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Share-Based Compensation

With the dot-com boom since 1995, financial newspapers have been replete with terms such as employee call options, stock purchase plans, restricted stocks, and stock appreciation rights. What are these arrangements for? Why were they so popular? The common thread of these arrangements is that they’re all based on the price of the company’s shares. With stock market going up so rapidly, these derivative arrangements based on stock price were ever more popular among startups and more established companies.

!!!What is Share-Based Compensation?

__Share-based compensation__ is now very common among companies as a part of compensation scheme. Many startups and mature companies supplement their cash payroll with the shares of their own companies or the options to buy shares. These companies also pay for the services and sometimes for the goods they receive in the form of stock options, restricted stocks, and/or stock appreciation rights.

Share-based compensation, therefore, allows management and employees to share in the growth of the company’s stock price without depleting the company’s cash reserves. If all the players in the companies have a stake in the value of the company’s shares, they will usually try to achieve the maximization of share price or be willing to stay with the company longer than otherwise.

Tech startups, however, use options more frequently. Larger and more established companies tend to use restricted stocks and other share-based methods compared with equity call options. Upstart tech companies use these compensation methods to recruit young talent and/or reward superior financial performance of existing emplyees. Share-based compensation schemes, however, must take into account applicable accounting disclosure and securities laws, such as securities registrations and regulatory disclosure requirements and fair value measurement.

Stock options usually have very little downside risk for the recipients. However, many studies have shown that options and other share-based compensation may encourage the current management to be reckless in undertaking new projects, which could have adverse long-term consequences for shareholders in the long run.

!!!Types of Compensation

The three common types of share-based compensation are stock call options, restricted stocks and stock appreciation rights.

!!Stock Call Option

A stock call option is a right, but not an obligation, to buy shares at a predetermined strike (exercise) price. American options can be exercised any time between the date of purchase and the expiration date of the option. European options, on the other hand, are slightly less common and can only be redeemed at the expiration date. When used as part of compensation, these options have a vesting period, however, which usually specifies when employees may exercise their options.

Startups usually are in need of cash reserves. They use stock options to save cash and to attract key employees. These key employees are usually the seasoned executives who are willing to sacrifice at first for the stock price increases later on.

Stock options usually have very little downside risk for the recipients. However, options and other share-based compensation may encourage moral hazard of managers by making them plunge into risky investments to influence share prices. This could have adverse long-term consequences for shareholders, though.

!!Restricted Stock

Companies issue restricted stock to employees, who may sell the stock only after meeting certain criteria, such as a vesting period or certain performance criteria. Usually, restricted stocks are those purchased in unregistered, private sales from the issuing company. Rule 144 identifies more specifically what kind of sales generate restricted stocks. Restricted stock is nontransferable and must be traded in compliance with Rule 144.

SEC Rule 144 is about resale of control and restricted stocks. They typically become available for sale under a graded vesting schedule. From the perspective of existing shareholders, these restricted stocks are less diluting than options.

!!Stock Appreciation Rights (SARs)

Similar to stock call options, Stock Appreciation Rights (SARs) give the participating employees a bonus in cash or shares if the company’s set of shares performs better than expected over a specified period. Sometimes called a ‘plan’, SARs resemble stock call options because the employees benefit if the company’s stock price increases above set price in the award. Depending on the company’s plan, however, SARs differ from call options in that the participating employees are not required to pay the exercise price, but just receive the amount of any increase in stock price either in cash or stocks upon exercising.

!!!Lesson Summary

__Share-based compensation__ serves many purposes. To cash-restrained startups, it could be a supplemental compensation in addition to its being incentive to stay longer with the risky venture. To more mature and established companies, share-based compensation could align the interests of all the players. The popular types are stock call options and restricted stocks.

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