Blog

Get expert advice on every topic you need as a small business owner, from the ideation stage to your eventual exit. Our articles, quick tips, infographics and how-to guides can offer entrepreneurs the most up-to-date information they need to flourish.

Subscribe to our blog

Stock-Based Compensation: A Comprehensive Guide

Posted by Early Growth

November 23, 2021    |     5-minute read (809 words)

Stock-based compensation is how many corporations choose to reward their employees. Known as stock options, they require a different approach to accounting.

Accounting for stock options must take into account the tax consequences. This can be a headache, which is why all businesses who choose to offer stock compensation need to give serious thought to the program’s administration.

Here we’re going to look at how stock-based compensation works and whether it is a smart idea for businesses to offer share-based compensation in the first place.

What is Stock-Based Compensation? 

Stock compensation is how corporations may choose to reward their employees with stock options. Employees who decide to take stock options need to know whether they retain their full value if they leave the company and whether they have vested stock.

In most cases, a vesting period may last for three to four years. What this means is employees cannot sell their stock during this time.

Regarding stock-based compensation accounting, the stock’s Fair Market Value (FMV) could mean that the stock is subject to tax withholding. It’s a complex issue and one a business needs to analyze when constructing their stock programs.

Do Dividends Affect Net Income? 

If an employee owns stock in a company, they become a shareholder. That means they may also be entitled to stock dividends distributed according to the company’s distribution schedule.

A major point of confusion when accounting for a stock option is whether these dividends will impact the company’s net income.

Shareholder dividends have zero influence on a company’s net income or profits. Instead, dividends are managed on the shareholders’ equity portion of the balance sheet.

The Pros of Stock-Based Compensation 

Offering stock options to employees has become a hugely popular perk of working for a major corporation. Let’s examine the benefits of offering stock as a reward to employees instead of cash.

Enhance the Employee Connection 

Anyone who owns a single share in a company owns a part of that company. Share-based compensation can make employees feel like they have some skin in the game. This can improve employee performance, teamwork and boost morale.

Due to the standard vesting period, stock options can also help to retain top-tier talent for longer.

Cost-Effective Employee Benefits 

Stock options are a compensation expense for accounting purposes. The way the accounting system works means that a stock-based compensation expense is a cost-effective way of rewarding employees.

There are also numerous tax benefits to opting for a partial employee ownership model, which an accountant can help you create.

Benefits packages are important for attracting the best talent, and this cost-effective perk could make a company more attractive to work for.

Let Employees Reap Financial Rewards

 Stock options can often be more valuable than direct salaries. Growing companies that are experiencing a significant period of expansion could soar in the stock market. When employees cash out, this can let them reap the financial rewards of a strong financial performance.

Plus, employees get to feel invested in the company’s results. Every time they perform to a high standard, they get rewarded through their stock.

The Cons of Stock-Based Compensation 

Stock options are not the right move for every company. There are downsides to creating a successful share-based compensation package. Let’s go through some of the drawbacks of offering stock to employees.

Complex Accounting 

Offering stock means new tax implications. Managing stock-based compensation expenses and the initial setup costs may be too much of a hassle. Companies need to weigh up the perceived benefits before committing to them.

Rewarding Mediocrity

Executives and high-level management tend to value stock options the most. The stock market is wild and unpredictable, meaning a stock’s value may not reflect its underlying value.

Many companies have found themselves in situations where executives have received huge compensation for objectively mediocre results.

Reliance on Collective Output 

To receive a bonus via stock options, employees need to perform to a high standard. The problem is that an individual employee could have a great month yet lose out because their team failed to pull their weight.

This can leave top employees feeling like they’re not receiving the credit they deserve for all their hard work.

Corporations need to think about their teams and how they perform before considering whether offering stock is the fairest compensation option.

Conclusion 

One of the biggest challenges of starting a stock-based compensation program is managing the accounting side. With new tax implications and reporting requirements, accounting for stock options is a major problem for many businesses.

Get help with your stock options program with the help of Early Growth. To learn more about handling the accountancy side of stock options, contact us today. Our startup tax advisor services can provide the guidance you need to succeed in your stock option program for employees. 

Learn how we can put more time back in your day.