Share Based Compensation

What is Share Based Compensation: An Introduction

In simple terms, share-based compensation is a method businesses use to reward their employees or executives. Instead of offering cash as part of their remuneration package, companies provide a portion of ownership in the form of shares or options.

Moreover, there are principal types of share-based compensation:

• Restricted Stock: This is a type of compensation where the employee is given company shares, but there are limitations on when they can be sold.
• Stock Options: In this case, the employee is offered the opportunity to buy company shares at a later date, typically at a set price. The hope is the company shares will increase in value, giving the employee a chance to purchase them at a lower price and make a profit.
• Performance Shares: These are shares given to an employee based on the achievement of specific performance targets.

The Essentials of Share Based Compensation Accounting

Understanding the accounting aspect is crucial to fully comprehend share-based compensation. The basic principle is that companies need to account for the fair value of the share-based payments as an expense in their financial statements. There are various methods of estimating this fair value, including the Black-Scholes model and the binomial model.

Let's examine this with a simplified formula:

In a hypothetical scenario, a company grants 1,000 stock options to an employee, and the fair value of each option (calculated using a pricing model like Black-Scholes) is £5. The accounting entry would depict an expense of £5,000 (1,000 * £5).

Interpreting Share Based Compensation IFRS Guidelines

The International Financial Reporting Standards (IFRS) guide how businesses should report their share-based compensation. The most relevant standard is IFRS 2, "Share-based Payment," which requires companies to recognise share-based payment transactions (including those with employees) in their financial statements.

The following table gives a simplified overview of the IFRS 2 application:

To conclude, share-based compensation is a critical element in understanding a company's remuneration strategies and its impact on financial statement reporting. This overview should serve as a stepping stone into a deeper comprehension of such complex business topics.

Various Types of Share Based Compensation Explained

Share-Based Compensation is a broad term that covers numerous methods businesses use to reward their employees using their own equity. The primary types of Share-Based Compensation are stock options and restricted stocks. Understanding how each type works is essential in grasping the broader concept of Share-Based Compensation.

Understanding Options in Share Based Compensation

The primary appeal of Stock Options lies in the potential for substantial profits if the company's stock performs well. When a company grants stock options, it gives employees the right to purchase a specific number of shares in the future at a predetermined price, known as the Exercise Price.

There are two main types of stock options—Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). NSOs are standard and can be granted to anyone, while ISOs are only available to employees and come with some potential tax advantages. However, both types function similarly in that the receiver can profit if the company's share price rises above the exercise price.

The profit, or gain, on a stock option is calculated using the following formula:

It's important to note that stock options often come with a vesting schedule. That means the options become exercisable, or "vest," over a certain period, typically a few years from the grant date. This schedule encourages employee loyalty and long-term commitment to the company's success.

Learning About Restricted Stocks in Share Based Compensation

Restricted Stock, also known as restricted stock units (RSUs), represents another common form of Share Based Compensation in which companies grant stock directly to the employee. However, as the name implies, this grant comes with certain restrictions—most notably, a vesting period during which the stocks cannot be sold.

The critical difference between restricted stock and options is that restricted stock grants ownership rights from the grant date. That means employees with restricted stocks have the right to vote and receive dividends, even during the vesting period. However, they cannot sell or transfer the shares until they are vested.

Bear in mind that the value of a restricted stock grant is taxable as ordinary income. The taxable amount is determined by the fair market value of the shares at the time they become vested. This taxation process differentiates from options, where the tax is usually imposed at the time of exercise and based on the gain made by the employee.

The principal advantage of restricted stocks over stock options is that they have value even if the stock price declines after the grant date. In contrast, stock options can become worthless if the stock price falls below the exercise price. Therefore, the choice between the two can come down to personal risk tolerance and expectations about the company's future performance.

Examining Examples of Share Based Compensation

In the practical world, companies use share-based compensation to drive their workforce's motivation and commitment. Let's delve into real-life instances and hypothetical scenarios to understand the dynamics of this compensation method better.

Exploring Real-Life Examples of Share Based Compensation

Many successful companies, particularly in the technology sector, are known for their generous share-based compensation plans. Notable examples include Amazon, Google, and Microsoft.

Amazon is particularly famous for its compelling equity compensation program. The retail behemoth has been handing out stock units to warehouse workers and other staff since 1997—a few years after the company was founded. The ownership stake not only helped Amazon conserve cash in its early days but also aligned every employee's interest with the company's success.

Google, now part of Alphabet Inc., has a similar story. The company's Stock Units (GSUs) are a form of share-based compensation tied to the company's performance. It has been a significant part of Google's talent attraction and retention strategy.

Microsoft leverages both stock options and restricted stocks as a part of its Share Based Compensation. Along with the competitive salaries, these share or stock options have helped Microsoft keep its employees happy and productive.

Analysing Share Based Compensation in Different Scenarios

Examining how share-based compensation can play out in various scenarios gives a deeper insight into its pros and cons. From ensuring company's growth to mitigating the financial risks, these compensations play a vital role. Let's look at a few hypothetical scenarios:

Scenario 1: High growth company

A tech-startup grants 100 options each to its early employees with an exercise price of £1. Over the years, the company fares well, and its share price soars to £10. In this condition: \[ \text{Gain per Option} = \text{Current Share Price} - \text{Exercise Price} = £10 - £1 = £9 \] \[ \text{Total Gain} = \text{Number of Options} \times \text{Gain per Option} = 100 \times £9 = £900 \]

Upon selling, the employees would each make a profit of £900, significantly increasing the overall compensation they initially agreed to.

Scenario 2: Stagnant or declining company performance

In contrast, let's consider a company that has seen minimal growth or a decline in its share price. If an employee was granted 100 options at £5, and the current share price is £4, their options would be 'out of money,' and exercising them would result in a loss. While the employee does not lose money in absolute terms (because an option can simply not be exercised), this situation is an example of the risk and speculative nature of share-based compensation.

Scenario 3: Change in employment

Suppose an employee leaves a company where they were granted 500 shares of restricted stock which are to vest over the next five years. If the employee leaves the company three years in, they will only get to keep the 300 shares that have already vested, sacrificing the 200 shares that were to vest in the future. This situation illustrates the contingent nature of share-based compensation and its use for employee retention.

In all these scenarios, it is clear that share-based compensation introduces a layer of complexity and variability into an employee's remuneration. Understanding these dynamics is essential for both employers designing these packages and employees deciding to accept them.