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Equity Compensation in China, Hong Kong

and Taiwan

5/11/2009
MIT Sloan School of Management
Ryan Carag, Ted Chan & Sandy Lin
Table of Contents

Abstract ............................................................................................................................................ 3
Equity Compensation in China in Hong Kong ................................................................................ 3
Equity Based Compensation in Taiwan ........................................................................................... 7
Conclusion & Recommendation .................................................................................................... 11

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Abstract

Equity compensation is commonly used in the US to reduce the principal-agency problem and
increase employee retention. However, much less is known about the use of equity compensation
outside of US but general sentiment is that it’s on the rise. This paper explores the use of equity-
based compensation to incentivize executives and employees in companies in China, Hong Kong,
and Taiwan.

In the past, limited guidance existed in regards to equity compensation in China. However, many
Chinese companies went public on the Hong Kong stock exchange as so called “red chip”
companies and such firms have an interesting and varied track record with regards to the success
of the use of equity compensation. Relative to mainland China and Hong Kong, Taiwan has had a
longer history of stock-based compensation. Taiwan’s tech-boom of the 1990s was driven largely
by stock-based-compensation largely in the form of stock-bonuses. The data show a steadily
growing number of Taiwanese firms offering some sort of stock-bonus program to either its
executives or entire core staff. Studies have also shown that these stock bonuses have been very
effective in attenuating many of the principle-agent issues inherent in fixed-wage compensation
schemes, both at the executive level and at the staff level of organizations, and in helping
Taiwanese firms compete against multinational corporations for top-talent.

Equity Compensation in China in Hong Kong

This section looks at stock option compensation in China and Hong Kong. Because the mainland
Chinese equity markets have only recently begun to mature, equity compensation in the mainland
is intimately tied to the Hong Kong exchange.

Private Unlisted Companies

Stock options are still difficult to execute in China for firms that are not listed on the Hong Kong
exchange. In particular, for private companies not yet listed on the exchange, Chinese employees
can only exercise stock options if the underlying stock becomes listed or if the employer is
acquired by a listed company. In contrast, in the US, employees can exercise their stock option by
becoming shareholders in the company while the company is private. This means that using stock
options as a means for employee retention for startups in companies in China is limited by the
company’s ability to be acquired or go IPO. Many employees may find stock options not as great
as a form of compensation given the risk of prolonged vesting period.

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Publicly Listed Companies

Historically, stock options in mainland China were considered nominal incentives because, in the
eyes of many, all senior executives at state owned enterprises were selected by the Communist
Party under the assumption their stock options would never be fully exercised.Today, the idea of
nominal stock options is dead. Among overseas listed SOEs, barriers to exercising stock options
have been overcome, and some senior executives have received substantial rewards and have
been cashing in substantially on them. (Xiu and Ming, 6/27/08)

In contrast, multinational companies listed in foreign exchanges or larger companies already on


the Hong Kong exchange have an advantage in using stock options as a compensation tool over
private companies. The Hong Kong exchange is by far the best option for companies on the
mainland that wish to use this type of structure. In foreign cases other than Hong Kong, a
structure known as Share Appreciation Rights (SARs) are used. A SAR uses a system that tracks
stock gains on paper, and pay the employee accordingly. Some times this equity is actually
traded by an overseas broker with the employee receiving the proceeds.

Gross and Minot (2008) summarize stock option use in China by multi-national corporations:

“MNCs in China often offer stock options (in one form or another) to
managers and key employees. However, not all Chinese employees
will necessarily be familiar with them. Even if they are familiar with
stock options, they still may not necessarily be interested, since the
compensation is delayed. Employees may prefer shorter vesting
periods. Still, stock options are continuing to gain ground overall.
Depending on the employee, stock options can be a useful method –
among others – to encourage employee performance and improve
retention.“

In private companies, compensation still tends to be up front for most employees except founders
and senior management. Equity compensation is not well understood and because it is not
received upfront, it is less popular.

Chen, Guan and Ke (2008) provide a comprehensive analysis of how equity compensation is used
in red-chip firms. The Hong Kong Exchange defines a red chip company as one that has at least
30% of its shares held by a mainland Chinese company, with mainland companies in aggregate
being the single large shareholders. A company can also be considered red chip if between 20
and 30% of its shares are head by mainland Chinese, and theyhold substantial influence on the
board of directors. These can include state-owned enterprises, town and village enterprises in
addition to privately owned firms. These companies essentially represent a subset of mainland
Chinese firms that have gone public in the more liquid and efficient Hong Kong market. (HKEx
Website)

Core et al. (2003) point out a major issue with equity compensation in less efficient markets. If
the markets do not reflect managerial actions in equity prices, then the effectiveness of equity
compensation must be question. It would in those cases cause deeper agency problems rather
than properly aligning incentives. Furthermore, companies running in mainland have poor
investor protection with regards to controls and disclosures. This has improved over the past 10
years, but remains an issue. Additionally, many of these enterprises have some element of state
control, which also affects the way incentives are structured and managerial decisions are made.

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Red chip firms are required to annually disclose their stock option compensation data, making it
ideal for Chen, Guan and Ke to study it. During their sample period from 1990 to 2005, there
were no Chinese regulations on stock options. Before this period, firms list in China were
prohibited from issuing options. Thus, companies who wished to do so had to become red chip
firms. At the end of 2005, China implemented a regulation permitting stock option
compensation. Citic Securities, a major brokerage, is one mainland Chinese company that has
implemented options according to Gross and Minot (2008).

Chen, Guan and Ke point out the regulations on stock options in Hong Kong are relatively similar
to the US except for two points. First, no single participant can receive more than 25% of all the
securities in a company’s stock option plan. Our interpretation is that this limits companies from
concentrating too much interest in the share price in the hands of senior management. Secondly,
the exercise price cannot be more than 20% below the average closing price of the stock for the 5
business days immediately preceding the option grant. This limits how far the option granted can
be in the money.

Additionally, Hong Kong has relatively simple accounting rules for stock options. The initial
grant of options is not a taxable event for the company or recipient, even if the grants are in the
money. Hong Kong has low overall taxes (15 to 17%) on income, making it an attractive place
to be granted in the money or high upside options.

Gross and Minot also mention that the Chinese government initiated a new plan which allows
foreign exchange purchases for the purpose of stock options in foreign companies with prior
approval from the government. Procter & Gamble China was the first to participate in this
program in February of 2008. (Gross and Minot, 2008).

Effectiveness of Equity Compensation in China and Hong Kong

Chiu, Luk and Tang (2002) found the biggest factors to retaining employees in Hong Kong were:

1. base salary
2. merit pay
3. year-end bonus,
4. annual leave
5. mortgage loan
6. profit sharing

In mainland China, Chiu, Luk and Tang found slightly different:

1. base salary
2. merit pay
3. year-end bonus
4. housing provision
5. cash allowance
6. overtime allowance
7. individual bonus

In both cases, merit pay means variable pay including options.

Xi (2006), cited by Conyon and He (2008) argued that independent directors exist not so much to
provide oversight of senior management, but rather to open up connections within the
government. In some way, this is not that different from companies anywhere in the world.

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Conyon and He (2008) found that at least for CEO, options are working in some respect to align
incentives for managers. They found that CEO equity incentives were positively correlated with
firm size and firm risk profile. Their paper implies that China’s corporate governance regulations
have done well to align managerial interests with the interest of shareholders. This study counters
to a certain extent that Chinese corporations are subject to ineffective controls and regulations.

Cultural Issues in the Effectiveness of Stock-based Compensation

For the Chinese, the year-end bonus has traditionally been the way of rewarding employees. This
is especially the case for lower level employees in blue collar and retail positions. Paid out
around the Lunar New Year, these bonuses are often as much as 40% of pay. However, at a
higher level, especially amongst “males, white-collar-employees, high performers, achievement
oriented employees and those who already work under a merit plan tend to favor merit pay or the
“equity approach”. (Chiu, Luk and Tang, 2002)

Different from U.S. executives, Red Chip firms’ executives rarely exercise vested stock options
during their tenures in the firm. (Chen, Guan, and Ke, 2008) The Economist's article, “False
Options” suggests that this can be due to cultural norms in China where cashing out on stock
options may indicate disloyalty to the firm since once the options cashed out the alignment of
ownership and management no longer exists. This calls into question how effective those options
actually would be in motivating employees.

Furthermore, employees often do not understand the value of stock options. This however, can be
corrected with time as more companies implement equity-based compensation programs and
employees become educated in their value as a whole. But, similar to the US, stock options and
their lengthy vesting periods are difficult for younger employees to understand. "Stock options
don't really work with young people," explained one HR manager. "Saying we'll give it to you in
five years doesn't fly. They want options and cash." (Melvin, 2001)

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Equity Based Compensation in Taiwan

In contrast to Chinese mainland firms’ compensation, stock-based compensation has been more
integral in Taiwan's industry growth, particularly in the tech-space and has been an integral part
of the overall compensation for a growing number of firms in Taiwan.

Taiwanese tech-firms such as TSMC used stock-based-compensation as a tool to compete in the


labor-force market. During the tech boom of the 1990s, for example, local Taiwanese companies
were able to attract and retain top-notch employees through stock-based-compensation, even so
far as being able to draw top talent from competing MNCs (Han, Shen 2004).

Figure 1. Number of cash bonus and stock bonus plans in Taiwan during 1990's tech-boom (unit:
establishments)
500
450
400
350
300
250
200
150
100
50
0
1988 1990 1992 1994 1996 1998 2000 2002

Stock Bonuses Combination Stock+Cash Bonus Plans

Source: Monthly Bulletin of Labor Statistics, Taiwan

Clearer guidance on treatment around taxation on stock-incentives through the last two decades
has made for a fairly well developed body-of-knowledge among hiring companies and their
employees.

Stock-based compensation in Taiwanese firms has come largely in the form of stock-bonuses,
which while mechanically similar to US employee stock option plans, have a few key
distinguishing characteristics. (Han, Shen 2004).

1. US Employee Stock Option Plans are typically structured through vesting schedules to be
long-term incentives whereas Taiwan's stock-bonuses are in contrast relatively short
term, given that the stock-bonuses given by Taiwanese high-tech firms are typically
allowed to be sold immediately.
2. US ESOPs are structured to encourage future performance, whereas Taiwanese stock
bonuses are awarded based on past performance.
3. US ESOPs recipients typically have to purchase the stock whereas employees in Taiwan

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have to make no such payment on their stock bonuses. This should be noted that the
mechanics of a typical US ESOP execution allows a simultaneous buy-then-sell
transaction where the employee executing the option does not have to make a cash
outlay, but there are still differences in tax implications.
4. While stock ownership is typically small portion of a US employee's compensation (at
least in the immediate term) in Taiwan, stock-bonuses typically represent a very
substantial portion of an employee's total annual compensation in firms where stock-
bonuses are offered. This is explained primarily by the fact that Taiwanese firms
typically pay less that their MNC counterparts, and as such use stock-based compensation
to make their overall compensation competitive to those of MNCs. Such a sharing
scheme as a higher percentage of employee compensation works particularly well in
firms with high profitability and stock prices or in smaller firms who are bootstrapping
their growth through profits.

Effectiveness of Stock-Based Compensation in Taiwan

There are arguments for and against stock-based compensation (and firm-performance-based
bonus compensation in general) which tend to follow the similar lines in economics discussions.

Arguments for include:


1. Since bonus amounts are tied to overall firm performance, bonuses induce employees to
exert more effort to improve operational efficiency.
2. Since bonus amounts are tied to firm profitability, bonuses can attenuate agency
problems found in fixed-waged employment and can reduce the impact of conflicts of
interest between principal and the agent. (Han and Shen 2004, Blasi et al., 1996; Kruse,
1993).
3. Since the payment of the bonus is a variable portion of the total compensation, the bonus
may produce an "efficiency-wage" effect which reduces shirking, turnover and attract
better applicants (Han and Shen 2004, Akerlof and Yellen, 1986; Yellen, 1984).
4. Bonuses can create group pressure, motivating employees to monitor and push each other
to higher performance and to cooperate towards overall better firm performance (Han and
Shen 2004, FitzRoy and Kraft, 1986; Kruse, 1993; Levine and Tyson, 1990).

Arguments against bonuses are primarily around the free-rider problems inherent with group-
based incentives, given bonuses are tied to overall firm performance. An additional argument
against bonuses has to do with the theory of team production (Han and Shen 2004, Alchian and
Demsetz, 1972), which says that optimal employee monitoring and management happens when
the management has residual equity in the firm. In the case where the employees share the equity
(thereby diluting management's equity relative to the case where employees did not receive stock-
bonuses), management will have less incentive to monitor and supervise the employees, thereby
causing reduced firm performance.

Empirically, Taiwan's high-tech firms have experienced an extremely rapid growth over the past
two decades, with many practitioners and academics believing that stock-bonuses have lead to
good outcomes with regard to attracting, retaining and incenting firms' human capital. (Han and
Shen 2004, Biagioli and Curatolo, 1999; Chen and Wang, 2001; Chiu and Tsai, in press; Tsao,
1999).

Chui and Tsai also found that stock-bonuses have over many years increased the average
employee's psychological ownership and organizational citizenship. They also found that given
the heavier distribution of stock bonuses to more senior and high-performing employees has

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shown potential to address the free-rider issues brought up by detractors of stock-based
compensation. They found that the growing use of these Taiwanese-style cash and stock bonuses
has had continuously positive effects on motivation, attraction, retention and performance of the
studied Taiwanese tech-firms.

The growth and potential effectiveness of the Taiwanese-style stock-bonuses to attracting top
talent might be shown by the example of Lien-Fa Technology Co., a Taiwanese IC design firm,
who gave out stocks worth approximately US $514,285 on average to each of its 248 employees
in 2001 and a considerably higher US $739,706 one year later (Han and Shen 2004). More
generally, the effectiveness of such compensation structures is that many MNCs such as IBM,
which was once viewed as a place for “the special group of preferred employees”, have been
seeing “fierce warfare” from local, Taiwanese high-tech firms in hiring top talent. Many MNCs
have even lost some high-level, key employees to local high-tech firms, in a striking similarly to
the experience of large US high-tech firms to startups.

Effectiveness of Stock-based Compensation: at the Executive Level in Taiwan

In their paper, The Determinants of the Relationship between Top Executive Stock-Based
Compensation and Performance Measures: A Study of Taiwan, Hung and Wang examined what
effect stock-based compensation had on firm performance. They found that in general, stock-
based compensation was effective at the executive level and identified the following four
determinants on level of effectiveness:

1. The President’s stock-based compensation will be relatively more sensitive to


market performance, as compared to accounting performance, the larger the growth
opportunities of the corporation.
2. The President’s stock-based compensation will be less sensitive to market
performance and accounting performance, the larger the size of the corporation.
3. The President’s stock-based compensation will be relatively less sensitive to
market performance, as compared to accounting performance, the greater the risk of the
corporation.
4. The President’s stock-based compensation will be relatively less sensitive to
market performance, as compared to accounting performance, the larger
the leverage ratio of the corporation.

The findings are intuitive in many ways, aligning with how much actual direct control executive
actions have on the outcome of the company’s performance versus the company’s inherent
growth potential through its core-technology, for example. Put in other terms, a fast car can still
go relatively fast even it’s not skillfully driven, but will achieve its peak performance, near its
limits of control, in the hands of an expert driver.

Effectiveness of Stock-based Compensation: at the R&D/Staff Level in Taiwan

In Compensation Structure, Perceived Equity and Individual Performance of R&D


Professional: The Moderating Effects of Achievement Orientation, Uen and Chien examined the
effectiveness of stock-based compensation at the R&D staff-level of high-tech firms, examining
258 high-tech firms in China. They found the following correlations:

• Compensation structure has a positive correlation to an employee’s perceived equity


• Employee perceived equity is positively correlated to individual performance
• Individual performance is affected by compensation structure through perceived equity

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• The interaction of compensation structure and achievement orientation does influences
perceived equity.

In short, they found that employees feeling of the fairness of their compensation to their level of
input (effort, seniority, gender, amount of responsibility, working conditions, knowledge, skills,
and abilities required by the job) in these high-tech firms was positively affected by their
compensation structure's inclusion of stock-based compensation. This backs up Chui and Tsai’s
findings regarding the positive correlation between stock-based compensation and psychological
ownership.

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Conclusion & Recommendation

We conclude from our study of China/Hong Kong and Taiwan that varying levels of maturity
affects the effectiveness of stock-based compensation in incentivizing and retaining key
employees for both larger companies (MNC’s and red-chip firms) and startups. For more mature
markets such as Taiwan, stock-based compensation is an effective tool to attract, incentivize, and
retain employees and is used as a tool against losing talent against MNCs. However, in China, the
use of stock-based compensation is only implemented since the beginning of 2006 and is
currently only limited to red-chip companies and MNCs that are publicly listed, commonly on the
Hong Kong Stock Exchange. The use of stock-based compensation for startups in China are not
as common because employees can only exercise their option if the underlying stock is publicly
listed. However, we foresee that China will update its regulations on stock-based compensation
for startup companies in the future to become more similar to the US, and in turn allow startups to
attract and retain employees through the stock-based compensation.

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Sources

“China’s Execs Sweating Over Stock Option”, by WenXiu and Ming Shuliang, Caijing
Magazine; June 27, 2008

“Retaining and motivating employees: Compensation preferences in Hong Kong and China”, by
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4, Pages 402-431, 2002.

“Stock Option Compensation with Chinese Characteristics: The Case of Hong Kong Listed Red
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Paper.

Conyon, Martin J. and He, Lerong,Executive Compensation and CEO Equity Incentives in
China's Listed Firms; August 31, 2008. SSRN Working Paper.

Hong Kong Stock Exchange, Investor FAQ, Online at


http://www.hkex.com.hk/invedu/faq/list_gen.htm

“Retaining Chinese Employees”, by Sheila Melvin; November-December 2001 issue of The


China Business Review

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Working Paper.

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May 27 2005. PriceWaterHouseCoopers Bulletin. IAS Global Watch.

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