Stock-based compensation (SBC) is a broad term used to describe any type of compensation that utilizes stock or equity as a primary form of incentive or reward. The most common forms of SBC are stock options, stock awards, and restricted stock units. Stock-based compensation has become one of the most popular tools used by companies to align and motivate employees. The most common use of SBC is as a form of incentive or retention tool.
In stock-based compensation employee receives shares of company stock instead of cash. Stock-based compensation is most commonly offered as an incentive in the form of stock options, which give the recipient the right to purchase a certain number of shares at a set price. When the share price increases, the value of the option increases as well, creating a potential windfall for the recipient. Stock-based compensation can also come in the form of restricted stock units, which are similar to stock options in that they grant the recipient the right to purchase a certain number of shares at a set price.
Stock-based compensation is designed to align employees' interests with those of shareholders and motivate them to increase the company's value. By offering employees the opportunity to purchase a certain number of shares at a set price, a company can grant employees a stake in the company's success without requiring a large cash outlay. Stock-based compensation is a type of deferred compensation, meaning that the value of the compensation won't be realized until the shares are purchased.
There are two main types of stock-based compensation: stock options and restricted stock awards. Restricted stock awards are similar to stock options in that they grant the recipient the right to purchase a certain number of shares at a set price. However, unlike stock options, which are only valuable after the stock price increases, restricted stock awards are valuable regardless of the stock price. This is because the recipient has the right to keep and sell the shares regardless of whether or not the stock price increases. Since restricted stock awards don't require the company to pay up front, they are often used as a way of granting employees a stake in the company's success without requiring a large cash outlay.
Unlike stock options, however, the recipient of a restricted stock award doesn't have the ability to sell the shares before they vest. This means that the recipient of a restricted stock award has the opportunity to build up the value of the shares over time. The recipient of a restricted stock award can't sell the shares until they vest, which occurs when the recipient has satisfied the conditions of the award, such as staying with the company for a certain period of time.
Advantages of stock based compensation
Stock-based compensation has a number of advantages for both companies and their employees. The primary advantage for companies is that the cost of providing stock-based compensation is far less than the cost of providing cash-based compensation. For employees, the primary advantage of stock-based compensation is that the value that they realize from their ownership stake in the company is often much higher than the value they would have realized had they received cash instead.
In addition, stock-based compensation can also be a powerful motivator for employees. For example, if a company offers its employees the opportunity to receive stock instead of cash in exchange for a raise, the employees will have a greater incentive to perform well and help the company succeed. The increased ownership stake that comes with stock-based compensation can also help employees feel more invested in the company, which can increase productivity and performance. Finally, because the cost of providing stock-based compensation is lower than the cost of providing cash, companies are often able to provide their employees with a greater share of their profits through stock-based compensation.
The value that the shares will ultimately be worth depends on the performance of the company's shares. If the company's shares are performing well, the shares that the employee was granted will increase in value and will ultimately be worth more than the cash that the employee would have received instead.
Related: Compensation and benefits
Disadvantages of stock based compensation
Stock-based compensation is a popular way for companies to compensate their employees. But just like any other type of compensation, stock-based compensation has some drawbacks. One of the biggest disadvantages is the dilution of the company’s shares.
The theory behind using stock-based compensation is that it aligns the interests of executives with those of shareholders, who bear the greatest risk in the enterprise. In theory, granting executives the opportunity to buy shares at a discount should motivate them to take actions that are best for the long-term health of the company. However, in practice, stock-based compensation has failed to live up to this promise. For one, the price at which a company initially issues its stock can significantly affect the amount of money a shareholder will make on their investment.
Another disadvantage of stock-based compensation is the dilution of the company’s shares. In order to issue more shares, a company must issue additional shares of stock, which means existing shareholders must be diluted. When a company doesn’t have enough shares to meet the needs of its employees, the employees often purchase shares on the open market. This purchase adds to the number of shares available, which in turn causes existing shareholders to be further diluted.
The world of stock-based compensation is a complicated one, with different types of awards, vesting schedules, and terms for stock grants. Because stock is a risky investment, it can be difficult for employees to understand the value of their stock awards.
Research shows that factors such as growth opportunities, dividend payments, firm size, and return on assets are positively related with the probability of adopting stock based compensation plans. Opponents contend that stock-based compensation instead provides management with the incentive to misreport the real state of the company, and that it even occasionally encourages them to engage in behavior that is blatantly dishonest.
Memory Nguwi is an Occupational Psychologist, Data Scientist, Speaker, & Managing Consultant- Industrial Psychology Consultants (Pvt) Ltd, a management and human resources consulting firm.
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