Value stock options
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While option plans can take many forms, I find it useful to divide them into three types. The first two—what I call fixed value plans and fixed number plans—extend over several years. The third—megagrants—consists of onetime lump sum distributions.
The three types of plans provide very different incentives and entail very different risks. With fixed value plans, executives receive options of a predetermined value every year over the life of the plan.
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Fixed value plans are popular today. Fixed value plans are therefore ideal for the many companies that set executive pay according to studies performed by compensation consultants that document how much comparable executives are paid and in what form. But fixed value plans have a big drawback. Because they set the value of future grants in advance, they weaken the link between pay and performance.
DBA Carta, Inc. Our university and professional ties have allowed us to develop strong working relationships with economists, vocational experts and statisticians across the country. With this benefit erased, another fundamental investing metric will be shifting for many companies. The first two—what I call fixed value plans and fixed number plans—extend over several years. The technology-fueled bubble in the stock market burst and millions of options that were once profitable had become worthless, or " underwater. Welcome to the eBriefcase Management Center. Most employee stock purchase plans impose restrictions on reselling the stock purchased under the plan.
Executives end up receiving fewer options in years of strong performance and high stock values and more options in years of weak performance and low stock values. The stock price has doubled; the number of options John receives has been cut in half. He ends up, in other words, being given a much larger piece of the company that he appears to be leading toward ruin. For that reason, fixed value plans provide the weakest incentives of the three types of programs.
I call them low-octane plans. Whereas fixed value plans stipulate an annual value for the options granted, fixed number plans stipulate the number of options the executive will receive over the plan period. Under a fixed number plan, John would receive 28, at-the-money options in each of the three years, regardless of what happened to the stock price.
Here, obviously, there is a much stronger link between pay and performance.
At their best, stock options still provide a way to align employee interests with those of upper management and the shareholders, as the reward. Stock options are deceptively simple compensation contracts. When an option is exercised, its payoff rises by one dollar for each dollar the stock.
Since the value of at-the-money options changes with the stock price, an increase in the stock price today increases the value of future option grants. Likewise, a decrease in stock price reduces the value of future option grants. Since fixed number plans do not insulate future pay from stock price changes, they create more powerful incentives than fixed value plans. I call them medium-octane plans, and, in most circumstances, I recommend them over their fixed value counterparts.
Now for the high-octane model: the lump-sum megagrant. While not as common as the multiyear plans, megagrants are widely used among private companies and post-IPO high-tech companies, particularly in Silicon Valley. Megagrants are the most highly leveraged type of grant because they not only fix the number of options in advance, they also fix the exercise price. Shifts in stock price have a dramatic effect on this large holding.
Every few years since , Eisner has received a megagrant of several million shares. Since the idea behind options is to gain leverage and since megagrants offer the most leverage, you might conclude that all companies should abandon multi-year plans and just give high-octane megagrants. When viewed in those terms, megagrants have a big problem. Look at what happened to John in our third scenario. After two years, his megagrant was so far under water that he had little hope of making much money on it, and it thus provided little incentive for boosting the stock value.
And he was not receiving any new at-the-money options to make up for the worthless ones—as he would have if he were in a multiyear plan.
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It would provide him with a strong motivation to quit, join a new company, and get some new at-the-money options. Ironically, the companies that most often use megagrants—high-tech start-ups—are precisely those most likely to endure such a worst-case scenario. Their stock prices are highly volatile, so extreme shifts in the value of their options are commonplace. And since their people are in high demand, they are very likely to head for greener pastures when their megagrants go bust.
Indeed, Silicon Valley is full of megagrant companies that have experienced human resources crises in response to stock price declines. Such companies must choose between two bad alternatives: they can reprice their options, which undermines the integrity of all future option plans and upsets shareholders, or they can refrain from repricing and watch their demoralized employees head out the door. Silicon Valley companies could avoid many such situations by using multiyear plans.
The answer lies in their heritage. Before going public, start-ups find the use of megagrants highly attractive. Accounting and tax rules allow them to issue options at significantly discounted exercise prices. The risk profile of these pre-IPO grants is actually closer to that of shares of stock than to the risk profile of what we commonly think of as options.
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When they go public, the companies continue to use megagrants out of habit and without much consideration of the alternatives. But now they issue at-the-money options. What had been an effective way to reward key people suddenly has the potential to demotivate them or even spur them to quit. Some high-tech executives claim that they have no choice—they need to offer megagrants to attract good people.
Yet in most cases, a fixed number grant of comparable value would provide an equal enticement with far less risk.
With a fixed number grant, after all, you still guarantee the recipient a large number of options; you simply set the exercise prices for portions of the grant at different intervals. By staggering the exercise prices in this way, the value of the package becomes more resilient to drops in the stock price. Switching to multiyear plans or staggering the exercise prices of megagrants are good ways to reduce the potential for a value implosion.
Small, highly volatile Silicon Valley companies are not the only ones that are led astray by old habits. Large, stable, well-established companies also routinely choose the wrong type of plan. But they tend to default to multiyear plans, particularly fixed value plans, even though they would often be better served by megagrants.
Think about your average big, bureaucratic company. The greatest threat to its well-being is not the loss of a few top executives indeed, that might be the best thing that could happen to it. The greatest threat is complacency. To thrive, it needs to constantly shake up its organization and get its managers to think creatively about new opportunities to generate value. The high-octane incentives of megagrants are ideally suited to such situations, yet those companies hardly ever consider them. Why not? The bad choices made by both incumbents and upstarts reveal how dangerous it is for executives and board members to ignore the details of the type of option plan they use.
While options in general have done a great deal to get executives to think and act like owners, not all option plans are created equal. The FASB has moved against "Opinion 25", which left it open to businesses to monetise options according to their 'intrinsic value', rather than their 'fair value'. The preference for fair value appears to be motivated by its voluntary adoption by several major listed businesses, and the need for a common standard of accounting. Opposition to the adoption of expensing has provoked some challenges towards the unusual, independent status of the FASB as a non-governmental regulatory body, notably a motion put to the US Senate to strike down "statement ".
From Wikipedia, the free encyclopedia.
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How to Value Employee Stock Options. Financial Analysts Journal. September 3, Another Option on Options. Wall Street Journal. Harvard Business Review. Retrieved 29 February Namespaces Article Talk.
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Perhaps the startup will give you a faster pace of learning, and this is important to you. Or perhaps salary growth is crucial and this is going to be more likely at a scale-up. The company should be able to give you advice, or you can seek advice from an accountant. Linked to tax is knowing when to exercise your options. This essentially made the options contract worthless to anyone not wanting to stay at the company for a very long time!
Our product is the smartest way to search for entry-level jobs at startups in London. Find your next role at a fast-growing company by visiting our website. If you need any help with how to think about your options offer, or anything else to do with your next move, email me at theo otta. Why is it important to understand options? What is an option? There are three crucial elements of this contract: The number of options. This translates to the number of shares you are able to buy The strike price sometimes referred to as the exercise price. Most companies issue you with options that vest over time.
Why are you offered options in the first place? At early stage companies, having all the employees motivated to work hard is vital for making that happen. How to think about valuing your options The value of your options depends on the difference between the strike price and the value of the shares the option converts to determined by the share price. What are my options worth today? What could my options be worth in the future?