Share-Based Compensation: Definition & Types

Instructor: Ryan Morales
Many US companies offer other forms of compensation, on top of the more traditional cash-based compensation- salaries, bonuses and allowances. Read this lesson to know more about share-based compensation.

Why Implement Share-Based Compensation?

Let us begin our lesson by going over the theory that promotes the implementation of share-based compensation across many companies.

This is called the agency conflict theory. In business organizations, managers are typically the agents of the owners. A lot of business owners out there merely put cash and other resources into their business. They leave the management of the organization to other persons. Hence, they hire managers. This theory proposes that managers do not always act to the best interest of the owners they work for. They sometimes make actions and decisions which benefit themselves but will not really benefit the business as a whole.

For instance, they spend too much on representation, travel and other avoidable costs. Some owners claim managers sometimes slack off and do not work hard. A number of managers even go to the point of misappropriating company assets for their personal gains. These actions result to poor company performance and consequently, will decrease the value of the firm. To address these conflicting interests of owners and managers, managers are either made part-owners of the firm or they are given cash incentives provided the firm performs very well, and as a result, its value increases. With share-based compensation, the company aligns these conflicting interests and fosters goal congruence.

Share-based compensation is a type of employee compensation that is based on the shares of the company. Examples of this form of compensation are stock options and stock appreciation rights.

Stock option

Stock option is a right given by the company to the employees to buy stock at an agreed-upon price within a certain period of time. It is emphasized that employees are not obligated to buy company shares. They merely have such an option. The agreed-upon price is called the strike price. The strike price is usually the market price of the stock on the grant date. Employees typically wait for a certain period of time before they can exercise their stock options.

This period is called the vesting period and during such a period, they have to remain employed with the company. The hope is that if managers and employees perform well, good performance will certainly have an impact on the company bottom line and cash flows. Consequently, the company stock price goes up. Employees then exercise their stock options at the strike price and sell their purchased shares later at a higher market price. That is how employees profit from stock options.

As a form of compensation, stock options should promote good employee performance as well as promoting retention of good employees. One thing to note though is that stock options become worthless if the company is not successful. If the company performs poorly over time and the stock price drops, what happens is that the strike price becomes higher than the current market price. Employees will typically not exercise their options and the options lose their value.

Stock Appreciation Right

Stock appreciation right is actually a cash incentive given to employees that is equal to the appreciation or increase of the company stock price over a certain period of time. Like stock options, it will only be beneficial to employees if the stock price increases. Employees will receive cash incentive equal to the number of shares covered by the stock appreciation rights multiplied by the dollar increase in stock price.

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