What is Stock-Based Compensation?
Stock-Based Compensation is a way companies use to reward their employees. It is also popularly known as stock options or Employee stock options (ESOPESOPEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more). Stock Options are given to the employees to retain or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the company.
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Explanation of Stock-Based Compensation
Stock options allow the company’s employees to buy a specific share at a predetermined price. Stock options are allotted to specific employees. Stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium.read more are different from other options available for the investor to buy and sell on exchange platforms. The difference is that a stock option is not available for investors and is not traded on exchange platforms. As noted earlier, stock options are given or rewarded to specific employees of the company. One of the reasons behind giving a stock option to employees is to retain them or attract them and to make them behave in certain ways so that their interests align with that of all the shareholders of the companyShareholders Of The CompanyA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more.
The company’s employees must wait for a specific period before they can exercise this option to buy the company’s share at a predetermined price. This waiting period is also called the vesting period. The vesting period also motivates the employee to stay with the company until the vesting period is over.
Impact of Stock-Based Compensation on Income Statement
Share-based compensation affects the Income Statement in two ways.
#1 – Decreased Net Income
Let us have a look at the Facebook Income Statement. Here the cost and expenses include the share-based compensation expense. This expense reduces the Net Income.
Also, note that Facebook has provided the breakup of Stock-based compensation included under each cost and expense item. In 2016, Facebook included $3,218 million worth of stock-based compensation.
source: Facebook 10K Filings
#2 – Diluted Earnings Per Share
When we calculate Diluted EPSCalculate Diluted EPSDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc.read more, we take the impact of the stock options exercised by the option holders. When stock options are exercised, the company must issue additional shares to compensate the employees or investors who have exercised them. Due to this, the total number of outstanding sharesTotal Number Of Outstanding SharesOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more increases resulting in a lower EPS.
As we see below, Facebook Employee stock options increase the total number of outstanding shares, thereby reducing the Earnings Per Share.
Overall, the impact of stock options on the income statement is to increase the expenses, reduce the net income, and increase the number of outstanding shares, all of which results in a smaller EPS.
Learn the calculation of the Impact of Stock Options on Diluted EPS from this detailed article – Treasury Stock MethodTreasury Stock MethodTreasury Stock Method is an accounting approach assuming that the options & stock warrants are exercised at the beginning of the year (or date of issue, if later) & proceeds from the exercise of these options & warrants are used to repurchase shares in the market. read more
Impact on the Balance Sheet
There are several ways a company can compensate its stock option holders. Here, we will consider the following two ways for explanation purposes:
First- The Company can pay the difference between the predetermined price and the price on the exercise date.
Second- The Company has an option to issue additional shares instead of the stock options outstanding for the year.
If the company goes by the second option, it will increase its paid-up capital instead of issuing the additional shares.
Impact on the Cash Flow Statement
Again consider the two ways of compensating the stock option holders as discussed above. If the company goes for the first option (paying the difference in cash), it will have to record a cash outflow from Financing ActivitiesFinancing ActivitiesThe various transactions that involve the movement of funds between the company and its investors, owners, or creditors in order to achieve long-term growth are referred to as financing activities. Such activities can be analyzed in the financial section of the company’s cash flow statement.read more in the Cash Flow Statement. Thus, the Cash Flow from Financing Cash Flow From Financing Cash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more activities will be reduced by the same amount as the Cash on the Asset side of the Balance Sheet.
If the company goes for the second option of issuing sharesIssuing SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more instead of paying cash, then there will be no impact on the Cash Flow Statement as no cash flow will happen.
Stock-Based Compensation Video
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Conclusion
Stock-based compensation is a kind of compensation given by companies to their employees in the form of equity shares. The executives who are given stock-based compensation can benefit only if they serve the company for a specified period. Start-up companies very commonly give this type of compensation to lock in their executives for a minimum number of years.
The most common type of stock-based compensation is employee stock options (ESOPS). These options may have tax implications depending upon whether they are Non-Qualified Stock Options or Incentive Stock Options. The companies can either show the costs associated with ESOPS in their Income Statements or the footnotes.
If expensed and reported in the Income Statement, the exercising of the ESOPS by the employees results in a reduction in EPS. And suppose the company pays the difference between stock price and exercise price, the option holders. In that case, it results in a reduction in Owners’ Equity and Cash on the Balance Sheet and a reduction in Cash from Financing Activities on the Cash Flow Statement. And if the company compensates the option holders in terms of additional shares, the paid-up capital increases on the Balance Sheet while there will be no impact on the Cash Flow Statement.
