Many tech companies compensate employees using stock-based compensation (SBC) models, allowing employees to share in the potential upside [or downside] of an emerging growth company. However, depending on the nature and characteristics of the model, such financial instruments may be classified as either equity or liability. For unprofitable start-ups needing to comply with debt covenants, determining the correct classification and structuring compensation accordingly is an important goal.
Stock-based compensation includes stock options, shares (both restricted and non-restricted), and other financial instruments that convert to shares or cash over time as the employee becomes vested in the instrument. Stock-based compensation consists of many different financial instruments that allow employees the right to enjoy the gains in a company’s stock price, whether by purchasing the stock through options, receiving a fixed amount of shares of restricted stock which vest over time or receiving a fixed cash amount of stock after meeting vesting criteria. Issuing options, warrants, and other instruments can be complex and the classification of the instrument as debt or equity will depend on the features and characteristics of the instrument.
The specific terms and timing of SBC awards are critical factors in determining whether or not stock-based compensation should be classified as equity or liability.
With respect to terms, stock-based compensation that is settled in a fixed amount of dollars is usually classified as a liability while awards settled in a fixed number of shares is classified as equity. In simpler terms, when a company’s stock-based compensation is ultimately settled in stock, rather than cash, the award is classified as equity.
Example 1: Company A awards an employee $50,000 worth of stock as compensation. Because the nature of the award is a cash obligation, this award is classified as a liability.
Example 2: Company B awards an employee 50,000 shares of stock as compensation. Because the nature of the award is an equity stake of fluctuating dollar value, this award is classified as equity.
Additionally, awards that are indexed to a factor other than the common criteria of performance, market and service conditions are also usually classified as liabilities.
With respect to timing, the events that determine the vesting and settlement of a stock-based award also affect the award’s balance sheet classification. Awards that are mandatorily redeemable or certain to become mandatorily redeemable for the issuer are classified as liabilities because they represent the equivalent of a future obligation for the payment of cash.
Awards that only become mandatorily redeemable based on a contingent event that is possible, but not certain to occur are considered contingently redeemable. These awards are classified as equity but must be reevaluated each reporting period to determine if the contingency is no longer applicable and the award represents one that is now mandatorily redeemable. When a redeeming event becomes certain to occur, companies must reclassify the awards as liabilities, as it becomes certain that the entity has an obligation to settle the award in cash.
Oftentimes, stock-based compensation is redeemable at the employee’s or employer’s option. Stock-based compensation that is redeemable at the employee’s option is a considered an employer obligation, and thus a liability while awards that are redeemable at the employer’s option are classified as equity. When terms are less clear, if the company’s history suggests that stock-based compensation is usually settled at the employee’s discretion, or is usually settled in cash, the stock-based compensation would be classified as a liability. Companies with a history of awards being settled in stock at the employer’s discretion would usually classify such compensation as equity.
Many technologies and emerging growth companies are often unprofitable and compensate employees with stock and options to give those employees a stake in the future upside potential of the company. Cash-strapped companies need to be aware of how such compensation is structured. Equity-classified awards may be advantageous in cases when liability-classified awards could put companies dependent on loans and lines-of-credit out of compliance with debt covenants. Company owners concerned with diluting ownership stakes may prefer liability-based awards that are settled in cash rather than stock. Companies need to evaluate their goals and priorities when creating stock-based compensation plans to determine if liability or equity-based compensation is most advantageous to their financial and management situations.
The information contained herein is not necessarily all-inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriately qualified professionals.