I’ve been studying stock-based compensation across a wide range of companies for a few years now.
One thing I’ve learnt is that stock-based compensation can come in a variety of different forms. Each will have a different impact on the future cash flows from a company that accrues to shareholders.
With this in mind, here is a short primer on four of the most common types of stock-based compensation and how they impact the shareholder.
Restricted stock units
Restricted stock units, or RSUs, is the most common form of stock-based compensation I’ve encountered. It is essentially the issuance of new shares to employees.
Well-known companies such as Meta Platforms and Zoom Video Communications issue RSUs to employees. Typically, employees are given RSUs when they join the company. However, these RSUs only turn into shares – or “vest” – over a period of time. Only when they vest can an employee sell them or receive any dividends from holding them.
You can find the number of RSUs outstanding for a company on the notes section of their financial reports . By looking at the RSUs outstanding, you can gauge what is the future diluted share count once all these RSUs have vested.
Options
Another common form of stock-based compensation is options. Options give employees the right to buy new shares of a company at a predetermined price by a certain date.
The good thing about options for shareholders is that unlike RSUs, the company receives cash when these options are exercised. This increases the company’s cash balance and if the exercise price is above the book value, it also increases the book value per share.
If the stock price is below the exercise price upon expiry, employees will not exercise the options and will result in the options expiring worthless. When this happens, no new shares are issued and no cash exchange hands.
A well-known company that predominantly uses options as its form of stock-based compensation is Netflix.
Performance stock units
As its name suggests, performance stock units, or PSUs, are converted to shares for an employee based on a company achieving certain performance goals. PSUs are typically only given to senior executives of a company.
Companies that use PSUs tend to combine it with other forms of stock-based compensation.
Employee share purchase plan
Employee share purchase plans, or ESPPs for short, are programs that allow a company’s employees to purchase new shares of the company with a portion of their salary.
So instead of getting all their salary in cash, they receive some in cash and some in shares. Employees are often incentivized to purchase shares using the ESPP as they can buy new shares of a company at a discount to market prices.
However, employees are only allowed to purchase up to a certain amount of shares per year. Companies such as Medtronic offer employees an ESPP if they wish to make use of it.
Like options, this form of dilution is not as bad for shareholders as a company receives cash in return, unlike both RSUs and PSUs.
Round up
The type of SBC that investors need to be most concerned about is usually RSUs and PSUs. These are dilutive to shareholders and companies do not receive cash back in return.
ESPPs are the least concerning as they usually only result in minimal dilution because of the cap that is imposed on how many shares an employee can purchase in a year, and discount that employees get tends to be small.
Options are also not as concerning as long as the exercise price is reasonably high. Most companies issue options that have an exercise price similar to the market price at the point of grant. However, some companies such as Wise issue options that have exercise prices much lower than market prices. In this case, these options are practically like RSUs and shareholders need to monitor the impact closely.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Meta Platforms, Netflix, Wise, and Zoom Video Communications. Holdings are subject to change at any time.