Do Stock Options Work as an Employee Incentive?

They’re not as popular as they were in their ’90s heyday, but stock options can still be an effective tool for driving performance.

By David Tobenkin Mar 1, 2015
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Stock options as performance incentives have been on a roller coaster ride for decades.

They were the quintessential get-rich-quick enticement used by tech startups during the dot-com boom in the late 1990s, but their star later dimmed amid allegations of abuse by unethical companies. So it’s hard for employers to know whether they are still a good, well, option.

Many executive compensation consultants say stock options are still a valuable tool—as long as employers know how and when to use them. If anything, stock options may be undervalued as a performance incentive tool, particularly as part of a long-term package.

Alternatives to Stock Options

As companies’ overall use of stock options has declined, many businesses have shifted to offering other forms of equity compensation, such as:

Restricted stock. With restricted stock, the company promises to pay shares of stock in the future based on performance or time-based vesting, without a requirement that the employee pay for them.

Phantom stock. These are not awards of actual stock, but rather a promise to pay a cash bonus equivalent to the value of company shares.

Stock appreciation rights. Similar to phantom stock, these rights award the appreciation in the value of a certain number of shares over a given period of time.

But it’s important to look at the economic big picture before making any decisions. “In a down market, options can be underwater and can create a disincentive to remain with the company, whereas restricted stocks will continue to have incentive potential,” says David Seitz, director of executive compensation at consulting firm Towers Watson’s Dallas office. “On the other hand, I’ve seen companies abandon stock options, and when I’ve asked why, they say, ‘Everyone else is.’ That is not the best-thought-out approach, either.”

A Conditional Benefit

Stock options involve awarding employees an option to purchase stock at a set price, known as the strike price or the exercise price, for a certain number of years. The strike price is usually the value of the underlying stock determined on the date the option is granted, and employees have the right to acquire the stock after the shares are vested, typically over a three- to four-year period.

Employees are economically motivated to exercise the option if the current stock price is above the strike price. The typical exercise period, also called the option term, is 10 years from the grant date, which theoretically allows enough time for the stock price to recover from a down market. In the U.S., option vesting is almost always based on years of service, although it is occasionally based on performance.

There are two types of stock options:

Non-qualified stock options. The most common type of stock options, these are taxed when they are exercised.

Incentive stock options. Taxation for these options can be deferred until the acquired stock is sold, and it occurs at more-favorable capital gain rates.

However, incentive stock options are subject to a variety of additional regulations and restrictions. For one thing, they can be awarded only to employees and are not available to board members or independent contractors. They also have a $100,000-per-employee limit on the value of stock that can vest in a given calendar year. Finally, recipients are required to hold option-generated stock for at least one year after the exercise date and for two years after the grant date in order to obtain favorable tax treatment.

Establishing value of Private Companies

According to David Seitz, director of executive compensation at consulting firm Towers Watson’s Dallas office, private companies can award stock options in one of two ways:

Using independent valuation or appraisal. This involves having an independent firm evaluate the value of the options every year.

Setting a formula. Some companies’ boards establish a formula, with stock price tied to common multiples or benchmarks that measure how the company is doing relative to similar organizations in terms of growth, profitability or other metrics. For example, the formula may be tied to earnings before interest, taxes, depreciation or amortization.

If a company’s stock price never reaches the strike price when the shares vest and during the remainder of the exercise period, both non-qualified and incentive stock options are valueless and expire “underwater.” For that reason, some companies have curtailed awards of options during periods when stock growth has lagged.

Conversely, in industries with high growth rates, such as certain tech fields, options can be a lucrative incentive. However, if the intent is to attract employees and motivate loyalty by giving them a stake in the company, the conditional nature of the options could make them less effective than some other long-term incentives that involve the award of actual stock. There is also the possibility that, if the stocks do pay off handsomely, employees may become independently wealthy and leave the company.

Stock Options Then and Now

There’s no question that companies’ use of stock options has waned in recent years. “Over the last 10 years, there has been an overall 33 percent decline in companies granting stock options, with 45 percent of large U.S. employers granting stock options in 2014 versus 66 percent 10 years ago,” Seitz says.

There are a number of reasons for this. Many people came to associate stock options with fraud and abuse in the mid-2000s, after they were liberally used by Enron and other companies. A lack of growth further diminished their appeal.

Even at larger companies, stock options typically make up less of senior leaders’ total compensation than they used to. According to the 2014 CEO Pay Strategies Reportby consultancy Equilar, 17.5 percent of the value of an average Standard & Poor 500 CEO’s 2013 pay package consisted of stock options, down from 23 percent in 2009.

Where are stock options today? As of 2012, an estimated 9 million employees in the U.S. held stock options, according to Loren Rodgers, executive director of the National Center for Employee Ownership, a nonprofit that serves as an information clearinghouse for stock ownership and equity compensation plans.

High-growth industry sectors, such as biotech and technology, are more likely to offer options. “For double-digit growth industries, stock options are phenomenal long-term wealth builders,” Seitz says.

They tend to be more common in public companies that can more easily establish stock value, notes Steve Parrish, national advanced solutions director at Principal Financial Group in Des Moines, Iowa. Starbucks and Southwest Airlines are two examples.

The largest number of stock options are awarded to individuals who can affect the fortune of the company, and at larger companies in particular, Parrish says.

Checklist for Private Employers

Experts encourage private employers thinking about using stock options to ask themselves the following questions:

  • Will offering options lead to increased employee scrutiny of management due to their vested interest in the company’s profitability as options holders?
  • Will it harm the salability of privately held businesses by complicating minority shareholder interests in the company?
  • What accounting will be needed to book the value of the stock options and the taxation of discounted stock options?
  • Can having too many shareholders convert the business into a public company under U.S. securities rules? This is a clear danger for small companies, as they will become subject to more-onerous public financial disclosure requirements.
  • Will shareholders need to approve stock option plans, including details such as classes of employees and others eligible for the options? What about the number of shares of company stock reserved for issuance under the plan?
  • Do employers have the right to repurchase shares if an options holder leaves the company?
  • What is the vesting treatment of stock options if the company undergoes a change in control? Recently, there has been a global shift away from vesting based solely on a change in control of the employer (“single trigger” vesting) toward a condition that also considers termination of the employee (“double trigger” vesting).

They are also common among startups. “My client base is primarily privately held companies that are startups looking forward to a liquidity event like an initial public offering [IPO] or the sale of the company to a larger company,” says Alison Wright, a partner in the San Francisco office of law firm Hanson Bridgett LLC. Pretty much across the board, startups offer stock options to employees, even at companies loaded with cash, because the offering reflects the company’s potential, she says: “Employees get in early, get options at a low price, and then there is a liquidity event that dramatically raises the value of the company stock, which is where employees expect to make the big bucks.”

Consider the November 2013 IPO of social media giant Twitter. Twitter executive Ali Rowghani exercised 300,000 stock options at 84 cents each and sold the shares for $33.76 per share, resulting in a $9.9 million profit.

Many companies tend to offer restricted stock to entry-level employees; a mixture of 50 percent time-vested restricted stock and 50 percent performance-based shares to more-senior-level employees; and a mixture of stock options, performance-based shares and time-vested restricted shares to the most-senior executives.

Evaluating Options

Should you grant stock options broadly or target them to senior management? There are pros and cons to each approach.

“Most tech companies, especially in the San Francisco Bay Area and Silicon Valley, grant options to everyone, even though the CEOs get more of them,” Wright says. “That can foster teamwork and creativity in a startup company. On the other hand, in some industries and in some geographic locations, it is likely that lower-paid employees would rather have extra cash, which is easier to understand and to spend.”

The timing of stock option awards varies. “There is no right or wrong when it comes to methodology, and many times it is unique to the culture and ethos of each company,” says Carrie Kovac, West Coast regional vice president at E-Trade Financial Corporate Services, an equity compensation plan manager. Most companies award stock options annually as part of total target compensation, and many tech companies give them throughout the year. To compete for talent, some employers offer stock options at the time of hire. “Performance is often also a factor in the award frequency and grant size,” Kovac says.

“We have even seen a few companies that let their employees decide,” she says. “Employees can choose their compensation ‘mix’—for example, 60 percent total compensation in stock and 40 percent in salary.”

The amount of stock to provide employees is also a key question. It’s best not to think of it as a percentage of all shares outstanding, Rodgers says. “Instead, look at it from the perspective of the employee. The point is how to align the incentive with what will motivate them. What percentage of base pay [do you want it to be]? It will be different percentages for different companies.”

Employers that decide to offer stock options must clearly communicate the benefit’s value to employees. An October 2014 report from UBS Wealth Management Americas found that 60 percent of employees do not place significant value on equity awards.

The survey identified three actions companies can take to involve employees and drive engagement around equity compensation plans:

Drive a strong culture. There is a correlation between a strong corporate culture and employees’ belief in the future prospects and value of equity awards at their organization.

Ensure that the plan design is straightforward. If employees can easily understand the plan, they are more likely to grasp the value of the awards.

Deliver personalized advice. Targeted communication, including offering one-on-one conversations between employees and business or financial specialists, will help explain the value of equity benefits and their place in employees’ overall financial plans.

“When employees believe that companies perform highly in these three areas, they place significantly more value on their equity awards,” says Michael Barry, head of Weehawken, N.J.-based UBS Equity Plan Advisory Services.

The UBS research found that stock options were viewed by employees as one of the more complicated performance incentives, second only to performance shares. Thus, it’s important that employers offering stock options also offer support if they want their employees to properly value and leverage the benefit.

While stock options may not seem as sexy as they did during the Internet gold rush of the ’90s, they’re still well worth considering as performance incentives. And offering clear communication and support will help make them an even better option.

David Tobenkin is a freelance writer based in the Washington, D.C., area.

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