An introduction to share-based compensation

Share-based compensation (and equity-based compensation in general) is an opportunity for owners and managers to align the goals of their employees with the goals of the business. By providing a “piece of the pie,” employees are allowed to participate in the pride of ownership and share directly in the success of the organization.

While there are many employee perks to this type of compensation, the accounting rules and requirements can be complex. There is also an issue for business owners in the loss of control and dilution of their ownership; however, there are a multitude of alternative options that can protect from this.

Understanding different types of share-based compensation plans

The accounting for most share-based compensation plans falls under the scope of Accounting Standards Codification (ASC) 718 Compensation — Stock Compensation. While there are many different parts of the ASC that an organization needs to consider, there are a few key determinations that an organization needs to make on each award:

• Whether the award is equity or liability classified, which determines the initial measurement, subsequent remeasurement (if applicable) and expensing of the award.
• How the award should be valued (if a simple valuation technique can be used or if a more in-depth technique needs to be used).

In order to make these determinations, management needs to review the award agreements in detail and understand the key parts of the agreements. Management should also consider implicit items (such as historical results and actions) and incorporate them in its analysis.

There are several common types of share-based compensation awards, and it’s important to understand how they can be classified and how an award should be accounted for based on its classification.

1. Stock options

• Stock options are a well-recognized form of equity-based compensation. They provide an employee with the right, but not the obligation, to purchase an equity interest in the organization for a predetermined and fixed price by a fixed date.
• Total expense is generally measured once and recognized over a period of time relating to when the individual earns the option. The expense runs through earnings through a compensation expense, and the offset is recorded to equity through additional paid-in capital.

Stock options are one of the most standard and traditional forms of share-based compensation. Vesting requirements can be placed so an employee cannot exercise all granted shares on the grant date and incentivizes them to meet service or other vesting conditions, such as performance conditions.

Stock options are usually equity-classified awards, so the total amount of compensation expense that an entity will recognize is determined once (on the grant date). Low-complexity options can usually be valued with a simple valuation technique such as a Black-Scholes model — which can avoid the need to engage a valuation specialist to value the option.

One important consideration is that a valuation of the underlying stock is usually always required as it is an input in essentially all valuation techniques. When options have more complex vesting structures such as market vesting (e.g., a stock price needs to rise by X% for the options to vest) or performance vesting (e.g., a company must achieve $X of revenue for the options to vest) then more in-depth valuation technique — such as a binomial model or Monte Carlo simulation may need to be used. This usually requires the assistance of a valuation specialist.

For expense recognition, the expense of the award is recognized over a period known as the requisite service period (which is the amount of time that an employee must work in order to earn the benefit). In more simplistic options with only time/service vesting, this period can follow the vesting period and the option is expensed equally over that period. As with all estimates, other factors can influence the service period so it’s important that Management consider explicit and implicit factors when creating its estimates.

2. Profit interest plans

• Generally, profit interest plans are for non-stock organizations (LLCs, partnerships, etc.) that grant an interest in the future appreciation and growth of the organization. The unit holder generally does not participate in the annual profits/losses of the business, but, if a change in control or other triggering event occurs, the holder receives a portion of the appreciation.
• Structuring of these plans can be complex and costly. Additionally, recordkeeping/administration can be complicated; however, the tax implications can be extremely beneficial for employees if properly structured.
• They can be equity classified or liability classified. The expense from the plan will run through earnings with the offset being included in members' equity for equity awards) or will create a liability (when liability is classified).

Profit interest plans (also known as a carried interest plan) are specifically designed for entities that are taxed as a partnership. These plans can be difficult to set up because individuals who participate in these plans are normally considered equity holders (and therefore ineligible to receive W-2 compensation — receiving a K-1 instead). Proper planning and organizational structuring can mitigate and work around this, but it is important to engage with a reputable firm for the design of these plans.

In most profit interest plans, participants do not receive annual distributions or income attributed from the business’s activities. Instead, they have a right to receive future appreciation of the business over a certain threshold, which is usually outlined in the plan document.

While these plans are normally classified as an equity award, they can be classified as a liability award if they meet certain qualitative factors. The valuation for equity classified awards will be similar to stock options in that they are valued once; however, due to the nature of a profit interests plan a valuation specialist is usually required.

When an award is liability classified, however, they are initially measured at their fair value and then subsequently remeasured each reporting period based on an updated fair value of the award. The compensation expense that is recognized each reporting period can change based on the remeasurement of the award. At the end of the day, the total compensation expense that is recognized will equal the intrinsic value of the award at its expiration.

Profit interest plans can be complex to set up and manage due to their legal structure and reporting requirements. They can carry a massive benefit for employees — when plans are properly set up, they can shift the tax treatment of the appreciation from compensation into capital gains treatment. This is one of the major benefits of profit interest plans along with being able to give employees an equity award in these types of companies.

There are various other plans and types of alternative compensation awards that management can consider adding to their total benefits package:

3. Restricted stock awards (RSAs)

• RSAs are similar to stock options; however, an employee is transferred actual shares of stock/membership units versus the right to purchase a share of stock in the future. This share is usually restricted for a period of time (or for a condition) before it becomes fully vested.

Like stock options, this award involves the granting and transfer of shares of stock. RSAs differ in that the actual equity shares are transferred to the employee (versus an option to purchase shares). RSAs are typically equity classified awards and therefore their expense recognition will be similar to our stock option example. Certain vesting conditions (such as a market or performance condition) can cause a more in-depth valuation technique to be required.

4. Stock appreciation rights (SARs)

• Normally, SARs do not involve the grant or transfer of an equity interest in the organization. Therefore, there is a limited risk of share dilution or loss of control.
• Setup and accounting can be complex depending on setup and vesting requirements.

For organizations that are concerned with transferring equity and possibility diluting their ownership, an alternative to actually granting an employee stock (or an equity interest) is a SAR. In general, a SAR agreement entitles an employee to share in the appreciation or growth of a stock price.

For example, a SAR plan is set up so that an employee receives a cash payment equal to the appreciation of a stock after three years so long as they remain employed. These plans usually set the price of the stock on its grant date and specify any conditions required for vesting.

These types of plans normally do not convey any equity rights. Moreover, they usually carry a cash payment at the end of vesting. These plans are usually liability classified for this reason and require annual remeasurement. Private companies can make an accounting policy election to apply a practical expedient which uses the intrinsic value of the SAR instead of having the SAR valued individually.

How Wipfli can help

In the world of share-based compensation, there are a variety of plans and options that can be tailored to meet the needs and goals of any organization. They are a great option to consider for employers that want to offer a competitive advantage over their peers. However, the potential tax implications and regulatory requirements can be difficult to navigate on your own.

As always, Wipfli has an experienced team of accounting, tax, valuation and assurance professionals who are here to help with share-based compensation needs. Our experienced associates are ready to work for you, so you can focus on driving results. Contact us today to learn more.