What is Stock Compensation?

Last Updated on September 26, 2023 by BFSLTeam BFSLTeam

Stock Compensation, in today’s evolving job landscape, plays a pivotal role in attracting and retaining top talent within the burgeoning startup ecosystem. With over 50,000 startups and 53 unicorns in India, it has become the world’s third-largest startup hub, and the strategy behind this phenomenal growth hinges on how these companies attract skilled individuals.

Before we delve into the intricacies of stock compensation meaning, it’s essential to understand how startups secure funding. These companies often offer unlisted shares to investors to raise capital. For instance, a startup aiming to raise Rs 100 crores would entice investors by offering them shares in the company. When the startup eventually goes public, these investors can sell their shares, reaping substantial returns on their initial investments.

Now, let’s shift our focus to the employees of these startups. To lure experienced and skilled professionals away from established, high-paying firms, startups promise competitive salaries and an array of benefits. However, startups, particularly in their early stages, aim to allocate their capital primarily to fuel business growth rather than internal matters. Consequently, they opt to provide employee benefits in the form of company stock.

This form of employee compensation is known as stock compensation. Essentially, startups offer their employees the chance to purchase or receive shares in the company at an initial, often significantly discounted, price. These shares come with a stipulated vesting period, which is the minimum duration employees must hold the shares before they can sell them.

Also Read: Treasury Stock

Types of Stock Based Compensation

There are four primary types of stock compensation:

1. Non-qualified Stock Options (NSOs): Employees receiving NSOs are obligated to pay taxes in cash based on the difference between the grant price and the exercised price.

2. Incentive Stock Options (ISOs): These stock options come with special tax advantages and are available to both employees and non-employees, such as directors or consultants.

3. Restricted Stocks: Employees acquire these shares either as a gift or by purchasing them after working for a predetermined number of years. They can only exercise these options after the vesting period elapses.

4. Performance Shares: In this scheme, company stocks are offered to employees once they achieve specific predetermined goals, tying compensation directly to performance.

For example, imagine you work at a startup that offers you 1,000 shares at an initial price of Rs 50 per share. These compensation options vest at a rate of 25% per year over 5 years. Regardless of whether the share value increases significantly during this period, you’ll still pay only Rs 50 per share.

Also Read: Sideways Market

Advantages of Stock Based Compensation

Stock compensation is a form of employee reward that allows them to own a stake in the company through stock options. This has several advantages for both the employees and the company. Some of the benefits are:

• Stock compensation aligns the interests of the employees with the shareholders, as they both benefit from the increase in the company’s value. This creates a sense of ownership and loyalty among the employees, who are motivated to work harder and smarter for the company’s success.
• Stock compensation can provide tax benefits for the employees, depending on the type and timing of the stock options. For example, if the employees receive incentive stock options (ISOs), they can defer taxes until they sell or dispose of the shares, and pay lower capital gains tax rates instead of ordinary income tax rates. This can also be used as a potential exit strategy for the owners, who can transfer their shares to the employees and reduce their tax liability.

Disadvantages of Stock Based Compensation

However, stock compensation also has some drawbacks that need to be considered. Some of the drawbacks are:

• Stock compensation can dilute the value of the existing shares, as more shares are issued to the employees. This can reduce the earnings per share (EPS) and the market price of the shares, which might not be favourable for the shareholders in the long run.
• Stock compensation can be difficult to value, as it depends on various factors such as the volatility of the stock price, the vesting period, and the exercise price. This can lead to overvaluation or undervaluation of the stock options, which can affect the accuracy and fairness of the compensation plan. Moreover, stock compensation can create incentives for executives to manipulate the stock price or earnings to increase their own pay, regardless of the actual performance of the company.
• Stock compensation can create dependency and uncertainty for the employees, as their reward is contingent on the collective outcome of all employees and management. The employees have no control over external factors such as market conditions, competition, or regulation that can affect the stock price. Moreover, stock compensation can create retention problems, as employees might leave the company after exercising their options or look for other opportunities with higher pay or better benefits.

Also Read: Share Dilution

Taxation of Stock Options

The Internal Revenue Service (IRS) governs the taxation of stock options, but the responsibility for paying taxes on stock options rests squarely with the employees who receive them. Essentially, stock options are a form of stock-based compensation, and their tax treatment resembles that of income tax. Employees are required to pay taxes on the value of these options, and concurrently, the company issuing these options must include them as part of their non-cash expenses.

SEC Documents Essential for Stock Compensation

When companies grant stock-based compensation to their employees, adherence to Securities and Exchange Commission (SEC) rules and regulations is paramount. Establishing a stock compensation program for new hires necessitates referencing specific documents:

1. Form 10-K: This is the company’s annual report submitted to the SEC, encompassing its financial performance. It’s crucial to use an up-to-date and properly signed version.

2. Form S-3 (Registration Statement): This SEC-approved registration statement is used for issuing new securities to employees, particularly relevant for stock-based compensation reporting by issuers of stock.

3. Form 4 (Statement of Changes in Beneficial Ownership): Employed to report any alterations in beneficial ownership of securities, including the issuance of stock options, to the SEC.

4. DEF 14A (Proxy Statement Pursuant to Section 14A of the SEC): This form is employed to register and designate voting representatives for shareholder elections.

Other Required Documents

Aside from the aforementioned SEC filings, companies must submit various other documents to meet regulatory obligations:

• Board of Directors and Compensation Committee Minutes: These encompass minutes from board and compensation committee meetings. They typically oversee overall compensation programs, payments to and from the company, and are reviewed by the board and/or committee.
• Employee Contracts: Both employees and employers enter into contracts outlining the terms and conditions of stock compensation, fostering mutual trust and confidence.

Guidelines for Reporting Stock-Based Compensation

Expenses linked to equity compensation must be reported as non-cash expenses, necessitating their inclusion in financial records. In this context, ASC 718 mandates that expenses associated with stock compensation plans be evaluated based on fair value.

ASC 718 Stock-Based Compensation Reporting

ASC 718 entails the preparation and submission of a report in compliance with the Financial Accounting Standards Board (FASB) requirements. Accurately calculating compensation expenses is a focal point of this report, assisting the FASB in discerning the costs of providing stock-based compensation to employees.

Steps to Report ASC 718 Expenses

Companies should follow a set of steps when reporting the expenses related to issuing stock-based compensation:

1. Collect the Required Information: Gather pertinent information such as the number of shares allocated to employees, exercise prices, and fair values.

2. Business Valuation: Determine the company’s valuation based on the gathered information, often facilitated by professional valuation firms.

3. Report All Expenses: Include proceeds and compensation expenses linked to stock compensation plans, as well as expenses associated with purchasing and delivering shares to employees.

4. Prepare Disclosure: Lastly, craft the necessary disclosures mandated by ASC 718, ensuring their inclusion in consolidated financial statements.

Also Read: Trailing Earnings Per Share (EPS)

Frequency of Expense Reports

Expense reports for stock compensation should be prepared on an annual basis. However, it is advisable to report expenses either upon issuance or after the vesting period has elapsed. This practice guarantees an accurate assessment of compensation expenses incurred within the year.

Concluding 

In conclusion, stock compensation stands as a compelling tool for both startups and their employees. It not only adds value to the company but also serves as a motivational factor for employees, encouraging them to stay with the company until the vesting period is over. This approach effectively reduces employee turnover, contributing to a stable and motivated workforce within the dynamic startup environment.