What is Stock-Based Compensation?
Stock-based compensation, also called share-based compensation, refers to the rewards given by the company to its employees by way of giving them the equity ownership rights in the company with the motive of aligning the interest of the management, shareholders, and the employees of the company.
Stock-Based Compensation is a way companies use to reward their employees. It is also popularly known as stock options or Employee stock options (ESOPESOPEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). ). Stock Options are given to the employees to retain or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the company.
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How Does Stock-Based Compensation Work?
Stock based compensation is a kind of compensation given by companies to their employees in the form of equity shares besides the regular cash or salary and bonuses they receive. The executives who are given stock based compensation can benefit only if they serve the company for a specified period. Start-up companies very commonly give this type of compensation to lock in their executives for a minimum number of years.
Stock options allow the company’s employees to buy a specific share at a predetermined price. Stock options are allotted to specific employees. Stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium. are different from other options available for the investor to buy and sell on exchange platforms. The difference is that a stock option is not available for investors and is not traded on exchange platforms. As noted earlier, stock options are given or rewarded to specific employees of the company. One of the reasons behind giving a stock option to employees is to retain them or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the companyShareholders Of The CompanyA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares..
The company’s employees must wait for a specific period before they can exercise this option to buy the company’s share at a predetermined price. This waiting period is also called the vesting period. The vesting period also motivates the employee to stay with the company until the vesting period is over.
The above chart compares stock-based compensation as a percentage of the Total Assets of three companies – Facebook, Box Inc, and Amazon. Box Inc has the highest Stock-Based Compensation percentage of Total AssetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity at 15.88%. Amazon and Facebook, on the other hand, have this ratio at 4.95% and 3.57%.
A stock based compensation offered to employees and stakeholders is available in different forms. Some of the most common types of such compensation are:
Stock Options or Shares
This is a contract that gives the employers the right, but does not make it an obligation for them, to purchase or sell shares at a predetermined price and specific time range. If the stocks or shares made available are not sold or purchased within a given time frame and reach their expiry, the option turns invalid.
Such options are further divided into:
- Non-qualified stock option (NSO): It is the stock option where the income tax levied on the exercise price or price that is paid per share to the company is deducted from the price of options exercised. These schemes offer tax benefits to investors who do not require reporting the transaction when the options become exercisable.
- Incentive stock option (ISO): As the name suggests, it is an incentive kind of stock option offered to employees as a reward for their honest service tenure. These special stock options offer certain tax advantages, preventing employees from paying huge taxes on the shares while they purchase them.
Restricted Share Units (RSUs)
A restricted share unit is a scheme whereby employers promise and offer their employees company shares in return for their loyal service. The employees can own the shares at a future date, but only when they fulfill certain criteria as set by the organizations. As these options are conditional, i.e., on completion of their vesting period, they are termed as a restricted stock based compensation type.
These share options, as the name implies, are offered to professionals at both management and executive levels, given their outstanding performance.
Employee Stock Ownership Plan (ESOP)
This is the stock based compensation expense type that allows employers to own a portion of company shares or get ownership of the entire company they work for. It is a type of succession scheme in which the organization’s control moves to employees having a maximum stake in it.
Let us consider the following examples to understand the stock based compensation meaning and also see how to calculate it:
Jane has been employed with company XYZ for over 15 years, and she has been performing exceptionally well with whatever she has been trusted with. As a result, the company offers her a better position at the managerial level, and along with that she also receives access to the company’s performance shares option as well as the RSUs as she has completed the vesting period of 15 years. Together, the company offered access to 300 shares each worth $30.
The technology sector has been into providing luring stock based compensation to attract talents from across the world. But the falling stock prices and rising number of stock compensations within the tech sector are raising the risk factor as returns are getting affected adversely.
How To Calculate?
When it comes to accounting for stock based compensation, there are multiple ways in which these expenses affect the financial statements. Let us study the impact of these compensation on:
Share-based compensation affects the Income Statement in two ways.
#1 – Decreased Net Income
Let us have a look at the Facebook Income Statement. Here the cost and expenses include the share-based compensation expense. This expense reduces the Net Income.
Also, note that Facebook has provided the breakup of Stock-based compensation included under each cost and expense item. In 2016, Facebook included $3,218 million worth of stock-based compensation.
source: Facebook 10K Filings
#2 – Diluted Earnings Per Share
When we calculate Diluted EPSCalculate Diluted EPSDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc., we take the impact of the stock options exercised by the option holders. When stock options are exercised, the company must issue additional shares to compensate the employees or investors who have exercised them. Due to this, the total number of outstanding sharesTotal Number Of Outstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. increases resulting in a lower EPS.
As we see below, Facebook Employee stock options increase the total number of outstanding shares, thereby reducing the Earnings Per Share.
source: Facebook 10K Filings
Overall, the impact of stock options on the income statement is to increase the expenses, reduce the net income, and increase the number of outstanding shares, all of which results in a smaller EPS.
Learn the calculation of the Impact of Stock Options on Diluted EPS from this detailed article – Treasury Stock MethodTreasury Stock MethodTreasury Stock Method is an accounting approach assuming that the options & stock warrants are exercised at the beginning of the year (or date of issue, if later) & proceeds from the exercise of these options & warrants are used to repurchase shares in the market.
There are several ways a company can compensate its stock option holders. Here, we will consider the following two ways for explanation purposes:
First- The Company can pay the difference between the predetermined price and the price on the exercise date.
Second- The Company has an option to issue additional shares instead of the stock options outstanding for the year.
If the company goes by the second option, it will increase its paid-up capital instead of issuing the additional shares.
Cash Flow Statement
Again consider the two ways of compensating the stock option holders as discussed above. If the company goes for the first option (paying the difference in cash), it will have to record a cash outflow from Financing ActivitiesFinancing ActivitiesThe various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achieve long-term growth are referred to as financing activities. Such activities can be analyzed in the financial section of the company's cash flow statement. in the Cash Flow Statement. Thus, the Cash Flow from Financing Cash Flow From Financing Cash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities. activities will be reduced by the same amount as the Cash on the Asset side of the Balance Sheet.
If the company goes for the second option of issuing sharesIssuing SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. instead of paying cash, then there will be no impact on the Cash Flow Statement as no cash flow will happen.
How It Is Taxed?
The most common type of stock based compensation is employee stock options (ESOPS). These options may have tax implications depending on whether they are Non-Qualified Stock Options or Incentive Stock Options. The companies can either show the costs associated with ESOPS in their Income Statements or the footnotes.
If expensed and reported in the Income Statement, the exercising of the ESOPS by the employees results in a reduction in EPS. And suppose the company pays the difference between stock price and exercise price, the option holders. In that case, it results in a reduction in Owners’ Equity and Cash on the Balance Sheet and a reduction in Cash from Financing Activities on the Cash Flow Statement. And if the company compensates the option holders in terms of additional shares, the paid-up capital increases on the Balance Sheet while there will be no impact on the Cash Flow Statement.
Stock-Based Compensation Video
This article has been a guide to what is Stock Based Compensation. Here, we explain the concept with examples, how it is taxed, its types, and how to record it. You may also look at the following articles for a better understanding of finance and accounting topics.