Stock Based Compensation (also called Share-Based Compensation or Equity Compensation) is a way of paying employees, executives, and directors of a company with equity in the business. It is typically used to motivate employees beyond their regular cash-based compensation
What is stock-based compensation and how does it work?
Stock-based compensation is a way corporations use stock or stock options to reward beyond their regular cash-based compensation. It also helps to align their interests with those of the company. Shares issued to employees are usually subject to a vesting period before they can be sold.
Why do companies use stock instead of cash to pay employees?
There are good reasons for companies to use stock instead of cash to compensate employees, including being cash-poor and aligning incentives. But there is no reason for investors to give stock-based compensation a free pass, when computing earnings or cash flows.
What is'stock compensation'?
What is 'Stock Compensation'. Stock compensation is a way corporations use stock options to reward employees. Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed with that company. Because tax consequences depend on the fair market value (FMV) of the stock,...
How do I find stock based compensation expenses?
The fastest and simplest way to find stock based compensation expense for a company is in its cash flow statement, under the Cash from Operations section. Here’s an example from Oracle’s latest 10-k:
Why is stock based compensation non-cash?
The reason that non-cash expenses like Depreciation and Amortization and Stock Based Compensation are added to Net Income to create Cash Flow from Operations is because these expenses don't represent literal cash coming from a business.
Does stock based compensation affect cash?
Under US GAAP, stock based compensation (SBC) is recognized as a non-cash expense on the income statement. Specifically, SBC expense is an operating expense (just like wages) and is allocated to the relevant operating line items: SBC issued to direct labor is allocated to cost of goods sold.
What are the advantages and disadvantages of using stock as compensation and incentives?
The advantage of incentive stock options is the favorable tax treatment for employees (generally employees' favorite variety of equity compensation). The disadvantages are the statutory requirements (quite constrictive) and the lack of any deduction for the Company.
Why do companies reward management with stock options as opposed to cash bonuses?
The rationale behind using stock options is that employees are goaded to perform better because if they perform better, the company does well, which in turn raises the stock price of the company.
Which is better cash or stock options?
If it's a company whose mission you can see carrying it places, more stock is a good way of making sure you get in on a good thing early. On the flip side, if you don't know enough to evaluate the business, or you're accepting the position as more of a career stepping stone, extra cash may be your move.
Why do companies pay in stock?
Stock options are a way for companies to motivate employees to be more productive. Through stock options, employees receive a percentage of ownership in the company. Stock options are the right to purchase shares in a company, usually over a period and according to a vesting schedule.
Why does stock based compensation increase equity?
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.
How does stock based compensation affect cash flow?
In accounting terms, stock based compensation expense represents a non-cash expense. And in the cash flow statement, accounting adds the expense to operating cash flow. Taking a similar route as depreciation and adding it back improves the operating cash flow because the cash expense is not “actually” paid out.
What are some potential benefits to companies of paying executives with stock options?
Aligning Interests By paying executives in stock options, executives receive a direct and personal financial incentive to better the company's performance. Executives also have a disincentive to mess up, because if share prices prices drop as a result of bad performance, executives lose lucrative options.
Why do CEOs take stock instead of salary?
Stock options can cause CEOs to focus on short-term performance or to manipulate numbers to meet targets. Executives act more like owners when they have a stake in the business in the form of stock ownership.
Why are employers willing to give stock options to employees?
Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares.
Why are executives given stock options?
The Pay-to-Performance Link. The main goal in granting stock options is, of course, to tie pay to performance—to ensure that executives profit when their companies prosper and suffer when they flounder.
How long does stock compensation last?
Stock compensation is often subject to a vesting period before it can be collected and sold by an employee. Vesting periods are often three to four years, typically beginning after the first anniversary of the date an employee became eligible for stock compensation.
What are the different types of stock compensation?
Types of Stock Compensation. There are different types of stock compensation, such as non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs are only available to employees and not non-employee directors or consultants. These options provide special tax advantages.
What is stock compensation?
Stock compensation is a way corporations use stock options to reward employees. Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed with that company.
How long does a vesting period last?
Vesting periods are often three to four years, typically beginning after the first anniversary of the date an employee became eligible for stock compensation.
How to exercise stock options?
Stock options may be exercised by paying cash, exchanging shares already owned, working with a stockbroker on a same-day sale, or executing a sell-to-cover transaction. However, a company typically allows only one or two of those methods.
How long do options vest?
The options vest 30% per year over three years and have a term of five years. The employee pays $20 per share when buying the stock, regardless of the stock price, over the five-year period.
What is restricted stock?
Restricted stock and restricted stock units (RSUs) let employees receive shares through purchase or gift after working a set number of years and meeting performance goals. Restricted stock requires the completion of a vesting period. This may be done all at once after a certain period of time.
What is Stock Based Compensation Expense?
First, we have to know that SBC is not something we can just ignore just because it is a “non-cash expense”.
Why You Should NOT Add Stock Based Compensation back to FCF
Returning back to the financials, the reason that stock based compensation can often be forgotten is because it can often get lost with the other moving pieces of the cash flow statement.
Issued, Vested, and Unvested Stock
One additional key detail about stock based compensation expense is that not all of the SBC expense in the cash flow statement represents the total potential dilution to shareholders.
What is a cliff and a four year vest?
6) What is the cliff and vesting schedule? A one year cliff and four year vest means that you must work at the company for one year before getting your first year’s options. If you get fired or leave a day before the one year cliff, you get nothing. With a four year vesting schedule, your 40,000 options are granted over four years at 10,000 a year. Most companies vest every month after the initial one year cliff.
What does it mean to own stock?
To own stock is to be an owner of the company. When you are an owner of the company, you tend to think in ways that are more beneficial to the firm. Perhaps you’ll be more inclined to pick up the trash that someone left in the hallway. Maybe you’ll be more vociferous in defending the merits of your CEO’s actions.
Can you have lower cash compensation at startup?
However, at a startup, you may elect to have lower cash compensation for more equity compensation.
Is every one of the owners of the Getty family an entrepreneur?
Every single one of the owners is an entrepreneur. There’s the Getty family (Getty Oil), the Ellison family (Oracle), the Haas family (Levi’s), and the Sachs family (Yammer), to name a few of the owners who are clustered in these few blocks of extreme wealth.
Who is going to get rich making a salary?
The only people who are going to get rich making a salary are perhaps investment bankers, hedge fund managers, strategy consultants, doctors, and big lawyers. But even those guys aren’t going to crush it with their six figure salaries unless they become partners in their respective firms or practices.
What are the two words that investors should dread the most in a financial statement?
As an investor, the two words that you should dread the most in a financial statement are “adjusted earnings”, as companies take accounting earnings and tweak them for sundry items. In the process, they almost always turn big losses into smaller ones, and losses into profits.
Is stock based compensation cash?
Stock-based compensation is an expense that should be recognised when granted and as employees have to continue to be compensated, it is an ongoing operating expense. To those who argue that it is non-cash, note that unlike depreciation, which is truly non-cash, stock-based compensation is closer to in-kind compensation.
Is there a reason to give stock based compensation a free pass?
But there is no reason for investors to give stock-based compensation a free pass, when computing earnings or cash flows. Aswath Damodaran is a professor of finance at the Stern School of Business at New York University.
What is the taxable event on exercise of NQSO?
If the taxable event occurs on exercise of the NQSO, the employer is entitled to an ordinary compensation deduction equal to the amount of ordinary income recognized by the employee on the spread between the FMV of the stock on the exercise date and the option exercise price.
What is a disqualifying disposition?
Upon a disqualifying disposition, the employer is entitled to a tax deduction equal to the taxable compensation reported on the employee's Form W - 2 (in fact, the deduction is contingent upon reporting the income on Form W - 2 ).
Why are ISOs preferred?
ISOs are preferred by employees when long - term capital gain rates are lower than ordinary income rates, because there is no taxable compensation when ISO shares are transferred to an employee and 100% of the stock's appreciation is taxed to the employee as capital gains when sold.
What is restricted stock award?
Restricted stock awards. RSAs are shares of company stock that employers transfer to employees, usually at no cost, subject to a vesting schedule. When the stock vests, the fair market value (FMV) of the shares on that date is deductible by the employer and constitutes taxable W - 2 wages to the employee.
When is Sec 409A avoided?
Application of Sec. 409A is avoided when the exercise price is no less than the stock's FMV on the grant date. Because most compensatory NQSOs do not have a readily ascertainable FMV on the grant date, they are not considered "property" on the date of grant under Sec. 83 and are not eligible for an 83 (b) election.
How long can you defer taxes on equity compensation?
83 (i), enacted as part of the TCJA, allows employees of certain privately held companies to elect to defer the payment of income taxes on certain equity compensation for up to five years. The amount of tax owed by the employee is calculated on the taxable event and compensation amount as described above, with only the remittance of the tax being delayed by the Sec. 83 (i) election. The delayed payment by the employee in turn delays the employer's tax deduction to the year in which the employee's tax is paid. Plans of qualifying employers are not automatically subject to these deferral rules.
What is an RSU?
RSUs are a promise from the employer to deliver stock or cash to the employee in the future, based on the stock's performance. Since RSUs are not property, they are not governed by Sec. 83. Accordingly, there are no tax implications when employers grant RSUs.
How To Vest Stock Option?
Startups typically do not have the cash on hand to pay employees competitive rates. Executives and staff may share in the company’s growth and profits that way. However, start-ups must adhere to many laws and compliance issues.
Types Of Stock-Based Compensation
There are different types of stock compensation. Some of them are non-qualified stock options (NSOs) and incentive stock options (ISOs). Some companies award performance shares to managers and executives.
Overcome The Challenges In Financial Consolidation, With The Help of Our team of experts
Employees are required to pay income tax based on the grant price minus the price of the exercised option. NQSOs are stock options that are not ISOs. Most compensatory NQSOs are not considered “property” on the date of grant and are not eligible for an election.
Exercising Stock Options
You may exercise Stock options by paying cash or exchanging shares that you already own. Working with a stockbroker on a same-day sale, or executing a sell-to-cover transaction is also acceptable.
Advantages of Stock-Based Compensation
It creates a stimulus for employees to stay at the company for longer. They have to wait for shares to vest.
Implications
It is important to take the impact of share compensation into account. Since the number of outstanding shares increases, the expense has an economic impact on the business. Some measures to avoid this impact are:
Additional Resources
Funding your business is one of the first — and most important — financial choices most business owners make.
Why do you pay with acquirer stock?
For buyers without a lot of cash on hand, paying with acquirer stock avoids the need to borrow in order to fund the deal. For the seller, a stock deal makes it possible to share in the future growth of the business and enables the seller to potentially defer the payment of tax on gain associated with the sale.
Can a seller defer paying taxes on a deal?
Meanwhile, if a portion of the deal is with acquirer stock, the seller can often defer paying tax. This is probably the largest tax issue to consider and as we’ll see shortly, these implications play prominently in the deal negotiations. Of course, the decision to pay with cash vs. stock also carries other sometimes significant legal, tax, ...
What is a stock deal?
In stock deals, sellers transition from full owners who exercise complete control over their business to minority owners of the combined entity. Decisions affecting the value of the business are now often in the hands of the acquirer.
Do acquirers have to borrow money?
Acquirers who pay with cash must either use their own cash balances or borrow money. Cash-rich companies like Microsoft, Google and Apple don’t have to borrow to affect large deals, but most companies do require external financing. In this case, acquirers must consider the impact on their cost of capital, capital structure, credit ratios and credit ratings.
The Setup
Like many growing tech companies, Dropbox isn’t profitable on a GAAP accounting basis. Instead, most investors value the company on cash flow.
What is SBC?
Let’s back up a bit. What is SBC, and where the hell did it come from?
Buyback Bait-and-Switch
Over the last few years, tech companies have plowed earnings into buying back their own stock. Generally this sorta thing works investors into a hot lather. But again, if we look a little more closely, we see something curiously awry.
Types of Equity Compensation
How It Works
- Companies compensate their employees by issuing them stock optionsor restricted shares. The shares typically vest over a few years, meaning, they are not earned by the employee until a specified period of time has passed. If the employee quits the company before the shares have vested, they forfeit those shares. As long as the employee stays long enough with the company, …
Stock-Based Compensation Example
- The easiest way to understand how it works is with an example. Let’s look at Amazon’s 2017 annual reportand examine how much they paid out in equity to employees, directors, and executives, as well as how they accounted for it on their financial statements. As you can see in the cash flow statement below, net income must be adjusted by adding back all non-cash items…
Disadvantages of Share Based Compensation
- Challenges and issues with equity remuneration include: 1. Dilutes the ownership of existing shareholders (by increasing the number of shares outstanding) 2. May not be useful for recruiting or retaining employees if the share price is decreasing
Implications in Financial Modeling & Analysis
- When building a discounted cash flow (DCF) modelto value a business, it’s important to factor in share compensation. As you saw in the example from Amazon above, the expense is added back to arrive at cash flow, since it’s a non-cash expense. While the expense does not require any cash, it does have a capital structure impact on the business, since the number of shares outstanding …
Additional Resources
- Thank you for reading CFI’s guide to Stock Based Compensation. To continue learning and advancing your career, these CFI resources will be helpful: 1. Financial Modeling Guide 2. Investment Banking Salary Guide 3. Financial Analyst Salary Guide 4. Investment Banking Job Description