What it means
For non-finance managers, understanding share-based payments is essential because they represent a real cost to the business, even if no cash leaves the bank account. When a company awards stock options or shares to its staff, it is essentially trading future ownership for current talent and hard work.
Start-ups and growing businesses often use this strategy to attract skilled people when they cannot compete with the high salaries offered by established corporations. From an accounting perspective, these payments must be recorded as an expense on the income statement, usually spread out over the period the employee earns them.
This is known as the vesting period. When employees meet certain conditions, such as staying with the company for a specific number of years, the shares officially become theirs.
While this does not affect your cash flow, it does dilute the ownership percentage of existing shareholders because the total number of shares increases. In practice, managing these programmes requires careful planning.
If you give away too much equity too soon, founders can lose control of their company. Conversely, offering fair equity stakes can motivate teams to drive profitability and increase company valuation.
Finance teams calculate the fair value of these shares when they are granted and track them closely to ensure compliance with reporting standards, giving leaders a clear picture of total compensation costs.
In practice
Real-world examples.
Example
A tech start-up offers its lead software engineer 5,000 stock options that vest over four years, conserving precious cash while securing top-tier technical talent.
Example
A growing marketing agency grants phantom shares to its department heads, promising a cash bonus tied to company share value growth after three years of service.
Example
A manufacturing firm rewards its retiring operations director with direct company shares in lieu of a traditional lump-sum cash retirement bonus.
Think of it
“Paying with shares is like offering a baker a slice of the bakery instead of a cash wage today, meaning they work extra hard to make the whole pie bigger and more valuable for everyone.
Formula
Calculation
Total Expense = Number of Instruments Granted x Fair Value per Instrument at Grant Date
Example: A firm grants 1,000 options to a manager. The fair value calculated for each option is 5 pounds. Total expense is 1,000 x 5 = 5,000 pounds, expensed over the vesting period.Case study
Seen in the real world.
BrightWeb, a digital design agency, wanted to hire a senior creative director but lacked the budget to match larger agency salaries. To bridge the gap, the founders offered a compensation package including a modest base salary and a share-based payment of 2,000 stock options, vesting evenly over three years.
The finance team calculated the fair value of each option at the grant date to be 10 pounds, creating a total compensation expense of 20,000 pounds. This expense was spread across three years at roughly 6,667 pounds per year on the income statement.
Over the next three years, the creative director helped secure major new clients, doubling the agency's revenue. When the vesting period completed, the director exercised the options. Although no cash was spent to buy the shares, current shareholders experienced a slight dilution. However, the business growth far outweighed this dilution, proving the share-based payment was a successful tool for aligning incentives and driving company value.
Watch out
Common mistakes.
- Treating share-based payments as free because they do not involve immediate cash outflows.
- Failing to account for dilution when calculating future earnings per share.
- Not setting clear vesting conditions tied to performance or time.
Questions
People also ask.
Do share-based payments reduce our company's bank balance?
No, they do not involve cash outflows at the time of the grant, which is why cash-strapped businesses find them useful.
Why do we have to record an expense for shares if no cash is paid?
Accounting rules require it because you are giving away a valuable asset, which is company ownership, in exchange for services.
What happens if an employee leaves before their shares vest?
Typically, unvested shares or options are forfeited back to the company, and previously recorded expenses for those specific shares may be reversed.
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