Equity settled vs. cash settled SBC

Equity settled and cash-settled share-based compensation each have their own advantages and disadvantages. When designing share-based compensation (SBC) plans, the settlement type is a crucial decision that impacts accounting, taxation, and capital markets and many other areas. Equity settled share-based compensation refers to the granting of instruments which are settled in real equity instruments like shares. In comparison, cash settled plans involve instruments that, when exercised, certify a right to receive a cash payment.

Preserving Cash

Equity settled plans offer the benefit of not requiring cash payment upon exercise, which helps to maintain the company’s liquidity. This can be particularly attractive for start-ups, growth companies, or those seeking to allocate their cash reserves towards other initiatives, such as debt repayment or returning funds to shareholders.

Dilution

Equity-settled compensation can lead to dilution of existing shareholders, which can negatively affect their share value and voting power in the company. Additionally, dilution may result in a decrease of earnings per share, which may cause the stock price to fall. In some cases, the dilution caused by share-based compensation can be significant enough to hinder the company’s ability to raise additional capital or pursue strategic opportunities. For instance, if the company needs to issue new shares to raise capital, the dilution caused by existing share-based compensation may make it more challenging to attract new investors.

Tax implications

Equity settled share-based compensation may offer tax benefits in certain jurisdictions. For instance, in the United States and some European countries, stock options are generally taxed at a lower rate compared to regular income and certain cash-settled plans. Conversely, cash settled compensation plans may not provide the same tax advantages for employees. When employees receive cash instead of shares or options, those payments are often treated as regular income and subject to ordinary income tax rates. Additionally, the company may not be able to deduct the value of the cash payments as an expense on their income statement until the payments are made to the employee.

Accounting

Equity settled plans result in the recording of capital reserves, whereas cash-settled plans create a liability. For companies with a high reliance on their debt-to-equity ratio, the benefits of equity settled plans are apparent. This can be particularly relevant in situations where the covenants of a debt issuance are based on this or similar ratios. In “IFRS, US GAAP, and many local GAAPs, equity settled grants are evaluated only once at the time of grant. This not only reduces administrative costs for valuing the grants , but also prevents an increase in expenses due to an increase in the company’s equity value, which can be especially advantageous for growth companies and startups.

Incentive effect vs. flexibility

Equity settled compensation may be more effective than cash settled compensation in retaining top talent, as employees tend to prefer having a direct stake in the company’s success. The reason for this is that cash-settled plans are often tied to other criteria, which makes it difficult for the grantees to directly trace their connection to the equity value of the company. Equity settled share-based compensation may have a disadvantage in terms of the incentive effect, which could be an advantage for cash settled plans in terms of flexibility. Cash settled plans offer a wide range of possibilities for combining cash payment with other conditions, such as internal company metrics like EBITDA or relative performance compared to an index like rTSR. This allows for a close alignment between the economic success derived from the share-based payment and the company’s objectives.

Choose wisely

Equity and cash settled share-based compensation each have their own advantages and disadvantages, and neither settlement type is universally superior to the other. However, certain characteristics of each type may be more suitable for high-growth, cash-intensive companies, while others may be better suited for established companies. Therefore, companies should carefully evaluate the pros and cons of each settlement type to ensure that the plan aligns with their goals and the needs of their target audience.