What it means
The two common forms are options, which give the right to buy shares at a set price in future, and restricted stock units, which deliver shares outright once vesting conditions are met. Both are designed to tie part of someone's reward to how the business performs over several years.
For growing companies the appeal is obvious: they can compete for talent without spending cash they would rather put into product or hiring. The cost is real all the same, because existing shareholders end up owning a smaller slice of the company.
Accounting rules require the fair value of the award at grant date to be expensed over the vesting period, even though no cash leaves the business. Options are valued using a pricing model that considers the exercise price, volatility and time, while restricted stock units are usually valued at the share price on the grant date.
Because the charge is non-cash, many companies present an adjusted profit figure that adds it back, which is one of the more argued-over habits in reporting. Investors who look past that adjustment focus instead on dilution: how many shares will exist once every outstanding award has vested.
Vesting schedules and forfeitures complicate the arithmetic in practice. Awards that lapse because someone leaves before vesting have their cumulative expense reversed, so the recorded charge moves around as staff turnover changes.
In practice
Real-world examples.
Example
A startup with limited cash offers a senior engineer a salary of $130,000 plus 20,000 restricted stock units valued at $6.00 each. The $120,000 total grant value is expensed at $30,000 a year over four years, while the cash cost stays at the lower salary figure.
Example
A listed retailer grants its executives options with an exercise price of $40.00 when the shares trade at $40.00. Three years later the shares sit at $34.00, the options are worthless to the holders, and the company has still recorded the full grant-date fair value as an expense.
Example
An investor comparing two software companies notices that one reports operating profit of $12,000,000 before a $9,000,000 stock compensation charge. Adding the charge back changes the picture entirely, so the investor works with the reported figure and the fully diluted share count instead.
Formula
Calculation
Total Grant Value = Number of Awards x Fair Value per Award at Grant Date
Annual Expense = Total Grant Value / Vesting Period in Years
A technology firm grants 48,000 restricted stock units on a day when its shares trade at $25.00. The total grant value is 48,000 x $25.00 = $1,200,000.
The awards vest evenly over 4 years, so the annual expense is $1,200,000 / 4 = $300,000, which is $300,000 / 4 = $75,000 charged in each quarter. None of this involves cash going out of the door.
Now suppose 6,000 units are forfeited when two employees resign during year two. The value now expected to vest falls to 42,000 x $25.00 = $1,050,000, and the cumulative charge is trued up so that the total recognised over the four years matches that lower figure.
Dilution is measured separately from the expense. With 12,000,000 shares already outstanding, the 48,000 units represent 48,000 / 12,000,000 = 0.4% of the company once they vest.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Bellrose Analytics, an invented data software firm, hired 40 people in a year and gave each of them restricted stock units worth $30,000 at grant date, vesting over four years.
The total grant value was 40 x $30,000 = $1,200,000, producing an annual charge of $1,200,000 / 4 = $300,000. Management of this fictional company presented an adjusted profit measure that stripped the charge out, and on that basis reported a profit of $220,000 against a reported loss of $80,000.
An investor reviewing a funding round pushed back. Over four years the awards would add roughly 160,000 new shares to a base of 8,000,000, diluting existing holders by about 2% for that year's hiring alone, and hiring was planned to continue. Bellrose kept the adjusted measure but began publishing the fully diluted share count and a four-year vesting schedule alongside it, which turned an argument about presentation into a straightforward discussion about ownership.
Watch out
Common mistakes.
- Treating stock compensation as free because no cash moves, when the cost lands on existing shareholders through dilution.
- Reworking the expense every time the share price moves, when the fair value of an equity-settled award is fixed at grant date.
- Comparing two companies on adjusted profit without checking how much stock compensation each one has added back.
Questions
People also ask.
What is the difference between share options and restricted stock units?
Options give the right to buy shares at a set price and are worthless if the price never rises above it, while restricted stock units deliver actual shares and retain value even if the price falls.
Why is stock compensation an expense if no cash is paid?
Because the company has received services from employees and paid for them with something of value, and leaving the cost out would overstate profit.
What happens to the expense when someone leaves before vesting?
The awards are forfeited and the cumulative expense already recorded for them is reversed, reducing the charge in the period the leaver is identified.
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