Employee Compensation: Salary or Stock Options?
Recently, stock options as a method of compensation have become increasingly popular. Within start-ups and tech firms, they’re often a go-to strategy in addition to or in place of a salary. And while there’s no standardized mathematical equation to determine the make-up of salary and/or stock options, what employers should consider is how the balance between the two can affect your current and prospective employees.
The Know-How On Stock Options
A stock option, sometimes referred to as employee stock options (ESOs), gives an employee the right to purchase a share of the company at a fixed price for a specified period of time. Typically, employees only get to exercise their options upon a liquidity event with the most common being an initial public offering (“IPO”). There may also be a vesting period or schedule where a portion of the shares are granted to an employee on a yearly basis for a specific number of years to prevent employees from simply exercising their options and leaving.
There are many reasons why an employer may want to offer a stock option:
- To preserve cash as stock options don’t require liquid cash, whereas salaries do
- To attract new employees
- To motivate current employees as performance incentives
- To keep employees within the company (the main reason behind vesting schedules)
Important Things to Consider
Usually, stock options are great where they provide employees another avenue for income, but in some cases, they’re trading salary for them which is where things get tricky. Take, for example, an offer is made to a candidate that lists a slightly lower-than-market-rate salary, but is compensated by stock option or equity offer. The question is: is this a good offer?
Well, that depends on the candidate’s risk tolerance and the future outlook of the company. If the company is relatively new, you can never truly know how the market will react to the stock when it goes public, as many start-ups will only exercise options upon an IPO. In cases where the liquidity date is unknown, or the stock performs poorly upon the event or the company itself goes under, the options themselves are then either unknown in terms of value or hold no value at all.
The best option in a majority of cases, as stated by Jeff Rose, a certified financial planner, is to give employees cash compensation that they are comfortable with and add stock options on top. This way, there is no real cost to the employee in terms of reduced salaries. This also ensures your employees don’t leave looking for better paying opportunities and reduces the level of risk associated with connection of the options to the stock market.
Of course, each candidate and company are different, perhaps the position is exactly what the candidate is looking for in terms of experience, maybe they prefer working in a fast-paced environment or they believe in the company’s future growth and valuation. Regardless, it’s important to make sure there’s a fit between both the candidate and the position.
There are many variables to consider when discussing compensation. As an employer, it’s important that you communicate these terms clearly to your team members to prevent misunderstandings or resentment. Stock-options can be a great way to incentive or attract top talent — you just have to do the math for it.