Meaning of Stoke-Based Compensation
Equity participation through employee stock plans constitutes an essential part of compensation packages offered to reward employees. Stock options are to purchase a specified number of shares of a company’s stock at a specified price (called the exercise or a stoke price) for a specified period of time (called the potion period or life of the potion).companies typically grant fixed options, where the exercise price is fixed and the number of shares can be determined at the grant date. The exercise price usually is set equal to the market price of the underlying stock at the grant date, and typically remains fixed over the life of the option, although there are exceptions. Employee stock options often a vesting period of several years before which the stock options cannot be exercised. The vesting period is a time frame over which the employee will become eligible to actually own the stock.
Companies use stock options as a method of long-term compensation. Options are more and more often granted to executives and other employees as an alternative to increase in base compensation. Some of the reasons for using stock options are:
- Options make employees have the same interests as shareholders.
- Options provide an opportunity to reduce employee’s base compensation. This balances the great differences between the compensation of executives and other employees.
- Options are also a tax-efficiency way to pay employees.
- Options encourage job creation in knowledge-related industries.
- Options help companies to cope with tight labour markets.
While the shift originally began with the rapid growth of stock option grants to executives, companies also structure compensation for broader groups of employees using stock options. It spread throughout the management and professional ranks. Part of the reason for the rise in stock options has been the tight and tightening labour market and the explosion in high technology job creation and economic growth. There are, however, opinions that stock-based compensation may actually hurt corporate performance. Murphy argues that the academic evidence “directly kinking current grants to future performance is, frankly, rather flimsy”. One common objection to the positive spin put on stock options is the observation that a company with a broader stock-based compensation plan may experience significant increase in its shareholder value over a certain time period. But if this company is compared to its entire industry group, then a controversy may arise as to whether employees did well or shareholder did well, which may prove to be a hoax if the company actually did worse than the rest of its industry group.
For these reasons, some companies have structured their stock option programs so that they assure some type of above average performance:
- Some options have a premium price set higher than the market price of the common stock on the date the option is grated and include the possibility that no options will be earned.
- Some options will not vest until certain strict performance targets are met by the company.
- Some options index their exercise to a market or industry group average to ensure that profit from the options comes as a result of the company’s performance rather than the performance of the market or the company’s industry group.
Nevertheless, stock-based compensation sensitivity has increased rapidly around the world. Jensen showed that stock options appeared to be quite low during the 1970s and early 1980s in the US. Evidence suggests that given change in the stock price changes the value of equity incentives by approximately fifty times more than changes in cash compensation. The global trend has also reached India, where stock options seem to be popular form of equity based compensation. Under this plan, employees are allotted the shares of the company below the ,market price in such way that they enjoy long-term benefits, either due to appreciation in share prices or options are convertible at different time periods ranging between one to five years.
§ Stock options are a right purchase a specified number of shares of a company’s stock at a specified price for a specified period of time.
§ A method of long-term compensation.
§ Commentators argue that stock-based compensations may actually hurt corporate performance.
§ For optimal results, companies have structured their stock option.
§ Set higher than the market price of the stock
§ Vesting linked to achievement of performance targets
§ Index exercise price to a market or industry group average.