Share-based compensation: stock grants, options and SARs

Why pay employees in shares, and what are the types?

Share-based compensation pays staff in shares or in cash tied to the share price, which aligns their interests with shareholders and needs no cash up front. It is common for executives and directors.

It has drawbacks the exam likes. Issuing shares dilutes existing owners. The employee has limited influence over the market price, so pay may reward or punish luck. And it can distort risk-taking: ownership can make managers risk-averse, while options (which can only lose their value, never go negative) can push them toward high-risk, high-reward projects.

Share-based compensation

• Equity-settled Memorize measured at grant, expensed over vesting, credit to equity
  • Stock grants Use it worth something while the share price is above zero
    • Outrightno conditions
    • Restricted stock and RSUsforfeited if the employee leaves early
    • Performance sharesearned by meeting non-price targets
  • Stock options Memorize valued with a pricing model; can expire worthless
• Cash-settled Memorize a liability, remeasured each period, no dilution
  • Stock appreciation rights cash for the share-price rise
  • Phantom stock Use it cash for the value of notional shares; works in private firms

A stock grant gives shares outright. Restricted stock and restricted stock units (RSUs) are forfeited if the employee leaves before vesting. Performance shares are earned by meeting targets such as earnings or return on assets, which can tempt managers to manipulate those numbers. Stock options give the right to buy shares at a fixed exercise price, so they can expire worthless. Companies have shifted from options toward restricted stock because grants keep value as long as the share price is above zero.

What are the key dates?

Four dates matter, in this order. On the grant date the award is made and its value is measured. The service period , usually from grant to vesting, is when the employee earns it. On the vesting date the employee can first exercise. On the exercise date the employee buys the shares, and unexercised options expire later, often 5 or 10 years after grant.

If an award vests immediately, the whole expense is recognized at grant. If vesting requires service, performance or a target share price, the expense is spread over the estimated service period.

How are equity-settled awards expensed?

The company measures the grant-date fair value once and expenses it evenly over the service period. The offsetting entry is an increase in paid-in capital, so total equity does not change: retained earnings fall by the expense and paid-in capital rises by the same amount. Later changes in the share price do not touch the expense.

Memorize

For stock grants, restricted stock, RSUs and performance shares, fair value is usually the share price at grant. For options it must be estimated with a pricing model.

$$E = \frac{N \times F}{T}$$

The exam turns this around too: the expense and the vesting period give you the fair value, or the number of awards.

Exam tip Two traps in one question: total cost uses the option’s fair value, not the share price, and you spread it, you do not book it all in year 1.

How is an option’s fair value estimated?

Market prices of employee options are not usable, because their terms differ from traded options. Companies use an option pricing model, commonly Black–Scholes or a binomial model. The standards do not name one: the model must be consistent with fair value, rooted in financial theory and reflect the award’s features.

Memorize

The option pricing model inputs are the exercise price, the share price, expected volatility, the expected life of the award, expected forfeitures, the dividend yield and the risk-free rate. The exercise price and share price are known at grant. Volatility and expected life are judgments that can move the fair value a lot.

Input higher	Fair value	Why
Volatility	higher	more chance of a large gain, no extra downside
Expected life	higher	more time for the price to rise
Risk-free rate	higher	the present value of the exercise price is lower
Dividend yield	lower	payouts reduce the share price over time

Assuming a lower volatility or a shorter life lowers reported expense, so an analyst checks the disclosed inputs against peers.

How are cash-settled awards different?

Cash-settled awards pay cash based on the share price instead of delivering shares. Stock appreciation rights pay the increase in the share price over a base price. Phantom stock pays the value of notional shares and can be used where there is no traded stock, such as a private company or a business unit.

Because the company will pay cash, it records a liability, remeasures it at fair value at each reporting date, and runs changes through profit. There is no dilution, but there is a cash outflow, and the expense moves with the share price, unlike an equity-settled award.

Go deeper A SAR liability over two years

A company grants 10,000 SARs that vest after 3 years. At the end of year 1 each SAR has a fair value of 4.00; at the end of year 2 it is 5.40.

• Year 1: liability = 10,000 × 4.00 × 1/3 = 13,333 (the share of the service period completed).
• Year 2: liability = 10,000 × 5.40 × 2/3 = 36,000. Expense for year 2 = 36,000 − 13,333 = 22,667.

The year-2 expense is larger than year 1 because the price rose and the liability was topped up. An equity-settled award would show the same expense every year, whatever the share price did.

What do companies disclose and what should an analyst do with it?

The notes describe each plan: terms and vesting conditions, the maximum term of options and whether it settles in cash or equity. For options they give a roll-forward of the number and weighted-average exercise price outstanding at the start of the year, granted, forfeited, exercised and expired, outstanding at the end and exercisable at the end. They also state the valuation model and inputs, and the fair value of other awards.

The most useful line for forecasting is unrecognized compensation cost: the cost of awards already granted that has not yet hit the income statement, with the weighted-average period over which it will be recognized. Divide the cost by the period to estimate near-term expense, and use the remainder in the last, partial year.

$$E = \frac{U}{W}$$

Share-based pay is a real cost even though it is non-cash. Analysts also watch dilution, which feeds diluted earnings per share (EPS), and non-GAAP profit measures that add it back. Non-GAAP means not following generally accepted accounting principles (GAAP).

Go deeper Forfeitures and why option expensing was contentious

Companies estimate how many awards will be forfeited (for example, because employees leave before vesting) and reduce the expense accordingly, truing it up when actual forfeitures differ. US GAAP also lets a company skip the estimate and record forfeitures as they happen. Before expensing was required, many companies argued that options were not a cost; once the fair-value rule applied, reported earnings of heavy option-granting firms fell. That history is why the inputs are disclosed in detail and why analysts compare them.