What Is Share Based Compensation and How Does It Work?

Share-based compensation is a non-cash form of remuneration that companies offer to employees, aligning their financial interests directly with the company’s performance. Instead of a direct salary or bonus payment, employees receive an interest in the company’s equity, such as shares or the right to purchase shares. The value of their compensation often depends on the company’s stock price growth over time. Companies utilize this compensation method as a tool for attracting, retaining, and incentivizing skilled professionals without immediately impacting cash reserves.

Common Types of Share-Based Compensation

Companies frequently grant Restricted Stock Units (RSUs) as a form of share-based compensation. An RSU represents a promise from the company to deliver actual shares of its stock to the employee at a future date, typically after certain conditions are met. These units convert into common stock upon vesting, at which point the employee takes ownership of the shares.

Stock options provide employees with the right, but not the obligation, to purchase a company’s stock at a predetermined price, known as the exercise or strike price, within a specified period. Non-qualified Stock Options (NSOs) are a common type, offering flexibility in their design and taxation for both the employer and employee. Incentive Stock Options (ISOs), on the other hand, offer potential tax advantages to the employee.

Employee Stock Purchase Plans (ESPPs) offer employees a way to acquire company stock, often at a discount, through convenient payroll deductions. These plans typically allow employees to contribute a portion of their salary to purchase company stock at a price that is usually 5% to 15% below the market price at either the beginning or end of a defined offering period. ESPPs are designed to encourage broad-based employee ownership, making it easier for many employees to become shareholders.

Understanding the Vesting Process

Vesting is the process by which an employee gains full ownership rights to their share-based compensation. The “grant date” is when the company initially awards the compensation, while the “vesting date” is when the employee officially earns the right to the shares or options. The period between these two dates is known as the “vesting period,” during which the employee typically must remain employed by the company or meet other specific conditions.

Time-based vesting is a common approach where ownership is earned over a specified period. One variation is “cliff vesting,” where the employee gains full ownership of the entire grant at once after a single, predetermined period, such as three or four years. For example, an employee granted 1,000 RSUs with a four-year cliff vesting schedule would receive all 1,000 shares on the fourth anniversary of the grant date.

Another common time-based method is “graded vesting,” where the employee earns ownership in increments over several years. For instance, an employee might vest in 25% of their stock options each year over a four-year period. Graded vesting offers more flexibility and a more immediate sense of ownership compared to cliff vesting.

Performance-based vesting links the earning of share-based compensation to the achievement of specific business objectives. This could involve company-wide metrics like revenue growth targets, profitability milestones, or individual or team performance goals. For example, RSUs might vest only if the company achieves a certain earnings per share target by a specific date.

Exercising Stock Options and Settling Restricted Stock Units

After stock options have vested, employees can “exercise” them, which means purchasing the company’s shares at the predetermined exercise price. One common method is a cash exercise, where the employee uses personal funds to pay the exercise price for the desired number of shares. This method requires the employee to have sufficient liquid funds available to cover the purchase.

A “cashless exercise,” also known as a “sell-to-cover,” is a popular method that does not require upfront cash from the employee. In this transaction, a portion of the newly acquired shares is immediately sold in the market to cover the exercise price and any associated tax obligations. The remaining shares, after these costs are settled, are then delivered to the employee’s brokerage account.

A “stock swap” or “net exercise” is a method where an employee uses existing shares they already own to pay the exercise price for new shares. This method can be advantageous for employees who wish to minimize cash outflow and avoid immediate sales of company stock.

For Restricted Stock Units (RSUs), the process after vesting is typically automatic and is referred to as “settlement.” Once RSUs vest, they automatically convert into actual shares of the company’s common stock. The company’s transfer agent or brokerage firm handles this conversion, and the shares are then deposited into the employee’s designated brokerage account.

Upon settlement of RSUs, companies typically withhold a portion of the shares to cover the employee’s statutory tax obligations, such as federal income tax, state income tax, and FICA taxes. This “sell-to-cover” for taxes is a standard procedure and is not an option the employee chooses; it is an automatic function of the RSU settlement process. The net number of shares, after tax withholding, is then delivered to the employee.