Public companies often compensate employees in part by giving them stock options. This form of employee compensation conserves cash, improves retention and aligns employees’ interests with the interests of their employers. However, stock option compensation also dilutes ownership of existing shareholders. Investors considering purchasing shares of a public company can find information about stock option compensation in the cash flow statement.
For help managing your money, including figuring out what to do with stock options, consider working with a financial advisor.
Stock Option Compensation Basics
Non-cash compensation in the form of stock options is particularly attractive to young companies that have limited cash and need to attract talented employees. It allows them to create appealing compensation packages for in-demand workers while conserving cash, improving retention and incentivizing performance.
In addition to paying cash salaries and bonuses and providing fringe benefits, employers sometimes choose to compensate employees by offering them ownership. Some companies give actual shares to employees, while others hand out stock options or restricted share units (RSUs) that give the employees the right but not the obligation to buy shares at a set price. Options are typically only exercisable after a vesting period of a few years. That encourages key workers to stay in their jobs until they are able to gain ownership of the optioned shares.
Making owners out of employees helps aligns their interests with those of the company and its investors, since options will be worth more when exercised if the company’s share price increases, and vice versa. Options can also motivate workers to put in more effort. Sometimes options are handed out in exchange for reaching performance benchmarks or achieving specific goals.
It’s important for investors to know when companies they invest in are using employee stock option compensation. The main reason is that granting options to employees increases the number of shares. When options are eventually exercised and shares are distributed to employees, it dilutes ownership of existing shareholders. Issuing more shares reduces earnings per share (EPS), an important determinant of the stock’s value and price.
Finding Stock Option Compensation Expense
Public companies list expenses for employee stock options in several documents. They are included in the detailed 10-K forms submitted to the Securities and Exchange Commission every year. They should also appear in the annual reports, which are shorter and more slickly produced information packages created to give to investors.
Figures for stock-based compensation should appear in the income statement and in the cash flow statement. In the income statement, employee stock options are used to calculate gross profit or operating profit. In the cash flow statement, stock option expense appears under the cash from operations heading.
Like depreciation and amortization, stock-based compensation is a non-cash expense. Therefore, like depreciation and amortization, the value of stock options can be added to cash from net income to produce the figure for cash from operations.
Calculating Stock Option Compensation Expense
To calculate total stock compensation expense, multiply the number of stock options that have been granted by the fair market value on the date of the grant. To determine how much stock compensation expense to record for each annual period, divided the total stock compensation expense figure by the number of years required for vesting.
For example, granting 10,000 options to shares on a date when the fair market value of the options is $12 each makes total stock compensation expense $120,000. If the vesting period is three years, then $120,000 is divided by three to indicate that $40,000 of stock compensation expense should be recorded every year.
The Bottom Line
Many public companies use stock options to attract, retain and incentivize employees. While compensating employees with options conserves essential cash, it can also dilute ownership and affect the value of holdings by existing shareholders. That makes employee stock compensation expense useful information for investors who are deciding whether or not to purchase shares of a company. Employee stock compensation expense can be found in the income statement and in the cash flow statement of a company’s annual report or 10-K.
Financial Planning Tips
- Consider talking to a financial advisor before investing in a company that uses employee stock compensation. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Even if you do receive stock options, you’ll likely still be earning some cash. Make sure you put some of it into a retirement account like a 401(k) or an individualized retirement account.
Photo credit: ©iStock.com/Riska, ©iStock.com/gorodenkoff, ©iStock.com/aquaArts studio