Question

Discuss the similarities and differences in various stock-based compensation plans.

Answer 1

Many tech companies compensate employees using stock-based compensation (SBC) models, allowing employees to share in the potential upside [or downside] of an emerging growth company. However, depending on the nature and characteristics of the model, such financial instruments may be classified as either equity or liability. For unprofitable start-ups needing to comply with debt covenants, determining the correct classification and structuring compensation accordingly is an important goal.

Stock-based compensation includes stock options, shares (both restricted and non-restricted), and other financial instruments that convert to shares or cash over time as the employee becomes vested in the instrument. Stock-based compensation consists of many different financial instruments that allow employees the right to enjoy the gains in a company’s stock price, whether by purchasing the stock through options, receiving a fixed amount of shares of restricted stock which vest over time, or receiving a fixed cash amount of stock after meeting vesting criteria. Issuing options, warrants, and other instruments can be complex and the classification of the instrument as debt or equity will depend on the features and characteristics of the instrument.

The specific terms and timing of SBC awards are critical factors in determining whether or not stock-based compensation should be classified as equity or liability.

With respect to terms, stock-based compensation that is settled in a fixed amount of dollars is usually classified as a liability while awards settled in a fixed number of shares is classified as equity. In simpler terms, when a company’s stock-based compensation is ultimately settled in stock, rather than cash, the award is classified as equity.

Example 1: Company A awards an employee $50,000 worth of stock as compensation. Because the nature of the award is a cash obligation, this award is classified as a liability.

Example 2: Company B awards an employee 50,000 shares of stock as compensation. Because the nature of the award is an equity stake of fluctuating dollar value, this award is classified as equity.

WHY STOCK-BASED AWARD CLASSIFICATION MATTERS:-

Many technology and emerging growth companies are often unprofitable and compensate employees with stock and options to give those employees a stake in the future upside potential of the company. Cash-strapped companies need to be aware of how such compensation is structured. Equity-classified awards may be advantageous in cases when liability-classified awards could put companies dependent on loans and lines-of-credit out of compliance with debt covenants. Company owners concerned with diluting ownership stakes may prefer liability-based awards that are settled in cash rather than stock. Companies need to evaluate their goals and priorities when creating stock-based compensation plans to determine if liability or equity- based compensation is most advantageous to their financial and management situations.

==> There are five basic kinds of individual equity compensation plans: stock options, restricted stock and restricted stock units, stock appreciation rights, phantom stock, and employee stock purchase plans. Each kind of plan provides employees with some special consideration in price or terms. We do not cover here simply offering employees the right to buy stock as any other investor would.

Stock Options

A few key concepts help define how stock options work:

Exercise: The purchase of stock pursuant to an option.

Exercise price: The price at which the stock can be purchased. This is also called the strike price or grant price. In most plans, the exercise price is the fair market value of the stock at the time the grant is made.

Spread: The difference between the exercise price and the market value of the stock at the time of exercise.

Option term: The length of time the employee can hold the option before it expires.

Vesting: The requirement that must be met in order to have the right to exercise the option-usually continuation of service for a specific period of time or the meeting of a performance goal.