The majority of compensation of most executive pay packages comes in the form of equity, typically company stock or a derivative form of company stock. Equity compensation provides a strong incentive because it is based on the relationship between the value of the award and the performance of a company's stock price. As the value of the company increases, the value of the equity increases, providing an incentive for the executive to strive to increase the company's success and boost its market value. There are three primary types of Equity which are used in Executive Compensation:
Stock Options: A stock option gives the holder the right to purchase a share of company stock at a particular price for a set period of time, usually 10 years. The price at which the options may be "exercised" is usually the price of the company's stock on the date the options are granted. If the company performs well, the stock price will increase over the exercise price, giving the options value and rewarding the executive for his role in the company's success. Typically, such options may not be exercised for a period of time, usually between one and five years, before they "vest," or can be exercised.
Restricted Stock: Shares of company stock which, despite being awarded as compensation, are not sellable by the recipient until a vesting schedule is completed. Although unable to sell shares of Restricted Stock before the vesting schedule is complete, owners enjoy all the other benefits of stock ownership, such as voting rights and dividends. If the executive leaves before the stock vests, the stock is forfeited. Restricted Stock is taxed on the amount received on the vesting date based on the closing market value of stock price.
Restricted Stock Units (RSUs) are a similar performing compensation tool as Restricted Stock RSUs represent a promise by an employer to pay an employee a certain number of company shares upon the completion of a vesting schedule and offer several distinct advantages compared with Restricted Stock. First, employers can issue RSUs without diluting the share base. Second, in issuing RSUs company administrative costs tend to be lower because there are no actual shares to issue, hold, record, and track. And third, RSUs can make tax deferrals easier by simply delaying actual share issuance. Because RSUs represent a promise of future shares, owners of RSUs do not enjoy any rights of stock ownership.
Performance Shares: Shares of company stock awarded over a performance period if specific performance measures are attained. There are two types of performance measures: performance conditions and market conditions. Performance conditions are financial goals, like earnings-per-share or return-on-equity. Market Conditions on the other hand compare company performance to the market or a segment of the market, for example, total shareholder return v. peers. Performance periods are typically three years in duration with grants made on an almost annual basis resulting in overlapping performance periods. Performance shares receive differing accounting treatment depending on whether they are settled in cash or stock and whether they are a market or performance condition.