As businesses grow, one of the key challenges is retaining talented employees. Many business owners use incentives to motivate and retain their workforce, with cash bonuses and Employee Share Option Plan (ESOP) being two of the most common options. This article explores the differences between the two and the factors businesses should consider when deciding which approach is more suitable.
What is a Cash Bonus?
A cash bonus is a monetary payment made to employees in addition to their regular salary. It may be awarded based on individual performance, business profitability, or the achievement of specific business targets. Cash bonuses provide employees with an immediate financial reward.
What is an Employee Share Option Plan (ESOP)?
An ESOP gives eligible employees the option (but not the obligation) to purchase shares in the company at a predetermined exercise price, subject to vesting conditions and other terms. If the company’s share value increases, the value of the option also increases. This allows employees to participate in the company’s growth and align their interests with those of the shareholders.
Which Incentive is More Suitable?
Although both are employee incentive mechanisms, they serve different business objectives. Business owners should consider the following factors when deciding between a cash bonus and an ESOP:
- Cash Flow Impact:
A cash bonus requires the company to make an immediate cash payment to employees. For start-ups, high-growth companies, or businesses that are reinvesting profits into expansion, substantial bonus payments may place pressure on working capital.
An ESOP, on the other hand, typically requires little or no immediate cash outflow when options are granted. Instead of paying employees cash today, the company offers them an opportunity to participate in the future appreciation of the company’s shares. This allows businesses to reward and retain key employees while preserving cash for operations.
- EPF Contributions:
Cash bonus generally falls within the definition of “wages” under Section 2 of the Employees Provident Fund Act 1991. As a result, employers are generally required to make EPF contributions, and employees’ EPF contributions must be deducted from the bonus payment.
In contrast, share options are generally not subject to EPF because they are not provided in the form of money. However, the EPF treatment may differ for other forms of share-based incentive schemes that result in employees receiving monetary remuneration. For more information, please refer to our article: Are Employee Stock Options Subject to EPF?
- Tax Implication:
Both cash bonus and ESOP have tax implications, although they are taxed differently. Cash bonus is treated as employment income under the Income Tax Act 1967 and is taxable in the hands of employees in the year they are received. Employers must also comply with applicable payroll reporting.
For ESOP, benefits derived from exercising share options are generally treated as employment income and are taxable as a perquisite. The tax will be levied on the market value of the shares on exercisable date OR exercise date (whichever is the lower) LESS the price paid for the shares (strike/exercise price). From the employer’s perspective, certain reporting obligations to the Inland Revenue Board (IRB) apply when implementing and administering an ESOP. For more information, please refer to our article: Employee Share Options in Start-Ups – Part 2: Tax Basics
- Employee Retention and Post-Departure Benefits:
Cash bonus is effective in rewarding past performance, but their impact on employee retention is often limited. Once the bonus has been paid, employees remain free to leave the company at any time. Conversely, employees who resign before the bonus payment date will generally forfeit any entitlement to the bonus, unless the company’s bonus policy or employment contract provides otherwise.
An ESOP is specifically designed to encourage longer-term commitment. Most ESOPs contain vesting schedules under which employees earn their options gradually over several years. Depending on the terms of the ESOP, employees who leave the company under certain circumstances (for example, as a good leaver) may be allowed to retain their vested options and exercise them. The opportunity to continue benefiting from the company’s future growth provides employees with a stronger incentive to remain with the company and contribute to its long-term success.
Key Considerations for Businesses
- Not All Incentive Plans are Treated the Same: While the position may be relatively straightforward for cash bonus and traditional ESOP, businesses should exercise caution when implementing hybrid or alternative incentive structures, such as share appreciation rights (SARs); phantom share schemes; or other incentive arrangements involving future cash payments. The legal, tax, and EPF implications of these arrangements can differ significantly, and businesses should seek legal advice before implementation.
- Ensure the ESOP is Properly Structured: When designing an ESOP, companies should carefully consider eligibility criteria; vesting schedules; exercise price; good leaver and bad leaver provisions; treatment of options upon resignation or termination; corporate approvals required under the Companies Act 2016; and tax implications for both the company and employees.
Conclusion
There is no one-size-fits-all answer to whether a cash bonus or an ESOP is better. If the objective is to reward employees for their contributions in the short term, a cash bonus remains a simple and effective solution. However, if the goal is to retain key talent, conserve cash, and align employees with the long-term success of the business, an ESOP can be a powerful strategic tool.
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This article was written by Low Rui Thong (Associate) from Donovan & Ho’s corporate practice.
Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds. Feel free to contact us if you have any queries.
