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10.3 The role of stock awards in compensation plan design
Publication date: 30 Nov 2022
us Stock-based compensation guide
Stock options, restricted stock, and other long-term incentives are critical components of effective compensation programs—in fact, the majority of companies grant at least one, if not a combination of these vehicles to select employee levels.
Figure SC 10-1 summarizes the accounting, tax and plan design considerations for the major categories of employee stock-based compensation awards.
Figure SC 10-1
A primer on stock-based-compensation awards
A primer on stock-based-compensation awards
All awards are presumed to be equity-classified except for the cash-settled SAR and phantom stock
At-the-money stock options (non-qualified) with service condition |
Incentive stock options (qualified) |
Discounted stock options |
Premium options |
Stock-settled SAR |
Cash-settled SAR |
Restricted stock or restricted stock units (RSUs) |
Performance shares with performance conditions |
|
Description |
Stock option with exercise price equal to stock price at grant date, vests based on continuous employment over specified time period |
Same as nonqualified at-the-money stock option except for special tax treatment if the option complies with IRC requirements |
Stock option with exercise price less than stock price at grant date |
Option with exercise price set higher than grant date stock price |
Employee receives stock equal to intrinsic value at exercise; otherwise identical to nonqualified stock option; may be at-the-money, discounted or premium exercise price |
Same as stock-settled SAR except intrinsic value at exercise paid in cash |
Grant of shares (restricted stock) or promise to issue shares (RSUs) upon completion of service condition |
Restricted stock or units that vest based on time-based vesting plus attainment of non-stock-price-related performance conditions (e.g., revenue or EPS) |
Pros |
Employee benefits from stock price increases; can be issued to employees and directors; simple to understand; provides more 'upside' potential than restricted stock |
Same as nonqualified at-the-money option except employee may receive capital gain treatment instead of being taxed as ordinary income |
Same as at-the-money option except provides reward even if stock price declines somewhat; employee may perceive that discount has more value than increase in fair value |
No value to employee unless stock price rises above premium; increases motivation; reduces fair value |
Same as nonqualified stock option plus exercise price need not be paid by employee, and reduces dilution compared to broker-assisted exercise |
Same pros as stock-settled SAR except for accounting under ASC 718 and no share dilution |
Simple for employees to understand; provides value if stock price declines; less share usage as compared to stock options |
No expense unless performance target attained; employee motivated to reach targets; shareholders also benefit if targets reached |
Cons |
Has no 'downside' risk if stock price declines below exercise price; may not provide optimal linkage with business, compensation and shareholder objectives |
Same as nonqualified at-the-money stock options; employer generally has no tax deduction unless disqualifying disposition; can only be issued to employees; no tax benefit recorded for accounting purposes until exercise and a disqualifying disposition |
Unfavorable tax treatment for employee under IRC Section 409A |
Employee may demand more options to make up for perceived reduction in value |
Same as nonqualified stock options |
Mark-to-market accounting; otherwise same as nonqualified stock options; requires use of cash |
Provides less value than options if stock price rises; may be viewed as a giveaway by shareholders |
Difficulty in calibrating performance condition |
Accounting under ASC 718 |
Expense based on fair value at grant and number of options that vest, recognized over service period |
Same as nonqualified at-the-money stock options; no tax benefit recorded for accounting purposes until exercise and a disqualifying disposition |
Same as nonqualified option; fair value higher than at-the-money stock options but generally increase is less than discount amount |
Same as nonqualified at-the-money stock options except lower grant-date fair value |
Same as nonqualified stock options |
Considered liability award with mark-to-market fair value (using an option-pricing model); total expense equals cash paid to employee |
Expense based on grant-date fair value of stock and number of shares that vest, recognized over service period |
Same as restricted stock except recognize compensation cost over the period when targets will probably be attained and true-up for actual vesting |
US taxation |
Employee: Subject to income and employment taxes based on intrinsic value (difference between stock price and exercise price) at exercise Employer: Deduction equal to employee's income |
Employee: No employment taxes; no tax at exercise (other than AMT); subject to capital gains tax at sale of shares (may have ordinary income if a disqualifying disposition occurs) Employer: Deduction equal to employee's ordinary income; no deduction unless disqualifying disposition |
Employee: Under IRC Section 409A, discounted options treated as deferred compensation with employee taxed at vesting and 20% penalty applied Employer: Deduction equal to employee's income |
Same as nonqualified at-the-money stock options |
Same as nonqualified stock options |
Same as nonqualified stock options |
Employee: Subject to tax at vesting based on stock price on that date; may elect under IRC Section 83(b) to be taxed at grant date for restricted stock. RSU's may allow for further deferral opportunities Employer: Deduction equal to employee's income when taxed |
Same as restricted stock |
Performance shares with market conditions |
Options with performance conditions |
Awards with vesting accelerators |
Indexed option |
Reload options |
Maximum value options |
Phantom stock |
|
Description |
Same as performance shares with performance conditions except with targets related to stock price increases or relationship of stock price to an index |
Stock option that vests based on attainment of performance condition |
Options or restricted stock with time-based vesting where vesting accelerates if specified targets are attained, (performance or market condition is attained) |
Options with exercise price that increases (or decreases) at regular intervals, either by fixed percentage, reference to published index or peer group stock price changes |
Grant of new options, subject to same expiration date as original option, for shares of owned stock used in option exercise |
Stock option with cap on maximum level of appreciation (e.g., two times exercise price) |
Grant of hypothetical stock units (full value or appreciation only) equivalent to shares of stock. Units generally valued based on a formula and employee receives cash upon exercise or vesting |
Pros |
Employee directly motivated to increase stock price; fair value per share generally lower than stock price at grant |
Same as performance shares except have greater upside potential of an option |
Increase employee motivation to achieve targets |
Same as premium options if exercise price only increases; exercise price could drop (e.g., when peer group prices fall) then employees may be rewarded for doing better than peers |
Locks in stock price appreciation for employee but retains value of future appreciation |
Reduced compensation expense with little or no reduction in employee's perceived value |
Simple to understand |
Cons |
Compensation expense not reversed if targets not attained; lattice or Monte Carlo model generally required to measure fair value |
Same as performance shares except no protection against reduction in stock price |
Targets may be outside employee's direct control; retention value lost once targets are reached |
More complicated to understand and administer; fair value complex to calculate; shareholders may question why employees are rewarded when stock price declines |
May ultimately have higher compensation expense |
Caps upside potential value; hard to explain to employees; generally requires lattice model |
Mark-to-market accounting if settled in cash |
Accounting under ASC 718 |
Fair value at grant-date reflects market condition using lattice model; expense recognized over derived requisite service period and not reversed if targets are not attained |
Same as performance shares with performance condition |
For awards with performance condition, see performance shares with performance conditions. For awards with market conditions, see performance shares with market conditions |
Generally needs a lattice model to measure fair value; cross-volatility assumption may be needed; otherwise accounting same as at-the-money stock options; could be a liability if index is something other than stock price |
Same as nonqualified options with reload treated as new grant; original grant and each reload may have short expected term assumption, reducing fair value and expense |
Same as at-the-money stock options except fair value lower due to cap; generally need lattice model to measure fair value |
Same as cash-settled SAR |
US taxation |
Same as restricted stock |
Same as nonqualified options |
Same as options or restricted stock |
Same as nonqualified options |
Same as nonqualified options with reload treated as new grant |
Same as nonqualified options |
Employee: Subject to ordinary income tax. |
10.3.1 Costs and benefits of stock-based compensation plans
Companies should attempt to estimate the perceived value to their employees of a stock-based compensation plan and compare that perceived value to the fair value determined under ASC 718. According to academic research and empirical data, there may be a significant gap between the cost, as measured in accounting terms, and the perceived value to the employee of a stock-based compensation award. Some of the more prominent observations are:
- Academic research finds that the cost of stock-based compensation to a company (fair value) often exceeds what participants perceive to be the value of stock-based compensation, due to factors such as lack of diversification, non-transferability, and risk aversion.
- Research further indicates that the cost/benefit gap increases for lower level employees because those employees are less able to bear the increased risks (i.e., lack of diversification) associated with stock-based compensation.
- Generally, the cost/benefit gap also increases proportionally to the extent that the stock-based compensation is out-of-the-money (e.g., the gap is narrowest for at-the-money options and widest for underwater or premium-priced stock options).
- In one study, observed trades of cash for stock-based compensation confirmed that the fair value of the stock-based compensation in such trades exceeded the value of the cash compensation that was replaced (e.g., $12,000 of stock-based compensation was required to replace $10,000 of cash compensation).
- Surveys of employees' preferences can be used to better understand the perceived value of alternative forms of stock-based and cash compensation. Perceived value is a temporal notion that hinges on current economic and market factors.
10.3.2 Practical implications of ASC 718 on plan design
When designing a long-term incentive plan, a company should consider the following steps:
- Estimate the fair value and compensation cost associated with each alternative design.
- Ascertain employee preferences regarding different forms of stock-based compensation (e.g., use focus groups, employee surveys, etc.) to estimate the cost/benefit relationship of alternative strategies.
- Develop plan designs that balance share usage/dilution, tax deductibility, deduction timing, the effective tax rate, compensation cost, cash flow, earnings per share and administrative costs.
- Re-evaluate the total compensation mix (e.g., cash vs. equity) to optimize value for total compensation cost.
- Introduce performance targets in stock-based compensation plans, particularly for senior executives and assess implications of market versus performance conditions.
- Develop methodologies to compare different forms of compensation for external benchmarking and internal purposes.
- For non-US employees, make sure that new plan designs maximize tax deductibility in all jurisdictions.
- Determine the administrative requirements and costs of new plan design.
- Evaluate communications strategies.
- Reconsider the range of long-term incentive eligibility within the organization.
- Provide differentiation in grants to reward high performers and/or employees with higher retention risk.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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