and attorneys can often minimize exposure in these areas with proper consultation before option grants are made.

Listing rules

In private companies, demand for stock options is fuelled by a hope that the company will make an initial public offering (IPO) of its shares on a stock exchange. In drafting their option plans, companies should consider where such a listing might ultimately take place. Most exchanges have rules for option plans. Many, including Nasdaq, Singapore and both Hong Kong boards, require shareholder approval. Singapore and Hong Kong go further and have set up substantive rules governing, among other things, eligible participants, exercise price, maximum number of shares eligible, and exercise term. Many exchanges provide for the grandfathering of existing option grants under the pre-IPO plan without disturbing their terms. In such cases, the terms of both must be disclosed. While Nasdaq does not impose rules covering the terms of an option plan, companies planning a Nasdaq listing are advised to consider US GAAP accounting issues and US securities law issues well in advance of starting the listing process.

Other concerns

Many Asian companies employ US taxpayers who want ISO-qualified stock options, and many decide that it is worth the added administrative burden to establish ISO plans. As the US provisions are very technical and generally not required for non-US purposes, companies may choose to maintain one plan for US employees and one plan for non-US employees. If more than one plan is maintained it is important to note that share limit restrictions generally apply to all plans in operation, not to each individual plan.

Summary

Equity compensation is just beginning to take off in Asia. Market trends show that increasing numbers of firms will join in, turning employees into interested owners. Companies have many, often conflicting, alternatives when looking to institute equity compensation plans and should look to legal and accounting professionals to ensure compliance with the complex tax, securities, accounting, labour and other laws in each jurisdiction to structure plans that meet the company's particular goals.




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