The SSE and Type II Restricted Stock
The Sci-tech Innovation Board, also known as the Shanghai Stock Exchange “Star” Market (Sci-Tech Innovation Board), hereinafter referred to as “the Board,” has seen a rise in companies resorting to Type II restricted stock (or sometimes referred to as “second category restricted stock”) as a measure to incentivize employees. This type of restricted stock does not require contribution of capital in advance. After the subject of the incentive has satisfied the conditions, he or she can use the reduced grant price to invest in the company’s stock, and can freely trade after the limited sale period.
Equity stock option plans, or “ESOPs,” are in place to incentivize employee performance through selling company stocks to these high performing employees. These plans are implemented with hopes of promoting the development of listed companies. For companies that have ESOPs in place, the quality of corporate development may be better than those without equity incentives. Sound corporate development, in turn, will help companies ultimately obtain higher valuations, benefitting its shareholders and investors all alike.
Trends in Implementation
With the continuous progress of the reform of the stock registration system, equity incentives have been further submerged in the regulatory policies. At the same time, the importance of equity incentive mechanism as a corporate strategy is becoming more and more prominent.
Through the year 2020, the SSE board’s listed companies tend to prefer “Type II restricted stock” as an equity incentive tool. The equity incentive growth has grown over the years. In fact, according to data from the Wind database, From June 2019, when the board opened, through year end of 2020, over 70 equity incentive plans have been issued. Most of these issuing companies tend to be privately-owned companies as compared to state owned enterprises.
Due to its high reliance on its core management and technology support team, Type II restricted stock allows companies to better attract and retain talent through giving them reduced-price equity, thus promoting employees’ innovation and dedication to the companies. With Type II, equity can be given to a company’s actual controller, core management personnel, and core employees, allowing many differently situated members of the companies to be eligible to incentives.
It is worth noting that ESOPs are incentive schemes that enable the subject to obtain a certain equity in the company, allowing him or her to enjoy the economic benefits and rights brought about by the equity, and can perhaps participate in the decision-making of the enterprise as a shareholder, share profits and bear risks, ultimately serving the long-term development of the company. This is an important way to attract top talent and professionals.
Case in Point: Frontier Biotechnologies Inc.
Frontier Biotechnologies Inc. is s biomedical company based in Nanjing, Jiangsu, China. It produces HIV medication. In China, this is a large patient base, and a sizable market for such for long-term treatment. According to the Center for Disease Control, the number of people infected with HIV in China exceeds 1 million, with a compound annual growth rate of 9.1%. This is a substantial market, illustrating the need for companies like Frontier Biotechnologies Inc. to develop its products.
With an anticipated large market and growth of sales, Frontiers has also taken steps to incentivize its management and core employees. In February it rolled out the equity incentive plan of 2021. According to the ESOP’s evaluation criteria, the company’s 2021-2023 business income shall reach 80 million RMB, 300 million RMB and 1 billion RMB, respectively, in order to unlock 100% of the restricted shares granted.
Impact on Companies and Their Concerns
However, despite the gains, there are also downsides of using Type II restricted stock. Equity incentives play an important role in enhancing employees’ sense of belonging, relieving cash flow pressure, boosting market confidence and promoting performance. However, from the perspective of corporate taxation, there are a few issues.
The first issue is that the equity incentive cost recognized by accounting standards does not match the period for which the tax can be deducted pre-tax. If individuals incentivized do not exercise the right, then the incentive fees cannot be deducted before tax. This is not conducive to encouraging enterprises to set a longer waiting period to build a long-term incentive mechanism
The second issue is that termination of equity incentives requires an accelerated one-time confirmation fee which cannot be deducted pre-tax. If the listed company voluntarily terminates the equity incentive, the incentivized subject has not obtained the shares, yet the listed company still has to bear the cost of the shares. Such cost cannot be used to deduct the taxable amount of the enterprise income tax, which is contrary to rational economic behavior.
Therefore, while Type II restricted stocks are growing in popularity, there are also drawbacks to keep in mind. Companies on the SSE are increasing resorting to Type II restricted stock, and the trend may continue in the coming years.
