1.0 IntroductionI keep reading that share-based compensation is bad, is evil, and it dilutes existing shareholders.I’ll argue the opposite: that share-based compensation is good. Yes, it dilutes the existing shareholders, but saying that in isolation sounds as if there’s a choice to completely avoid that. That choice doesn’t exist.Employees can be compensated:Fully in cashPartly in equity (where the share-based compensation comes in)2.0 ScenariosLet’s for a moment assume that we’re looking into an unprofitable company that has high growth and is innovative. Let’s assume that it’ll take 10 years until the company breaks even. There are two options:Option 1: Compensate employees partly with shares, so the gap that exists in these 10 years doesn’t require additional funding. This leads to dilution.Option 2: Raise funds (whether from existing or new investors) and compensate employees in cash. This leads to dilution.Dilution happens anyway. The second comes with additional costs and is ultimately more expensive:Underwriting spreadIf there are new investors and the funding is significant, they’ll demand a discount to the market priceLegal fees, filing requirementsRoadshows and time of the management to “sell” the visionYou might wonder, well, what if this is not an unprofitable company, then what?3.0 Benefits of share-based compensationWhen employees own shares in the company, especially through share-based compensation, two things happen:First, the shares vest over time, so they’re incentivized to stay within the company. Leaving means forfeiting the equity compensation. If you own a company or have run a department before, you know there’s a cost to replacing an employee (hiring time, but even more important, training). Having a reason to stay means lower turnover.Second, they’re more motivated to increase the value of the company, as they directly benefit from it.As an investor, I would be thrilled if the employees had the same incentives as me.4.0 Types of share-based compensationMany read about share-based compensation, see the dilution, and “advise” against it, as if it’s a button to click and turn off. Removing share-based compensation means replacing it with cash compensation. There is no free lunch. Now let’s have a look at the types of share-based compensation:4.1 Restricted stock units (“RSUs“)In order for employees to get the RSUs, they need to remain in the company, as the shares vest over time (3-5 years is quite common). Does that mean they can just leave after this period without any penalty? Not really. A “vesting plan” starts every year. So there are always shares that are vesting.4.2 Stock optionsStock options give employees the option to buy shares of the company at today’s share price. You might wonder, well, they can already do that. The difference is that they can use this option in the future. If the share price is $100 today but $150 in 2 years, they can use the option, buy the share at $100, and sell it at $150. For the option to be used, they need to remain part of the company, and the incentive to increase the company’s value is still there.4.3 Employee stock purchase plan (“ESPP“)This allows the employees to buy shares of the company at discounted prices, but the shares cannot be sold for a certain period of time.4.4 Performance sharesMost common for executives and are rewarded based on targets (revenue/profitability are most common).Here’s the important part. The employees also share the risk. If the company doesn’t do well, their compensation (measured in equity) would be lower; the stock options might be worthless; they might not make any profit on their employee stock purchase plan; and they might not get performance shares.The only part that is important to be careful with is the cash-flow statement, as this is a non-cash expense. Ignoring it and using free cash flow without adjusting for share-based compensation leads to ignoring the impact it has.I hope you found this post valuable.The Finance Corner is a reader-supported publication. To receive new posts and support my work, consider becoming a free or paid subscriber.