Stock compensation – Everything you need to know
This article will provide you with the general mechanisms and principles behind stock compensation and how it works.
In recent years, companies have been increasingly looking for new ways to incentivize their employees. Stock-based compensation refers to a particular kind of compensation that is awarded in the form of the shares of the company. Recent research has shown that stock-based compensation is a highly effective and efficient way for companies to retain and align the interests of their employees. That being said, increasingly, companies have been focusing on the integration of equity compensation into their compensation plans. This article will provide you with the general mechanisms and principles behind stock compensation and how it works.
Stock-based compensation, also known as equity compensation or share-based compensation, refers to an employee’s right to receive a certain number of shares of the company’s stock upon the completion of a period of service or achievement of an established milestone. It is a form of an incentive program that is proven to be a motivating factor for the employees.
Unlike most other forms of compensation, such as salary and bonuses which are based on a predetermined amount, stock compensation gives the employee the ability to be actively involved in the company’s performance. In fact, equity compensation is the most preferred form for employees in terms of satisfaction and retention. Establishing and fully implementing stock-based compensation is, therefore, central to the overall goals of a business. Thus, to get the best out of this compensation method, it is vital to approach the process properly.
How does stock compensation work?
Stock compensation is normally established in a variety of ways. Depending on the type of the stock-based compensation scheme, there may be different ways for a company to structure it. The vesting period, exercise price, expiration date, and other conditions are all factors that will affect the way the stock compensation is structured. However, all of them follow the same basic principles regardless of their particularities.
Types of stock compensation
Let us now look at the different types of stock compensation schemes.
- Shares – The most widely used form of stock compensation in the corporate world is the granting of shares. This is typically done through the issuance of shares to the employees. In fact, shares are the most commonly traded form of securities in the world. Employees are motivated to acquire shares as they may increase in value and will help employees enjoy significant long-term wealth gains. Depending on their performance, designation, and other factors, employees can receive various amounts of shares.
- Stock Options – This is another type of stock compensation offered by most companies. In fact, it is among the most popular forms of equity compensation schemes. This is a form of a contract that gives the right to purchase shares at specified prices within a specified period of time. Instead of directly issuing shares to the employees, companies can grant their employees the right to purchase stocks at a later date. This provides them with the option to buy a stock at a particular price, known as the exercise price. There are two types of options – call and put options. Call options give them the option to buy a share, whereas put options provide them with an option to sell it. Stock Options are usually exercisable over a period of time after the on or before the grant date.
- Phantom Shares – In this form of stock compensation, instead of providing physical stock to the employees, companies instead create a legal agreement that states the ownership of the shares being held. Basically, they are deferred employee compensation, and the employees are granted the equivalent to the company share price at the time of the grant. This equity compensation is generally offered to senior management, directors and other executives. Thus, the conversion price is usually determined based on the market price of the actual stock at the time of execution.
- Restricted Share Units (RSU) – RSUs are a type of share of the company that is awarded to an employee and that has a vesting schedule, usually linked to the employee’s services. In other words, the shares are restricted and are not fully transferable until certain conditions are met, such as a period of employment, completion of the work period, certain milestones, etc. The vesting period is the time it takes for employees to acquire the full rights of holding these shares. Basically, during the vesting period, employees can only receive a “pro-rata” amount of equity.
- Employee Stock Ownership Plan (ESOP) – An employee stock ownership plan (ESOP) is a form of stock-based compensation that gives employees an interest in the company’s stock. It is one of the most common ways of granting shares to employees in a company as an attempt to align their interests with those of the company, thereby acting as an incentive for them. Employees are encouraged to acquire shares from the company, thereby becoming stakeholders.
Pros and cons of stock compensation
There are several benefits of equity compensation that employees receive in exchange for their contributions. In fact, stock options are considered a simple and cost-effective form of equity compensation schemes. However, there are drawbacks to this technique as well. Following are some of the most common pros and cons of using stock compensation.
- Taking part in the ownership of the company provides employees with a greater sense of responsibility towards it. This is especially true for senior management, executive officers, and other executives. Overall, stock-based compensation is a great way to reward employees and help them build long-term wealth.
- The best way to motivate employees to stay in a company is to provide them with valuable company shares. This, in turn, will make them feel valued and subsequently encourage them to stay and continue contributing to the growth of the company.
- Stock-based compensation is a great way to align the interests of employers and employees. When an employee’s career and wealth are tied directly to the company’s performance, they are more likely to continuously contribute to its positive growth in order to benefit from the value of their shares.
- When setting up equity compensation, it is important to properly budget for all of the associated compensation expenses. As such, the disadvantage of using this form of compensation is the additional costs associated with it.
- A company that shares its stock with employees should also be prepared for the possibility of fluctuation in the share price. This is because if the company’s stock price drops, the employee’s holdings are likely to decrease in value. Although they are still eligible to receive dividends or exercise their options, the equity compensation scheme is most valuable when the share price increases.
- The dilution of ownership is one of the biggest disadvantages of stock-based compensation. It dilutes the ownership of the company by distributing a large portion of shares among its employees. As such, the company’s management should ensure that this does not lead to an extreme loss in value for the company.
How to exercise stock options?
An option is a contract that gives the holder the right to buy or sell a security at a certain price within a certain period of time, wherein this certain price is known as the exercise price or strike price. Employees who have been granted stock options must exercise them within a certain period of time. This is usually referred to as the vesting period.
Stock options taxation
The Internal Revenue Service (IRS) has particular rules for taxing stock options. However, the taxability of the stock options lies in the employee’s hands since it is a form of stock-based compensation. As such, it is similar to income tax, this means that the employee pays taxes for it, and the company that issued these options will also have to declare them as part of their non-cash expense.
SEC documents required for stock compensation
When issuing stock-based compensation to employees, companies must comply with certain rules and regulations issued by the Securities and Exchange Commission (SEC). Therefore, when setting up a stock compensation scheme for new employees, companies should refer to the following documents.
- Form 10-K – The form used by the company to submit to the Securities and Exchange Commission (SEC) its annual report, which includes the company’s financial performance. Be sure that the form you are using is up-to-date and is duly signed.
- Form S-3 (Registration Statement) – It is an SEC-approved registration statement that should be used for the issuance of new securities to employees. The stock-based compensation reporting company issuers are required to file in order to issue shelf offerings.
- Form 4 (Statement of Changes in Beneficial Ownership) – It is a form used to report all changes in the beneficial ownership of securities, including the issuance of stock options, to the SEC.
- DEF 14A (Proxy Statement Pursuant to Section 14A of the SEC) – The form used to register and appoint voting representatives for the election of shareholders.
While the above mentioned documents are required to be filed with the SEC, there are several other documents that a company must file with the SEC in order to comply with its rules and regulations. These documents include:
- Board of Directors and Compensation Committee Minutes – It includes all of the meeting minutes of the board and members of the compensation committee. Generally, to oversee the company’s overall compensation programs, all payments to and from the company, as well as reviewed by the board and/or committee.
- Employee Contract – Both the employee and the employer must have mutual confidence and trust, wherein they sign a contract that outlines the terms and conditions of their stock compensation.
Rules and guidelines for stock-based compensation reporting should follow
The expenses of equity compensation should be reported as a non-cash expense, which means the compensation expenses must be added to the books of accounts. In this regard, ASC 718 requires that the amount of expenses related to stock compensation plans should be measured on a fair value basis.
ASC 718 stock-based compensation reporting
ASC 718 expense report is a document that should be completed and submitted in accordance with the requirements of the Financial Accounting Standards Board (FASB). Properly calculating the compensation expense is important. Overall, the primary focus of this report is to help the FASB find out the costs of issuing stock-based compensation to employees.
Steps to report ASC 718 expenses
The following are the steps that companies should follow when reporting the expense of issuing stock-based compensation to employees:
- Collect the required information – Gather the relevant information and data required for expensing stock options, including the number of shares held by the employees, the exercise price, and its fair value.
- Get business valuation – Once the required information is gathered, the valuation of the business is computed and reported. You may hire a professional valuation firm to determine the valuation of the company.
- Report all expenses – The proceeds and compensation expenses that are related to stock compensation plans should be reported. In addition, all expenses related to purchasing and delivering the shares of stock to employees should be included.
- Prepare disclosure – Lastly, prepare the appropriate disclosures required by ASC 718. The information should also be included in the consolidated financial statements.
How often should companies prepare expense reports?
The expense of issuing stock compensation should be reported on an annual basis. However, it is recommended to report the expense after issuance or after the vesting period has passed. This ensures that the company is able to find out the exact amount of compensation expenses made in the year.
Get help with Eqvista for ASC 718 reporting
At Eqvista, they are able to assist with the ASC 718 reporting process. This will enable you to be compliant and avoid unnecessary penalties. Eqvista provides the most accurate and timely results that are within the required parameters. With years of experience, Eqvista’s team is able to provide comprehensive assistance with your ASC 718 expenses. Be assured to receive the best help from Eqvista.
Why choose Eqvista for business valuation and ASC 718 reporting?
Stock compensation is a powerful tool that companies can utilize to motivate and retain their employees. By issuing the stock options to employees, they are given the opportunity to earn extra income as well as to build their wealth. However, issuing stock options has a cost in the form of stock-based compensation expenses that must be included in the company’s books of accounts. Choose Eqvista to help you to establish the equity compensation along with other financial reporting procedures. Get in touch with Eqvista today!