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. 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.
In practice
Real-world examples
Example 1
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. If the fair value of each option is $4, the total expense is 5,000 x $4 = $20,000, or $5,000 a year. The finance team records this on the income statement each year.
Example 2
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. No real shares are issued, but the company must still record a liability that grows as the agency's value rises. This is why finance managers track the agency's valuation every year.
Example 3
A manufacturing firm rewards its retiring operations director with direct company shares in lieu of a traditional lump-sum cash retirement bonus. If the shares are worth $60,000 on the grant date, the firm records $60,000 of expense and saves the same amount in cash. The director becomes a long-term shareholder rather than leaving the business entirely.
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
Worked example: a firm grants 1,000 options to a manager. The fair value calculated for each option is $5, so the total expense is 1,000 x $5 = $5,000, expensed over the vesting period. If the options vest over four years, the annual expense is $5,000 / 4 = $1,250.
Suppose the manager leaves after one year and forfeits the rest. The expense recognised for the year is $1,250, and the remaining $3,750 that had not yet been recorded is not charged. If a manager stays and the options are later exercised at a strike price of $8, the company receives 1,000 x $8 = $8,000 in cash and issues 1,000 new shares. This cash is separate from the expense, which is a measure of the value given for services.Case study
Seen in the real world
This is a fictional, illustrative scenario. 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, creating a total compensation expense of 2,000 x $10 = $20,000.
This expense was spread across three years at roughly $6,667 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 at an agreed strike price of $8 per share, paying 2,000 x $8 = $16,000 to the company. The agency issued 2,000 new shares, so 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. The agency had 98,000 shares in issue before the exercise, so the new total was 100,000 and existing owners were diluted by 2,000 / 100,000 = 2%. With the agency's value doubling, the remaining owners' stakes were worth far more than before. The finance team reported the $20,000 expense, the $16,000 of cash received and the 2% dilution together so that the board could see the full picture.
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.