Share-based compensation has become a significant component of total executive compensation for public companies, with the goal of aligning management incentives with long-term shareholder value. As investors and regulators continue to scrutinize pay practices, compensation committees must navigate increasingly complex regulatory, accounting, valuation, and disclosure requirements.

This overview highlights key considerations for compensation committees making decisions about approving or modifying share-based compensation awards.

Governance and Design Considerations

The compensation committee plays a critical role in ensuring that equity awards align executive behavior with long-term shareholder value creation while maintaining fairness, transparency, and market competitiveness. This involves striking a careful balance between providing sufficient retention incentives and avoiding perceived windfalls or excessive dilution.

Designing equity programs requires thoughtful consideration of award mix and structure. Time-based awards can support retention and simplicity, while performance-based or market-based awards emphasize accountability and value creation. Many companies now incorporate multi-year performance cycles or relative total shareholder return (TSR) metrics to reinforce pay-for-performance alignment.

Peer benchmarking, external compensation surveys, and investor sentiment are essential inputs in determining appropriate grant levels, performance metrics, and vesting structures. Committees should also remain attentive to macroeconomic factors (such as stock market volatility, interest rate shifts, and sector trends) that influence the perceived and actual value of equity.

Regulatory and Disclosure Requirements

The regulatory environment governing share-based compensation is anchored in several key frameworks emphasizing transparency, accountability, and alignment between executive pay and shareholder outcomes. These include:

  • SEC Regulation S-K, Item 402: This requires detailed and transparent proxy disclosure of executive compensation, including the grant-date fair value of equity awards, performance metrics, and narrative discussions linking pay to company performance. The SEC’s 2022 Pay-Versus-Performance rules expanded these disclosures, requiring companies to present tabular and graphical comparisons of compensation actually paid to named executive officers (NEOs) with TSR, peer group TSR, net income, and a company-selected financial metric.
  • SEC Rule 10D-1 (Clawback Requirements): This mandates that NYSE- and Nasdaq-listed issuers adopt and enforce policies to recover incentive-based compensation if a financial restatement occurs, regardless of executive misconduct. Companies must disclose their clawback policies and any recoveries made under those policies.
  • Internal Revenue Code Section 162(m): This limits corporate tax deductions for compensation paid to covered executives to $1 million annually, eliminating the performance-based exception following the 2017 Tax Cuts and Jobs Act. Committees should consider the after-tax cost and shareholder optics when setting executive compensation levels.

Overview of Share-Based Compensation Award Types

Understanding the different forms of share-based compensation helps committees evaluate incentive alignment, cost implications, and potential shareholder impact. Here are the most common types of awards used by public companies:

  • Restricted Stock Awards (RSAs): Actual shares issued to employees, typically subject to vesting based on service or performance. Dividends and voting rights may apply during the vesting period.
  • Restricted Stock Units (RSUs): A promise to deliver shares upon vesting typically subject to vesting based on service or performance. RSUs generally do not carry voting or dividend rights until settled.
  • Stock Options: Rights to purchase shares at a fixed exercise price (often the fair market value at grant). Options typically vest over time and may be forfeited if employment ends before vesting.
  • Stock Appreciation Rights (SARs): Provide the value of share price appreciation over a specified period, paid in stock or cash, without requiring employees to pay an exercise price.
  • Performance Share Units (PSUs): RSU-like awards that vest based on achievement of predefined performance metrics such as total shareholder return, earnings per share (EPS) growth, and/or revenue targets.
  • Employee Stock Purchase Plans (ESPPs): Allow employees to purchase shares, often at a discount, through payroll deductions.

Accounting and Valuation (ASC 718)

Accounting

Under ASC 718, the accounting for share-based compensation focuses on measuring and recognizing the grant date fair value of awards over the requisite service period. The grant-date fair value represents the total compensation cost and is determined using appropriate valuation models such as the Black-Scholes, lattice, or Monte Carlo simulation, depending on the award’s structure.

The following summarizes the accounting for the most common types of awards used by public companies:

  • Expense Recognition: Expense is recognized over the requisite service period, regardless of actual stock price movements after the grant date, typically on a straight-line basis, unless the awards have performance conditions. Awards with performance conditions are only recognized to expense when the performance condition is considered probable of being met. Awards that are forfeited, except for awards with market condition, reduces the expense recognized, either by estimating and recognizing the reduction over the requisite service period or recognizing the reduction only when forfeitures occur, based on the policy a company has elected. For awards with market conditions, expense is recognized if services are provided, irrespective of whether the market condition is ultimately achieved.
  • Equity-Classified Awards: Most RSAs, RSUs, stock options, and PSUs are equity-classified because they are settled in shares and do not obligate the company to transfer cash or other assets. Expense is measured at grant-date fair value and not re-measured thereafter, reported in additional paid-in capital within shareholders’ equity.
  • Liability-Classified Awards: Awards that may be or are required to be settled in cash, awards where the employee receives a variable number of shares with a fair value that is predominately fixed, or, in situations where a company has a practice of repurchasing or settling awards in cash, among other considerations, are classified as liabilities. These awards are remeasured to fair value at each reporting date until settlement (not merely until vesting), creating potential income-statement volatility even after vesting but before payout. The total recognized compensation cost equals the fair value of the liability on the settlement date.
  • Modification Accounting: Any change to award terms (e.g., extending vesting, adjusting targets, or repricing options) generally triggers incremental expense, equal to the difference between the fair value of the award immediately after the modification less the fair value of the award immediately before the modification.

Valuation Considerations by Award Type

Below is a summary of common valuation methods and considerations to estimate the fair value for each type of award:

Award Type Typical Valuation Method Key Inputs / Assumptions Notes for Committees
RSAs / RSUs (Time-based) Stock price at grant date (intrinsic value) Stock price, expected forfeitures Simple valuation; expense adjusted for forfeitures until vested.
Stock Options Black-Scholes or lattice model Expected volatility, expected term, risk-free rate, dividend yield Longer expected terms increase value; highly sensitive to volatility assumptions.
SARs Black-Scholes or lattice model Same as options If cash-settled, liability award — remeasured each reporting period.
PSUs (Performance-based) Grant-date stock price × probability of achieving target Probability of goal attainment reassessed periodically Changes in estimated probability affect expense prospectively.
PSUs (Market-based) Monte Carlo simulation Volatility, correlation with peers, risk-free rate, dividend yield Expense fixed at grant; fair value incorporates likelihood of achieving market condition.
PSUs (Performance + Market-based) Combination approach (Monte Carlo for market component + probability weighting for performance) Inputs above Complex; careful coordination between finance and valuation specialists required.
ESPPs Black-Scholes (if discount > 5% or look-back feature) Expected term (purchase period), volatility, risk-free rate, dividend yield May qualify for non-compensatory treatment if discount ≤ 5% and offered broadly.

 

Summary

Compensation committees should balance incentive effectiveness, competitiveness and alignment with peers, shareholder alignment, transparency, and financial statement impact while maintaining compliance with accounting and SEC disclosure requirements.

Effective coordination across corporate functions ensures that compensation decisions are both compliant and strategically sound and that companies are ready for proxy season disclosures. The finance and accounting teams provide critical input on expense recognition and EPS impact, while legal counsel ensures plan documentation and insider-trading compliance. Human resources teams translate these technical requirements into practical communications and administration.

Key Questions for the Compensation Committee

As compensation committees work to align executive pay with shareholder interests, the following questions can guide them in evaluating aware metrics, understanding financial impacts, and more.

  1. How do current award metrics align with long-term shareholder value creation?
  2. What is the anticipated compensation expense and EPS impact of share-based payment awards?
  3. Are we compliant with all applicable SEC and exchange listing requirements?
  4. How does our share-based awards compare with peers?
  5. Have potential modification or repricing implications been evaluated for accounting and disclosure purposes?