Updated July 14, 2023
Definition of Share Based Compensation
Share-Based compensation is allotting shares to the best-performing employees, directors, top management, etc. Shareholders are part-owners of the company. So when shares are allotted to stakeholders, it aligns with the interest of the existing owners and the stakeholders. Stakeholders start to feel the company is their own and work more passionately.
Explanation
Companies issue shared-based compensation as additional compensation to several stakeholders. The shares issued through the Share-Based compensation scheme generally have a vesting period. This means that the recipient will have to wait until the locking period to sell the shares in the market. The recipient wants to sell the shares at the highest price; this is only possible if the company does well. This motive will encourage the recipient of shares to give their best for the company.
How Does Share Based Compensation Work?
The most critical issue of a public company is the principal-agent problem. Shareholders are the principal of the company as they are the owners. Management, directors, employees, etc., are the agent who works for the principal. So share-based compensation tries to align the interest of agents with that of the principal. These kinds of compensations make the agents also the owner of the company. Under the share-based compensation scheme, companies issue restricted shares or share options with a locking period. Restricted shares are given for free to the recipient, but the shares can’t be sold in the locking period.
On the other hand, stock options are the right to buy the shares at a discounted price after the locking period. Recipients must work in the company until the vesting period to vest the shares. If they quit, then the shares will be forfeited.
Example of Share-Based Compensation
Company XYZ is planning to issue restrictive shares to its employees. The company announced this at the beginning of the year 2020. Below are the details:
Restrictive shares to be issued: 600,000
The current share price of company XYZ in the market: is $10 per share
Locking period / Service Period: 2 years
Show the journal entries in the company’s book.
Solution:
The below entry will be made when a share is granted on the grant date.
Contra Equity Dr 6,000,000
To Common Stock Cr 6,000,000
(There are 600,000 shares granted at the market price of $10. So common stock capital will increase by $6,000,000. All the shares will be issued after the service period, resulting in no net effect as no new shares will be issued. Common Stock capital increased and decreased by the contra entry.)
After One Year
Retained Earnings Dr 3,000,000
To Contra Equity Cr 3,000,000
(Half of the restricted shares must be paid from retained earnings after one year. As the restricted shares have a service period of 2 years, so, at the end of year 1, half needs to be adjusted)
After Two Years
Retained Earnings Dr 3,000,000
To Contra Equity Cr 3,000,000
(The rest half got adjusted after the end of the service period, which is the end of year 2)
The recipient of restricted shares can sell the shares in the market and earn a capital gain.
Use of Share-Based Compensation
- It is utilized by the company to award employees who already possess a particular number of years of service for their great performance. This proves the loyalty of the employee toward the organization.
- The company issues Share-Based compensation to the Board of Directors to align their interests with the benefits of shareholders and influence their decision-making accordingly.
Advantages
Some of the advantages are given below:
- Share-based compensation mainly aligns shareholders’ interests with other company agents. The agents will try to feel the company is their own when they have equity shares, making them part-owners.
- It is helpful for the company during a cash crisis as no cash outflow happens in this transaction at the beginning, so it helps the company to retain cash.
- The service period is usually for 2 to 3 years. So it helps management retain valuable employees for a long time.
- If the stock option is issued and the market share price is lower than the vesting price, the recipient will choose not to exercise the opportunity, and management will not have to make payments from the reserve.
Disadvantages
Some of the disadvantages are given below:
- With the issue of share-based compensation, the company’s total outstanding shares will also increase. As the market’s outstanding share increases, existing shareholders’ ownership will be diluted.
- In the case of stock options, if the share price in the market decreases below the vesting price, then employees will not be motivated as they can buy the shares from the market at a cheaper rate.
- The company may have to buy shares from the market at an extremely high rate if the share price increases significantly. So the compensation may turn out to be costly for the company.
Conclusion
Share-based compensation is extremely popular in aligning the interest of the agent and principal of a publicly traded company. The compensation should be used carefully to motivate the employees. If share prices in the market go down, then employees will not be motivated by the Share-Based compensation.
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This is a guide to Share Based Compensation. We also discuss the introduction and how share-based compensation has advantages and disadvantages. You may also have a look at the following articles to learn more –
