The impact of Stock Based Compensation: Should You Be Wary? | ALCOR FUND

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The impact of Stock Based Compensation: Should You Be Wary?

  • September 10, 2020
  • AF Bureau
The impact of Stock Based Compensation: Should You Be Wary?

Stock based compensation is a way corporations use stock or stock options to reward beyond their regular cash-based compensation. It also helps to align their interests with those of the company.

 

Shares issued to  employees are usually subject to a vesting period before they can be sold.

 

How To Vest Stock Option?

Startups typically do not have the cash on hand to pay employees competitive rates. Executives and staff may share in the company’s growth and profits that way. However, start-ups must adhere to many laws and compliance issues.

 

For example, fiduciary duty, tax treatment and deductibility, registration issues and expense charges.

 

When vesting, companies allow employees to purchase a pre-established number of shares at a fixed price.

 

Companies may vest on a specific date or a monthly, quarterly, or annual schedule. The schedule may be set as per company-wide or individual performance targets being met.

 

Vesting periods are often three to four years. Usually, it begins after the first anniversary of the date an employee becomes eligible for stock compensation.

 

Once vested, the employee may exercise their stock-purchasing option. The start up can do this any time before the expiration date.

 

For example, assume that an employee has the right to purchase 2,000 shares of stock at $20 per share. The options vest 35% per year over three years and have a term of five years.

 

The employee pays $20 per share when buying the stock, regardless of the stock price, over the five years.

 

Types Of Stock Based Compensation

There are different types of stock compensation. Some of them are non-qualified stock options (NSOs) and incentive stock options (ISOs). Some companies award performance shares to managers and executives.

 

This happens if you meet certain performance metrics, such as earnings per share (EPS) or return on equity (ROE). 

 

Incentive Stock Based Compensation Options

ISOs are only available to employees.  There is an exemption for Non-employee directors or consultants. These options provide special tax advantages.

 

Employees prefer ISOs when long-term capital gain rates are lower than ordinary income rates.

 

When you transfer ISO shares  to an employee there isn’t any taxable compensation. All of the stock’s appreciation is taxable to the employee as capital gains when sold.

 

Both employers and employees must satisfy various requirements regulations for the employee to obtain the favourable tax treatment.

 

In case you meet all of the ISO requirements, the employer would never get a tax deduction for the ISO stock compensation.

 

However, if any of the ISO conditions are not fulfilled, the ISO is considered as an NQSO. Upon a disqualifying disposition, the employer is entitled to a tax deduction equal to the reported taxable compensation.

 

Employers are not obliged to withhold income taxes on the amount of taxable compensation. Such compensation is created by a disqualifying disposition of stock that was acquired through the exercise of ISOs.

 

Non qualified Stock Based Compensation Options

Employees are required to pay income tax based on the grant price minus the price of the exercised option. NQSOs are stock options that are not ISOs. Most compensatory NQSOs are not considered “property” on the date of grant and are not eligible for an election.

 

Hence the taxable event often occurs when one exercises the NQSO. Nevertheless, there is an exception that could defer the taxable event after the NQSO exercise date.

 

If the stock acquired upon exercise of the NQSO is subject to a substantial risk of forfeiture and an election is not made for that stock, then the taxable event occurs when the considerable risk of forfeiture ceases.

 

Suppose the taxable event occurs when the stock received from the exercise of the NQSO vests. Then the employer can seek an ordinary compensation deduction.

 

This amount equal to the ordinary income recognized by the employee. The employer  must withhold the applicable federal, state, and local income taxes, and pay the employer’s share of employment taxes, on the compensation at that time.

 

Exercising Stock Options

You may exercise Stock options by paying cash or exchanging shares that you already own. Working with a stockbroker on a same-day sale, or executing a sell-to-cover transaction is also acceptable.

 

However, a company typically allows only one or two of those methods.

 

For example, private companies may restrict the sale of acquired shares until the company goes public or is sold. Besides, private companies do not offer sell-to-cover or same-day sales.

 

Employees with stock options need to know whether their stock is vested.

 

If employees are no longer work with that company, they should find out if their stock will retain full value. Tax consequences depend on the fair market value of the stock.

 

If the stock is subject to tax withholding, you must pay the tax in cash. Even if the start-up pays the employee by equity compensation.

 

Advantages of Stock-Based Compensation

There are several benefits to this kind of remittance:

  • It creates a stimulus for employees to stay at the company for longer. They have to wait for shares to vest.
  • Both employees and shareholders want to see the company prosper and the share price rise. Thus we observe an alignment of the interests.
  • It is cashless

 

Disadvantages of Share-Based Compensation

Challenges and issues with equity remuneration include:

  • Increasing the number of outstanding shares dilutes the ownership of existing shareholders
  • If the share price is going down, recruitment or retention of employees will be difficult.

 

Implications

It is important to take the impact of share compensation into account. Since the number of outstanding shares increases, the expense has an economic impact on the business. Some measure  to avoid this impact are:

  • Without adding it back, treat the expense as a cash item.
  • If added back, increase the number of outstanding shares by the number of shares awarded to employees

 

Additional Resources

Funding your business is one of the first — and most important — financial choices most business owners make.

 

You can also use our Venture Capital Pre Screening Assessments to evaluate your business. This will also help you in getting funding  for your business in just 5 steps.

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