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 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.
Stock appreciation rights also have vesting periods. When these rights are vested, they become available to be exercised. When employees exercise their rights, they receive the cash incentive. To illustrate, suppose as an employee, you receive stock appreciation rights for 10,000 shares on January 1, 2017. The grant price is $50 per share and the vesting period is two years. This means that you can exercise your rights after two years starting December 31, 2018. When you exercise your rights, you will receive cash equal to the increase in stock price beyond $50 multiplied by the 10,000 shares covered by the rights. Given that you exercised all your rights on December 31, 2019 when the market price is $60, then the total cash incentive that you will receive is $100,000.
Again, companies offer these rights to encourage good employee performance. The idea is that employees will certainly work harder so that company figures improve and the stock price increases. If the stock price decreases, the stock appreciation right will have no value at all
Share-based compensation is additional compensation on top of the traditional cash-based compensation and is based on the company's shares. Usually, this is given to promote better employee performance. Examples of this are stock options and stock appreciation rights.
Stock options give employees the right to buy shares of the company at the grant price or strike price. Employees benefit from this plan when the stock price increases. If such happens, employees may then exercise their options, purchase the shares at the strike price and later sell them at the higher market price. Stock appreciation rights entitle employees to receive cash for the difference between the stock price on the exercise date and the grant price. On the exercise date, the employees receive cash for the increase in stock price multiplied by the number of shares covered by the stock appreciation rights.
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