By Sal Bommarito
During the past few decades, high tech companies have used stock options, in lieu of high cash compensation to lure, retain and incentivize employees at every level. Stock options (and restricted stock awards) have been used for a much longer time to compensate senior corporate executives.
Many tech companies are cash starved when they go into business . Investors provide funds for growth and for research and are resistant to using their money to fund excessive compensation. As an alternative, companies drive down cash compensation by bestowing stock options on their employees that enable workers to buy stock at a pre-initial public offering price for an extended period of time.
As an example, assume a new employee deserves compensation of $100,00 based upon his experience. A tech company could offer him $70,000 in salary and stock worth $30,000 for the first year. If the enterprise grows rapidly, as most tech companies hope they will do, the valuation of the company could double or triple in a few years and even be ten-fold by the time the company goes public.
So, the new hire’s initial stock options (he would probably receive more over time at higher conversion prices) might be worth $60,000, $90,000 or $300,000 in a relatively short period of time. Receiving stock instead of cash would be very rewarding in these instances. But, if the company stumbles, the options could be valueless, and the new hire would have been better off had he received cash.
Successful tech companies sometimes opt to pay large portions of compensation in stock to conserve cash, even after an IPO. Another reason they opt to do so is to retain employees. Usually, stock options vest over several years, meaning that employees must stay employed at the company for a specific number of years to be able to convert the options into cash. This effectively helps retain key and critical employees because they would lose significant value if they left the company before the options were fully vested.
Also, and most important, is that options give employees a longer-term perspective relating to the company’s success. Obviously, they will receive less value if the company is not so successful (or possibly nothing). So, they have the same risk as management and outside stockholders.
In recent years, the investment community has been paying close attention to the magnitude of stock incentives being provided by tech companies (See the following article). For one thing, stock paid in lieu of cash compensation is an expense, even though it is not a cash item. So, it should be considered part of the company’s employee compensation currently. From and accounting perspective, it is deducted like any compensation expense.
Additionally, in a successful company, the most expensive way to provide compensation is with equity. Paying a $25,000 bonus, as opposed to a $25,000 stock option, could be much less expensive if the company is growing successfully. Investors, including public shareholders, generally would like to see less stock distributed as compensation over time notwithstanding the benefits to the company and the employees described earlier.