Stock compensation definition (types and how it works)

Some companies offer their employees stock compensation in various situations, such as supplementing cash remuneration, rewarding employees or in place of cash payments. Offering this compensation can benefit both employers and employees, as it encourages long-term commitment to companies by giving employees a vested interest in the business. Learning about this concept can help you decide whether it's worth accepting if your employer offers it. In this article, we look at what stock compensation is, its functions and the various kinds and offer an example to illustrate how it works.

What is stock compensation?

Stock compensation is a form of financial reward companies can give their employees in place of their regular wages or as a supplement. When employers give stock or stock options, they offer employees partial ownership of the company and a proportional share of the profits. This act can be good for new companies that want to save money on wages because they haven't reached substantial profit levels. Paying employees in stock can be a great way to incentivise productivity, as working hard can directly increase the value of the stock.

Many large companies also offer stock options, as it's an effective way to encourage people to grow the value of company shares. It's a technique businesses use to form partnerships with employees and incentivise loyalty since it gives recipients a stake in the company. Businesses may also give stock options in place of monetary compensation if they want to relieve pressure on cash flow. Whether employees might want to accept stock options depends on their circumstances. Speaking with a financial advisor can also help you decide.

Related: What an employee stock purchase plan is, and why to join one

How shares as compensation work

Employees experience vesting periods, which is the length of time it takes for them to gain full ownership of their shares or options by staying with the company. The time employees own their shares also determines which options they can exercise. For example, if a company gives an employee 1000 shares with an annual vesting period over four years, the employee can exercise 250 shares per year for four years.

Employers can leverage vesting as a powerful tool for driving employee retention, as employees typically forfeit their unvested shares if they leave their role during this period. During vesting, employees can purchase a set number of shares at a specified price. Employers often look at the employee's performance record and the time of year to help them decide when and what to offer. There is typically an expiration date on stock options, often around ten years, and employees can exercise their stock any time before they expire.

Related: What are stock options? (A comprehensive professional guide)

Types of stock compensation

Companies may offer this compensation in different circumstances according to internal needs or reasoning. These needs include tax optimisation purposes and performance metrics. Some compensation types companies offer are as follows:

Stock options

This method enables employees to buy company stock at a set price, also known as the exercise or strike price, for a predetermined number of years. It's a good technique for boosting employee retention rates. If employees want to exercise their stock options, it's imperative they remain in their position for the vesting period, which may last several years. After this period, employees can sell the options.

These differ from shares because they provide employees with different rights and advantages. For example, companies performing well in the marketplace may offer an exercise price that's lower than the fair market value, which enables employees to buy at discounted prices and sell at the higher market value later. This method can increase profits when companies perform well and their stock value rises quickly. Stock options can also offer tax advantages and help employees save money, since it's unnecessary to pay tax on the stock until after you liquidate it at a profit.

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Non-qualified stock options (NSOs)

These stock options require holders to pay income tax based on the exercise price, or the value per share they pay to the company, minus the exercised option price. Non-qualified stock options allow you to report them only once they become exercisable, offering a tax advantage. Their price is typically close to that of the share's market value once the company goes public. Because employees can normally acquire the stock at significantly discounted rates, the fact they pay income tax is not usually a concern.

Sometimes businesses use clawback provisions, which state the company can reclaim the NSOs under specific circumstances, such as bankruptcy or a buyout. Clawbacks can also apply when employees leave their position before an agreed date. This requirement creates a powerful incentive for people to remain with companies for the long term.

Incentive stock options (ISOs)

These are special stock options that only employees can access. ISOs come with tax advantages because HMRC doesn't require employees to pay tax on them at the point of purchase. ISOs can also be advantageous for tax purposes because capital gains tax rates are lower than income tax rates meaning the overall tax liability may be lower when you take some of your wage in this form. Companies usually reserve these stock options for their best employees, who they want to encourage to stay for as long as possible.

ISOs are most commonly available with publicly traded companies and privately owned firms that plan on going public later. Like other company benefits, ISOs can be an attractive incentive for highly talented employees and can bring the best professionals to organisations. As with NSOs, ISOs may also come with clawback clauses that demand employees hold them for a designated time to manipulate tax rates.

Related: What is treasury stock? (With definition and example)

Performance shares

Companies that offer performance shares typically give them to high-level managers and executives as rewards for meeting performance metrics. They most commonly come as bonuses and stock options since these encourage hard work in important business areas, further boosting stock value and productivity. Companies may award employees with these in response to them hitting targets like return on investment (ROI) or earnings per share (EPS).

One potential downside to this type of share is it often relies heavily on the company's performance. For this reason, companies may issue performance shares only if they reach their targets, such as the stock reaching or exceeding a particular value. They may also use another accounting metric to determine how they issue these shares, such as cash flow targets.

Read more: How to become a stock trader (with job and salary info)

Restricted stock

Restricted stock includes company stock that goes through a vesting process. The company can choose what the vesting process entails. Employees can still reap benefits from owning the stock since they may receive dividends, but like the others, it's only possible to sell them after the vesting period. As with other options, employees lose the right to stock ownership if they leave their position early. Once the vesting date arrives, employees pay taxes on their shares based on their market value at the close.

Restricted stock units (RSU)

An RSU is a company's promise to pay a certain number of shares based on a vesting schedule. RSUs make it easier for a company to avoid diluting its share base and lower administrative costs because the company hasn't yet issued the shares to employees. After vesting, an employee gains the rights of stock ownership, such as voting rights. For tax purposes, the entire value of an employee's stock counts as ordinary income on the vesting date or when the stocks become transferable.

Related: What is equity investment? (A guide to understanding it)

Example answer for accepting a compensation offer

When deciding whether to accept your employer's compensation offer, consider the following example as a guide:

Example: An employee works for an electrical company, which grants them the option to purchase 1,000 shares in the company at £40 per share. The company uses a multi-year vesting schedule for five years, so they can exercise 200 shares in the first year, which means they can purchase and sell the stocks included in the option. The company experiences impressive financial growth in the first year, and the value of the company's stock rises to £80. The employee purchases the 200 shares at £40, or £8,000 in total.

They decide to sell those same stocks on the market at the £80 value for £16,000. As a result, they gained £8,000 in profit since the value of the stock doubled. The next year, the employee can exercise the options again until they eventually reach the 1,000 shares.

Disclaimer: The model shown is for illustration purposes only, and may require additional formatting to meet accepted standards.